The Redistributive Effects of Financial Deregulation 1 Anton Korinek Jonathan Kreamer Johns Hopkins and NBER University of Maryland Presentation at the NBER Summer Institute (EFCE) July 2013, Cambridge, MA 1Financial support from INET is gratefully acknowledged. Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 1 / 32
Introduction Motivation Motivation Trends over the past decades: financial deregulation increasing ‘size’ of financial sector crises with devastating effects on real economy Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 2 / 32
Introduction Motivation Motivation ������������������������������������� �� �� �� �� �� �� �� � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � �������������������� ���������������������� Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 3 / 32
Introduction Motivation Motivation ������������������������������������������ ����� ���� ����� ���� ����� ���� ����� � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � ����������� ����������������������������������� Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 4 / 32
Introduction Motivation Motivation Deregulation allows financial sector to: take on greater risk earn higher expected return BUT: financial risk-taking can hurt the real economy: losses in financial sector capital lead to credit crunch steep declines in output, wage earnings, etc. = negative externalities on the real economy → Led to calls from Main Street for tighter regulation → Fiercely opposed by Wall Street Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 5 / 32
Introduction Motivation Bank equity Real wage bill 76 5500 75 5000 4500 Pct. Rate 74 Bil. $ 4000 73 3500 3000 72 2500 71 2006Q3 2008Q3 2010Q3 2012Q2 2006Q3 2008Q3 2010Q3 2012Q2 Commodity price index (metals) Spread on risky borrowing 6 240 5 220 200 4 Pct. Rate Index 180 3 160 140 2 120 1 2006Q3 2008Q3 2010Q3 2012Q2 2006Q3 2008Q3 2010Q3 2012Q2 Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 6 / 32
Introduction Motivation Further Motivation Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 7 / 32
Introduction Contribution Key Questions Objective of this paper: develop a formal model to analyze: How does risk-taking by banks affect the distribution of surplus in the economy? What are the distributive effects of different financial policies? ◮ restrictions on risk-taking ◮ bailouts Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 8 / 32
Introduction Contribution Key Considerations Financial sector is special: 1 ◮ exclusive in its ability to intermediate capital to real economy → at the heart of a modern economy Financial markets are incomplete: 2 ◮ banks need to have skin in the game → bank capital matters ◮ individuals cannot perfectly share risk → redistributions matter Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 9 / 32
Introduction Contribution Key Results Risk-taking by the financial sector leads to: 1 ◮ externalities on the real economy when downside risk materializes (credit crunch, output collapse, ...) ◮ financial sector does not internalize these when trading off risk vs. return → Wall Street prefers more risk than Main Street → distributive conflict Channels that affect equilibrium risk-taking: 2 ◮ financial deregulation ◮ market power in the financial sector ◮ bailouts ◮ financial innovation → shift surplus from Main Street to Wall Street Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 10 / 32
Introduction Contribution Key Results Risk-taking by the financial sector leads to: 1 ◮ externalities on the real economy when downside risk materializes (credit crunch, output collapse, ...) ◮ financial sector does not internalize these when trading off risk vs. return → Wall Street prefers more risk than Main Street → distributive conflict Channels that affect equilibrium risk-taking: 2 ◮ financial deregulation ◮ market power in the financial sector ◮ bailouts ◮ financial innovation → shift surplus from Main Street to Wall Street Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 10 / 32
Introduction Contribution Literature Relationship to the Literature on financial regulation: traditional argument: offset moral hazard arising from safety nets e.g. Bagehot (1873), ... on optimal bank capital levels: e.g. Admati et al. (2010), Miles et al. (2012), ... on the macroeconomic effects of losses in the financial sector: e.g. Gertler and Kiyotaki (2010), Gertler and Karadi (2011), ... on incomplete markets and pecuniary externalities: e.g. Lorenzoni (2008), Korinek (2010), ... Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 11 / 32
Benchmark Model Model Setup Benchmark Model Benchmark model: two agents: ◮ bankers (Wall Street): allocate capital ◮ workers (Main Street): provide labor, own firms linear utility single homogenous good three time periods t = 0 , 1 , 2 Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 12 / 32
Benchmark Model Model Setup Benchmark Model Bankers: Period 0: ◮ born with 1 unit of capital ◮ invest fraction x ∈ [ 0 , 1 ] in risky return ˜ A with E [˜ A ] > 1 ◮ remainder 1 − x earns safe return 1 Period 1: ◮ return shock ˜ A determines bank equity: e = ˜ Ax + ( 1 − x ) ◮ raise deposits d at deposit rate r ◮ rent out k = d + e at lending rate R ◮ financial constraint as e.g. in Holmstrom-Tirole: rd ≤ φ Rk Period 2 payoff: Π = Rk − rd Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 13 / 32
Benchmark Model Model Setup Benchmark Model Workers: Period 1: ◮ born with large endowment of good ◮ supply ℓ = 1 unit of labor at wage w to firms ◮ supply d units of capital at deposit rate r to bankers Period 2: ◮ receive wage bill w ℓ , return on deposits rd and consume Firms: collectively owned by workers Period 1: ◮ rent capital k from banks at price R ◮ hire labor ℓ from workers at wage w Period 2: ◮ produce output F ( k , ℓ ) = Ak α ℓ 1 − α ◮ pay banks, workers → zero profits Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 14 / 32
Benchmark Model First-Best First-Best Maximize Total Surplus Employment ℓ = 1 Capital investment k ∗ s.t. F k ( k ∗ , 1 ) = 1 Risk-taking x ∗ = 1 since E [˜ A ] > 1 Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 15 / 32
Benchmark Model Period 1 Equilibrium Laissez-Faire Equilibrium: Backward Induction Period 1 and 2 Allocations for given bank equity e : First-best level of capital intermediation is feasible iff e ≥ e ∗ := ( 1 − φ ) k ∗ If e < e ∗ , then k ( e ) is solution to implicit equation k = e + φ kF k ( k , 1 ) In summary, 1 � 1 − φα F k > 1 for e < e ∗ k ′ ( e ) = 0 for e ≥ e ∗ → bank equity matters for real economy when financial constraint is binding Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 16 / 32
Benchmark Model Period 1 Equilibrium Marginal Value of Bank Equity Marginal value of aggregate bank equity for workers: � ( 1 − α ) F k · k ′ ( e ) for e < e ∗ w ′ ( e ) = for e ≥ e ∗ 0 Marginal value of aggregate bank equity for bankers: � ( 1 − φ ) α F k · k ′ ( e ) for e < e ∗ π ′ ( e ) = 1 for e ≥ e ∗ Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 17 / 32
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