Preventive policy means targeting incentives over cycle
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Preventive policy means targeting incentives over cycle. Enrico Perotti Univ Amsterdam, DNB and DSF. Basel III From exogenous to endogenous risk control. Statistical view of risk in Basel II, independent of rules and cycle

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Preventive policy means targeting incentives over cycle

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Preventive policy means targeting incentives over cycle

Preventive policy means targeting incentives over cycle

Enrico Perotti

Univ Amsterdam, DNB and DSF


Basel iii from exogenous to endogenous risk control

Basel III From exogenous to endogenous risk control

  • Statistical view of risk in Basel II, independent of rules and cycle

  • No account of incentives; bank equity as pure buffer; exogenous correlation

  • Market liquidity never a problem

  • But risk creation evolves with risk shifting incentives


Some lessons to learn

Some lessons to learn

  • When credit expands fast, incentives for more correlated investment choices

    • Self reinforced via prices bubbles

    • Correlation increases chance of bailout

  • Excess credit growth feeds on short term funding

    • Favored by reduced monitoring

  • Risk incentives not linear

    • Once capital falls below some threshold, risk preferences jump


A preventive risk control policy must be incentive based

A preventive risk control policy must be incentive-based

  • Ensure a opportunity cost of gambling by using risk sensitive instruments

    • equity

    • long term funding

  • Induce investors to keep risk bearing as risk increases: more equity, long term debt

  • Fully charge for risk externalities


Concrete examples

Concrete examples

  • Ensure countercyclical ratios at the system level

  • Design CoCo to have early conversion thresholds

  • Raises gambling cost in good times

  • Slow down carry trades in exhuberant markets by taxing unstable funding


Prevent not absorb

Prevent, not absorb

Choose equity ratios not as buffers, but as tools to align incentives

Contain risk creation early on. Trigger adjustment to funding to restore incentives when they deteriorate

Measure precisely few critical risk factors, track them closely

Signal early on any risk build up, enabling markets to question it before too large, least disclosure may lead to panic.


Optimal liquidity regulation quantity versus price policy perotti suarez 2010

Optimal liquidity regulationQuantity versus price policy (Perotti Suarez, 2010)

Price (liquidity charges):

  • Solvent banks use too much short term funding as they do not feel all liquidity risk costs

  • Pigouvian charges aligns private and social costs, still allows better banks to lend more

    Quantity (capital or funding ratios)

  • Low charter value banks may gamble (risk shift to deposit insurance), not deterred by levies

  • Here, better quantity constrains. Capital ratios contains risk shifting (low charter value banks)


Liquidity buffers

Liquidity buffers

  • Liquidity buffers least efficient

    • As ratios, disadvantages better lenders

    • Net liquidity risk is the same (unless liquidity costly, then it is a tax)

    • Main net result is subsidy to Treasury bills at cost of funding cost for banks

    • Keeping incentives stable requires adjusting buffers to risk spreads


Limit risk incentives with cocos

Limit risk incentives with CoCos

  • Avoid discontinuity of CoCo prices at conversion. Conversion at par is simple, harder to game, avoids multiple equilibria

  • Conversion at market value (implying more dilution) ensures bankers will become careful earlier, contain increased risk incentives

  • A gradual conversion scheme so that triggers occur before problem is large, limit market response


Summary

Summary

Quantity instruments (capital ratios, net funding ratios) best to contain gamblers

Price tools (eg liquidity charges) increase opportunity costs of strategies with externality effects

Price tools easier to adjust than ratios

Price tools should be used with higher frequency for preventive goals


Liquidity risk regulation quantity versus prices

Liquidity Risk Regulation: Quantity versus Prices

  • Losses in liquidity crisis larger if aggregate ST funding larger (forces faster fire sales)

  • Banks differ in

    • credit assessment (incentive to expand lending)

    • charter value (incentive to remain solvent; limits gambling)

  • Short term funding only way to boost credit

  • Both good credit banks and low charter banks want to expand credit more


Levies contain solvent banks

Levies contain solvent banks

  • Solvent banks borrow more short term than socially optimal as they do not internalize the liquidity risk externality

  • Better banks wants to lend more

  • An optimal liquidity charge corrects by adjusting private cost


Advantages of prices and ratios

Advantages of prices and ratios

Price:

  • Solvent banks expand loans too much as they do not feel all liquidity risk costs

  • Liquidity charges allows better banks to lend more than others

    Quantity (capital or funding ratios)

  • Low charter value banks take zero NPV gambles (risk shift to deposit insurance)

  • Capital requirement screen out pure risk shifting banks (low charter value banks)


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