Heterogenous Regulation Europlace Insitute of Finance Grant Frédéric Malherbe and Wolf Wagner LBS & Tilburg Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 1 / 27
Recent regulatory initiatives aim to increase the reach of banking regulation Following the experience of the crisis of 2007-2008, there is debate on whether to extend banking-style regulation beyond the traditional banking sector. Some examples: Dodd-Frank gives FED the power to regulate all institutions of systemic importance Regulating shadow banking system is top priority for FSB G20 leaders consider regulation of securitization and money market funds Investment banks became BHCs and are now in the regulated depository sphere Solvency II requires insurance companies to hold capital like banks ("Basel for insurers") Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 2 / 27
Rationale for increasing bank-style regulation: Avoid regulatory arbitrage Make sure all parts of …nancial systemic are regulated . . However, it is not necessarily optimal to regulate all parts of …nancial system in same way More homogeneity in …nancial system leads to similar behaviour 1 (ex-post) We may want a diversity of activities being undertaken in the 2 …nancial system (ex-ante) Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 3 / 27
Homogeneity has increased in recent years Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 4 / 27
A model of heterogenous regulation If di¤erent activities can be undertaken in the …nancial system, it may be optimal to regulate them di¤erently Traditional activity: Requires less unique skills and less susceptible to incentive problems Safe but low return Examples: community bank lending, mortgage and consumer loan lending (institutions that carry out such activities: commercial banks) Fancy activity: Highly dependent on e¤orts and skills of managers High start-up cost and potentially high return Examples: …nancial innovation, funding of new and high-risk activities (institutions that carry out such activities: hedge funds, investment banks, private equity funds) ) Optimal regulation of institutions (considered in isolation) may hence depend on which activities they carry out Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 5 / 27
A model of heterogenous regulation Institutions that specialize in these activities will also interact with each other, in particular in times of crisis: Access to common pools of liquidity for liquidation of assets 1 Institutions may buy assets from each other 2 Optimal sectoral regulation not determined in isolation. In particular, it may be optimal to design di¤erent regulatory environments, one with light regulation and another one with strict regulation Light regulation provides environment for fancy activities to be 1 undertaken But light regulation is only optimal because at the same time there is 2 a traditional sector is heavily regulated. Traditional sector acts as "backstop". Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 6 / 27
Existing work on shadow banking and regulation Allen and Carletti (2006) and Allen and Gale (2005), credit risk transfer between the banking sector and the insurance sector can cause spillbacks to the banking sector when there are failures in the insurance sector. This is because following the transfer of risk, the insurance sector invests in the same assets as the banking sector. When there is a systemic event in the insurance sector, these assets are then liquidated. This depresses their price and can, in turn, cause bankruptcies in the banking sector. Gennaioli, Shleifer, and Vishny (2012) show that an increase in investors’ wealth drives up securitization. This also introduces fragility because banks become interconnected and more exposed to systemic risk. In their model, securitization is also welfare improving and only subject to crises when agents neglect those systemic risk. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 7 / 27
Existing work on shadow banking and regulation Acharya, Schnabl, and Suarez (2013) show that the banks that used ABCP more intensively before the recent crisis were also the banks that were more heavily constrained by regulation, hence arguing that these conduits were e¤ectively used to avoid regulatory pressures and to reduce capital requirements Plantin (2012): If shadow banking cannot be perfectly regulated, it may be optimal not to regulate traditional banking system too much because risk is then pushed in shadow banking system Ordonez (2013): Shadow banking spurs when outside investors believe that capital requirements are not critical to guarantee the quality of banks’ assets (reputation concerns -discipline bank behavior). However, reputation concerns collapse when bad news about the future arise. Investors stop believing in the self-discipline of banks, moving their funds to a less e¢cient, but safer, traditional banking. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 8 / 27
Setup There are three dates: t = 0 , 1 , 2 There is a measure 1 of bankers endowed with two investment opportunities, scaleable up to one unit. The liability side of banks is given: equity e and (demand) deposits d = 1 � e The two long-term technologies convert date-0 funds into funds at date 2 traditional activity: unit return of R > 1 at date 2 fancy activity: unit return of R + b at date 2 but requires private …xed cost of k < b (that is, if operated at full scale, fancy project dominates the traditional one) choice of activity is private information but the scale of the activity is not. There is also a standard storage technology (liquid asset) which translates one unit of funds at t into one unit at t + 1 Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 9 / 27
Setup Liquidity risk With probability π ( 2 ( 0 , 1 ) ) no depositor withdraws at date 1 With probability 1 � π , a mass λ ( 2 ( 0 , d ) ) of depositors withdraws Liquidation technology and externality There is a liquidation technology which at date 1 transforms 1 unit of the long-term project into φ ( l ) � 1 units of the consumption good, where l is the aggregate amount liquidated The function φ ( . ) is decreasing. The liquidation technology creates an externality as individual bankers take φ as given (externality could for instance arise from …re-sales) We assume no insolvency. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 10 / 27
Homogenous regulation The regulator sets a single regulatory requirement that applies to all bankers. We denote with x a banker’s investment in liquid assets. Total investment in illiquid projects is hence y = 1 � x . We can think of regulation as either a liquidity requirement x or a constraint on illiquid activities y = 1 � x . Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 11 / 27
Banker’s optimization problem A banker has to decide how much to invest in illiquid activities and how to split this investment among the two technologies. Due to liquidation externality, the banker’s private bene…ts from investing in illiquid activities are higher than the social ones. It follows that the regulatory constraint y will be binding for the banker. The banker hence chooses the maximum permissible extent of illiquidity: y = y . In addition, a banker will never mix fancy with traditional projects due to the …xed cost of investing in fancy projects. His optimization problems thus boils down to choosing whether to invest y in the traditional of the fancy activity. The expected utility from undertaking the traditional activity is given by v T = π ( yR + x � d ) + ( 1 � π ) (( y � l ) R + x � ( d � λ )) , (1) where l denotes amount that has to be liquidated at t = 1 in case depositors withdraw. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 12 / 27
Banker’s optimization problem How much has to be liquidated? Liquidity needs are λ � x and liquidation proceeds are l φ , thus liquidations are given by l = λ � x . (2) φ Using that x = 1 � y and y = y , we can simplify (1) to v T = yR + 1 � y � d � ( 1 � π ) ( lR � λ ) , (3) where ( 1 � π ) ( lR � λ ) is the expected cost due to liquidations. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 13 / 27
Banker’s optimization problem Similarly, we can derive the expected utility from undertaking the fancy activity v F = y ( R + b ) + 1 � y � d � ( 1 � π ) ( lR � λ ) � k . (4) It follows that the banker will choose the fancy activity i¤ yb � k . (5) y = k This gives a critical threshold b b such that banker "goes for fancy" if y � b y , and undertakes traditional activities if y < b y . Intuition: Given that there are …xed costs of undertaking the fancy activity, the banker has to get su¢cient bene…ts from undertaking this activity in order to make it worth his while. This means that regulation has to be su¢ciently light to allow him to operate the fancy activity a large scale. Malherbe and Wagner () Heterogenous Regulation LBS & Tilburg 14 / 27
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