The Redistributive Effects of Financial Deregulation 1 Anton Korinek - - PowerPoint PPT Presentation

The Redistributive Effects

• f Financial Deregulation1

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 2006Q3 2008Q3 2010Q3 2012Q2 2500 3000 3500 4000 4500 5000 5500

• Bil. $

Bank equity 2006Q3 2008Q3 2010Q3 2012Q2 71 72 73 74 75 76

• Pct. Rate

Real wage bill 2006Q3 2008Q3 2010Q3 2012Q2 120 140 160 180 200 220 240 Index Commodity price index (metals) 2006Q3 2008Q3 2010Q3 2012Q2 1 2 3 4 5 6

• Pct. Rate

Spread on risky borrowing 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

1

Financial sector is special:

◮ exclusive in its ability to intermediate capital to real economy

→ at the heart of a modern economy

2

Financial markets are incomplete:

◮ 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

1

Risk-taking by the financial sector leads to:

◮ 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

2

Channels that affect equilibrium risk-taking:

◮ 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

1

Risk-taking by the financial sector leads to:

◮ 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

2

Channels that affect equilibrium risk-taking:

◮ 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

• n financial regulation:

traditional argument: offset moral hazard arising from safety nets e.g. Bagehot (1873), ...

• n optimal bank capital levels:

e.g. Admati et al. (2010), Miles et al. (2012), ...

• n the macroeconomic effects of losses in the financial sector:

e.g. Gertler and Kiyotaki (2010), Gertler and Karadi (2011), ...

• n 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 ≤ φRk

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 wℓ, 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) = Akαℓ1−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. Fk(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 + φkFk(k, 1) In summary, k′(e) =

• 1

1−φαFk > 1

for e < e∗ 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: w′(e) = (1 − α)Fk · k′(e) for e < e∗ for e ≥ e∗ Marginal value of aggregate bank equity for bankers: π′(e) = (1 − φ)αFk · k′(e) for e < e∗ 1 for e ≥ e∗

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 17 / 32

Benchmark Model Period 1 Equilibrium

Marginal Value of Bank Equity

Marginal value of bank capital perceived by banker i: π1

• ei, e
• =

1 + [R(e) − 1] · k1

• ei, e
• =

(1 − φ)Fk 1 − φFk Compare with bankers collectively: π′(e) = (1 − φ)αFk 1 − φαFk Note that for e < e∗, we have: π′(e) < π1(e, e)

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 18 / 32

Benchmark Model Period 1 Equilibrium

Marginal Value of Bank Equity

e* e s(e) w(e) π(e) e* e 1 π1(ei,e) w’(e) π’(e) Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 19 / 32

Benchmark Model Period 0 Equilibrium

Period 0 Problem

In period 0, bankers choose xi ∈ [0, 1] to solve: max

xi∈[0,1],ei Πi

xi; x

• = E
• π
• ei, e
• s.t.

ei =

• 1 − xi

+ ˜ Axi Equilibrium xLF satisfies E

• π1
• ei, e

˜ A − 1

• = 0

Analogous expressions for workers xW and bankers xB collectively

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 20 / 32

Benchmark Model Pareto Frontier

Pareto Frontier

Proposition (Pareto Frontier)

(i) The preferred risk allocations of workers and bankers satisfy xW < xB (ii) Over the interval

• xW, xB

, worker welfare W (x) is strictly decreasing in x banker welfare Π (x) is strictly increasing in x (iii) Equilibrium risk-taking satisfies: bankers collectively prefer xB > xLF if e∗ ≤ 1, workers prefer xW < xLF

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 21 / 32

Benchmark Model Pareto Frontier

Pareto Frontier

xW xB xLF W Π

Figure: Risk-taking by the financial sector has distributive effects

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 22 / 32

Benchmark Model Pareto Frontier

Intuition for Distributive Conflict

Consider two polar cases:

1

Model without financial constraint:

◮ financial intermediation does not depend on bank capital

(capital imposes no pecuniary externalities)

→ no distributive conflict over risk-taking

2

Model of capitalists and workers (no intermediation/storage):

◮ capitalists earn profit π = αF(e, 1) ◮ workers earn wage

w = (1 − α)F(e, 1) (capital imposes symmetric pecuniary externalities on wages)

→ no distributive conflict Our framework: asymmetric externalities on the downside, but not upside

• ccasionally binding constraints lead to redistributive conflict

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 23 / 32

Equilibrium Risk-Taking Overview

Equilibrium Risk-Taking

Channels that affect equilibrium risk-taking: financial deregulation market power financial innovation bailouts → shift surplus from Main Street to Wall Street

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 24 / 32

Equilibrium Risk-Taking Financial Regulation

Financial Regulation

Two simple forms of regulation of risk-taking: quantity intervention x = ¯ x or ceiling x ≤ ¯ x tax on risk-taking τ x

Corollary (Financial Regulation)

(i) A quantity intervention x = ¯ x or a tax τ x can implement any risk allocation on the Pareto frontier (ii) A risk ceiling x ≤ ¯ x implements any allocation xR ≤ xLF (iii) Lowering x increases worker welfare and reduces banker welfare

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 25 / 32

Equilibrium Risk-Taking Financial Regulation

Pareto-Improving Deregulation?

→ needs to compensate workers for higher crisis risk uncontingent transfer at t = 0 or 1 doesn’t work: → tightens constraint in low states uncontingent transfer at t = 2: emulates LT debt stake, substitutes for limited pledgeability contingent transfer in good states of t = 1: emulates equity stake, substitutes for missing risk markets → could be implemented as excess profit tax/bonus tax Deregulation can only create Pareto-improvement if we can overcome one of the two financial imperfections

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 26 / 32

Equilibrium Risk-Taking Market Power

Market Power

Suppose there are n banks of mass 1/n e = 1

nei + n−1 n e−i

Marginal value of equity is increasing in n: πi,n

1 (ei, e−i) = 1

n · π′(e) + n − 1 n · πi

1(ei, e)

Large bankers worry less about credit crunches since they internalize that constraints push up lending rate R(e)

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 27 / 32

Equilibrium Risk-Taking Financial Innovation

Financial Innovation

Important dimension of financial innovation: new assets Simplest case:

◮ initially only safe asset ◮ then introduce risky asset ˜

A

◮ banks choose x > 0

→ total surplus increases → workers unambiguously worse off (assuming e∗ ≤ 1)

Equivalent to deregulation (raising ¯ x from 0) Holds for any innovation that raises riskiness of bank portfolio

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 28 / 32

Equilibrium Risk-Taking Bailouts

Bailouts

In credit crunch, workers collectively benefit from bailouts: Wages w(e) increasing in aggregate bank equity Bailout threshold ˆ e is determined by w′(e) = Fℓk(k(e), 1) · k′(e) = 1 (marginal increase in wage bill equals marginal cost of bailout) Optimal bailout transfer t(e) = max{0, ˆ e − e}

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 29 / 32

Equilibrium Risk-Taking Bailouts

Bailouts

Ex-Post: bailouts substitute for incomplete insurance markets but involve transfer from workers to bankers Ex-Ante: bailouts increase incentive for risk-taking (“moral hazard”) this exacerbates negative externalities on Main Street ex-ante effects often outweigh ex-post effects → bailout guarantees cause redistribution even if no monetary cost

Korinek and Kreamer (JHU and UMD) Redistributive Effects of Deregulation NBER SI 2013 30 / 32

Equilibrium Risk-Taking Bailouts

Pareto Frontier

xW xB xBL xLF ∆ Π ∆ W W Π

Figure: Bailouts are akin to “banker-biased” technological progress

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Conclusions

Conclusions

Level of financial risk-taking affects the real economy:

◮ bank capital has characteristics of a public good ◮ low bank capital has negative externalities

→ distributive conflict Financial risk-taking is affected by:

1

financial regulation/deregulation

2

market power

3

government safety nets

4

financial innovation

→ exacerbate distributive conflict

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