Systemic Risk And Regulation - Wharton Finance
Systemic Risk and Regulation Franklin AllenDepartment of FinanceWharton SchoolUniversity of PennsylvaniaPhiladelphia, PA 19104allenf@wharton.upenn.eduDouglas GaleDepartment of EconomicsNew York University269 Mercer StreetNew York, NY 10003douglas.gale@nyu.eduJanuary 4, 2006AbstractHistorically, much of the banking regulation that was put in placewas designed to reduce systemic risk. In many countries capital regulation in the form of the Basel agreements is currently one of the mostimportant measures to reduce systemic risk. In recent years there hasbeen considerable growth in the transfer of credit risk across and between sectors of the financial system. In particular there is evidencethat risk has been transfered from the banking sector to the insurancesector. One argument is that this is desirable and simply reflects diversification opportunities. Another is that it represents regulatoryarbitrage and the concentration of risk that may result from this could We are grateful to our discussant Charles Calomiris and other participants at theNBER Conference on "The Risks of Financial Institutions" held in Woodstock, Vermont,October 22-23, 2004, our discussant Martin Hellwig and other participants at the CFSConference on "Risk Transfer between (Re-)Insurers, Banks, and Markets" held in Frankfurt, June 10-11, 2005, and our discussant Charles Kahn and other participants at theBank of Portugal Conference on "Financial Fragility and Bank Regulation" held in Lisbon, June 24-25, 2005. Finally, we also thank the editors, Mark Carey and Rene Stulz,for their very helpful comments on an earlier version and Florian Preis for pointing outan error in a previous version.1
increase systemic risk. This paper shows that both scenarios are possible depending on whether markets and contracts are complete orincomplete.1IntroductionThe experience of banking crises in the 1930s was severe. Before this assuringfinancial stability was primarily the responsibility of central banks. The Bankof England had led the way. The last true panic in England was associatedwith the collapse of the Overend, Gurney and Company in 1866. Afterthat the Bank avoided crises by skilful manipulation of the discount rate andsupply of liquidity to the market. Many other central banks followed suit andby the end of the nineteenth century crises in Europe were rare. Althoughthe Federal Reserve System was founded in 1914 its decentralized structuremeant that it was not able to effectively prevent banking crises. The effectof the banking crises in the 1930s was so detrimental that in addition toreforming the Federal Reserve System the US also imposed many types ofbanking regulation to prevent systemic risk. These included capital adequacystandards, asset restrictions, liquidity requirements, reserve requirements,interest rate ceilings on deposits, and restrictions on services and productlines. Over the years many of these regulations have been removed. However,capital adequacy requirements in the form of the Basel agreements remain.If properly designed and implemented capital regulations may reduce systemic risk. However, the growing importance of credit risk transfer has raisedconcerns about whether regulation as currently implemented does increasefinancial stability. The evidence reviewed below suggests that there is atransfer of risk from the banks to insurance companies. One view is that thiscredit risk transfer is desirable because it allows diversification between different sectors of the financial system that cannot be achieved in other ways.On the other hand, if the transfer arises because of ill-designed regulations itmay be undesirable. For example, regulatory arbitrage between the bankingand insurance sectors could conceivably lead to an increase in risk in the insurance sector which increases overall systemic risk. As Hellwig (1994, 1995,1998) has repeatedly argued, attempts to shift risks can lead to a situationwhere these risks come back in the form of counterparty credit risk.The purpose of this paper is to consider both arguments. We showfirstly that diversification across sectors can lead to an optimal allocation of2
resources and secondly that poorly designed and implemented capital regulation can lead to an increase in systemic risk.Our analysis builds on our previous work on financial crises (see, e.g.,Allen and Gale (1998, 2000a-c, 2003, 2004a-b) and Gale (2003, 2004)). InAllen and Gale (2004a) we argued that financial regulation should be basedon a careful analysis of the market failure that justifies government intervention. We developed a model of intermediaries and financial markets inwhich intermediaries could trade risk. It was shown that provided financialmarkets and financial contracts are complete the allocation is incentive efficient. When contracts are incomplete, for example, if the banks use depositcontracts with fixed promised payments, then the allocation is constrainedefficient. In other words, there is no justification for regulation by the government. In order for regulation to be justified markets must be incomplete.As in standard theories of government regulation it is first necessary to identify a market failure to analyze intervention. In Allen and Gale (2003) wesuggested that the standard justification for capital regulation, namely thatit controls moral hazard arising from deposit insurance is not a good motivation. The two policies must be jointly justified and the literature does notdo this.There is a small but growing literature on credit risk transfer. The firstpart considers the impact of credit risk transfer on the allocation of resourceswhen there is asymmetric information. Morrison (2005) shows that a market for credit derivatives can destroy the signalling role of bank debt andlead to an overall reduction in welfare as a result. He suggests that disclosure requirements for credit derivatives can help offset this effect. Nicoloand Pelizzon (2004) show that if there are banks with different abilities toscreen borrowers then good banks can signal their type using first-to-defaultbasket contracts that are often used in practice. These involve a paymentto the protection buyer if any of a basket of assets defaults. Only protection sellers with very good screening abilities will be prepared to use suchcontracts. Chiesa (2004) considers a situation where banks have a comparative advantage in evaluating and monitoring risks but limited risk bearingcapacity. Credit risk transfer improves efficiency by allowing the monitoreddebt of large firms to be transfered to the market while banks can use theirlimited risk bearing capacity for loans to small businesses. In contrast tothese papers, our paper focuses on the situation where there is symmetricinformation and shows how credit risk transfer can improve the allocation ofresources through better risk sharing.3
The second part of the literature focuses on the stability aspects of creditrisk transfer. Wagner and Marsh (2004) considers the transfer of risk betweenbanking and non-banking sectors. They find that the transfer of risk outof a relatively fragile banking sector leads to an improvement in stability.Wagner (2005a) develops a model where credit risk transfer improves theliquidity of bank assets. However, this can increase the probability of crisesby increasing the risks that banks are prepared to take. Wagner (2005b)shows that the increased portfolio diversification possibilities introduced bycredit risk transfer can increase the probability of liquidity-based crises. Thereason is that the increased diversification leads banks to reduce the amountof liquid assets they hold and increase the amount of risky assets. In contrastto these contributions, in our paper the focus is on the role of poorly designedregulation and its interaction with credit risk transfer in increasing systemicrisk.The rest of the paper proceeds as follows. We start in Section 2 by considering the institutional background of credit risk transfer. We consider theevidence on how important risk transfers are quantitatively and which entities they occur between. Section 3 develops a model with a banking sectorwhere consumers deposit their funds and firms borrow and repay these loanswith some probability. There is also an insurance sector. Some firms have anasset that may be damaged. They require insurance to allow this asset to berepaired if it is damaged. The equilibrium with complete markets and contracts is characterized. In this case complete markets allow full risk sharing.Section 4 develops an example with incomplete markets and contracts andshows how inefficient capital regulation can increase systemic risk. FinallySection 5 contains concluding remarks.2Institutional background on credit risk transferCredit risk has been transferred between parties for many years. Bank guarantees and credit insurance provided by insurance companies, for example,have a long history. Securitization of mortgages occurred in the 1970s. Bankloans were syndicated in the 1970s and secondary markets for bank loansdeveloped in the 1980s. In recent years a number of other methods of risktransfer have come to be widely used.4
Table 1 (BIS (2003)) shows the size of credit risk transfer markets usingvarious instruments from 1995-2002. Institutions transferring risk out arereferred to as “risk shedders” while institutions taking on risk on are referredto as “risk buyers”. One important class of instrument is credit derivatives.An example of these is credit default swaps. These are bilateral contractswhere the risk shedder pays a fixed periodic fee in exchange for a paymentcontingent on an event such as default on a reference asset or assets. Thecontingent payment is provided by the risk buyer. With asset-backed securities, loans, bonds, or other receivables are transferred to a special purposevehicle (SPV). The payoffs from these assets are then paid out to investors.The credit risk of the instruments in the SPV is borne by the investors. Theunderlying pool of assets in asset-backed securities is relatively homogeneous.Collateralized debt obligations also use an SPV but have more heterogeneousassets. Payouts are tranched with claims on the pools separated into differentdegrees of seniority in bankruptcy and timing of default. The equity trancheis the residual claim and has the highest risk. The mezzanine tranche comesnext in priority. The senior tranche has the highest priority and is oftenAAA rated.It can be seen from Table 1 that the use of all types of credit risk transferhas increased substantially. The growth has been particularly rapid in creditderivatives and collateralized debt obligations, however. Despite this rapidgrowth a comparison of the outstanding amounts of credit risk transfer instruments with the total outstanding amounts of bank credit and corporatedebt securities shows that they remain small in relative terms.Table 2 (BBA (2002)) shows the buyers of credit protection in Panel Aand the sellers in Panel B. From Panel A it can be seen that the buyersare primarily banks. Securities houses also play an important role. Hedgefunds went from being fairly insignificant in 1999 to being significant in 2001.Corporates, insurance companies and the other buyers do not constitute animportant part of demand in the market. From Panel B, it can be seen thatbanks are also important sellers of credit protection. In contrast to theirinvolvement as buyers, the role of insurance companies as sellers is significant.Securities houses also sell significant amounts while the remaining institutionsplay a fairly limited role. The results of a survey contained in Fitch (2003)are consistent with Table 2. They found that the global insurance sectorhad a net seller position after deducting protection bought of 283 billion.The global banking industry purchased 97 billion of credit protection. Asignificant amount of risk is thus being transferred into the insurance industry5
from banks and other financial institutions. However, BIS (2005) reportsthat credit risk transfer investments made up only 1 percent of insurers’total investments and their financial strength is not thereatened by theirinvolvement in these types of investment.As discussed in the introduction, these figures raise the important issueof why these transfers of risk are taking place. Is it the result of financialinstitutions seeking to diversify their risk? Alternatively, is it the result ofregulatory arbitrage and if so can this arbitrage lead to a concentration ofrisk that increases the probability of systemic collapse?We turn to the role of credit risk transfer in allowing diversification between different sectors of the economy next.3Diversification through credit risk transferWe use a simple Arrow-Debreu economy to illustrate the welfare propertiesof credit risk transfer when markets are complete. First we describe theprimitives of the model, which will be used here and in following sections.Then we describe an equilibrium with complete markets. We note that thefundamental theorems of welfare economics imply that risk sharing is efficientand, hence, there is no role for government regulation in this setting. It isalso worth noting that there is no role for capital. More precisely, the capitalstructure is irrelevant to the value of the firm, as claimed by Modigliani andMiller, and in particular there is no rationale for capital regulation. (Thispoint has been made repeatedly by Gale, 2003, 2004; Allen and Gale, 2003;and Gale and Özgür, 2005).The model serves two purposes. First, it serves to show how credit risktransfers can promote efficient risk sharing if we interpret the markets forcontingent securities in the Arrow-Debreu model as derivatives or insurancecontracts. Secondly, it provides a benchmark for the discussion of incompletemarkets that follows. By contrast with the Arrow-Debreu model, there is noreason to think that the equilibrium allocation of risk bearing is efficient whenmarkets are incomplete. So incompleteness of markets provides a potentialrole for regulation to improve risk sharing. However, as we shall see, a badlydesigned policy of capital regulation may lead to greater instability.6
3.1The basic modelThere are three dates t 0, 1, 2 and a single, all-purpose good that canbe used for consumption or investment at each date. There are two securities, one short and one long. The short security is represented by a storagetechnology: one unit at date t produces one unit at date t 1. The longsecurity is represented by a constant-returns-to-scale investment technologythat takes two periods to mature: one unit invested in the long security atdate 0 produces R 1 units of the good at date 2 (and nothing at date 1).This simple structure provides a tradeoff between liquidity and the rate ofreturn (the yield curve). Banks would like to earn the higher return offeredby the long asset, but that may cause problems because the banks’ liabilities(demand deposits) are liquid.In addition to these securities, banks and insurance companies have distinct profitable investment opportunities. Banks can make loans to firmswhich succeed with probability β. More precisely, each firm borrows oneunit at date 0 and invests in a risky venture that produces BH units of thegood at date 2 if successful and BL if unsuccessful. There is assumed to bean infinite supply of such firms, so the banks take all the surplus. (In effect,these “firms” simply represent a constant-returns-to-scale investment technology for the banks). Because we are only interested in non-diversifiablerisks, we assume that the loans made by an individual bank are perfectlycorrelated: either they all pay off or none do. This is a gross simplificationthat does not essentially affect the points we want to make.The bank’s other customers are depositors, who have one unit of thegood at date 0 and none at dates 1 and 2. Depositors are uncertain of theirpreferences: with probability λ they are early consumers, who only value thegood at date 1 and with probability 1 λ they are late consumers, who onlyvalue the good at date 2. The utility of consumption is represented by autility function U (c) with the usual properties. We normalize the number ofconsumers to 1. The form of the depositors’ preferences provides a demandfor liquidity and explains why the bank must offer a contract that allows theoption of withdrawing either at date 1 or date 2.The insurance companies have access to a large number of firms, whosemeasure is normalized to one. Each firm owns an asset that produces A unitsof the good at date 2. With probability α the asset suffers some damage atdate 1. Unless this damage is repaired, at a cost of C, the asset becomesworthless and will produce nothing at date 2. The firms also have a unit7
endowment at date 0 which the insurance company invests in the short andlong securities in order to pay the firms’ damages at date 1. The risks todifferent firms are assumed to be independent, so the fraction of firms suffering damage in any state is equal to the probability α. More importantly,the risks faced by the insurance and banking sectors are not perfectly correlated, so there are some gains from sharing risks. This in turn provides thepotential for gains from credit risk transfer.Finally, we introduce a class of risk neutral investors who provide “capital” to the insurance and banking sectors. Although investors are risk neutral, we assume that their consumption must be non-negative at each date.This is a crucial assumption. Without it, the investors could absorb all riskand provide unlimited liquidity and the problem of achieving efficient risksharing would be trivial. The assumption of non-negative consumption, onthe other hand, implies that investors can only provide risk sharing servicesto banks and/or insurance companies if they invest in real assets that providefuture income streams. The investor’s utility function is defined byu(c0 , c1 , c2 ) ρc0 c1 c2 ,where ct 0 denotes the investor’s consumption at date t 0, 1, 2. Theconstant ρ E[R] represents the investor’s opportunity cost of funds. Forexample, the investors may have access to investments that yield a very highrate of return but are very risky and very illiquid. Markets are segmentedand other agents do not have access to these assets. Banks cannot includethese assets in their portfolios, so they cannot earn as much on the capitalinvested in the bank as the investors could. This gap defines the economiccost of capital: in order to compensate the investors for the opportunity costof the capital they invest, the depositors must take a smaller payout in orderto subsidize the earnings of the investors.We can assume without loss of generality that the role of investors is simply to provide capital to the intermediary through a contract e (e0 , e1 , e2 )where e0 0 denotes the investor’s supply of capital at date t 0, andet 0 denotes the investor’s consumption at dates t 1, 2. While it isfeasible for the investors to invest in assets at date 0 and trade them at date1, it can never be profitable for them to do so in equilibrium. More precisely, the no-arbitrage conditions ensure that profits from trading assets arezero or negative at any admissible prices and the investor’s preferences forconsumption at date 0 imply that the investors will never want to invest in8
assets at date 0 and consume the returns at dates 1 and 2. An investor’sendowment consists of a large (unbounded) amount of the good X0 at date0 and nothing at dates 1 and 2. This assumption has two important implications. First, since the investors have an unbounded endowment at date 0there is free entry into the capital market and the usual zero-profit conditionimplies that investors receive no surplus in equilibrium. Secondly, the factthat investors have no endowment (and non-negative consumption) at dates1 and 2 implies that their capital must be converted into asse
Systemic Risk and Regulation . supply of liquidity to the market. Many other central banks followed suit and . For example, regulatory arbitrage between the banking and insurance sectors could conceivably lead to an increase in risk in the in-surance sector which increases overall systemic risk. As Hellwig (1994, 1995, .
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