Edmund Cannon

1. Edmund Cannon Banking Crisis University of Verona Lecture 2

2. Plan for today • Brief review of yesterday • Opportunity for questions • Leverage in the banking system • Effect of limited liability • Systemic risk

3. Remember yesterday! • Banks are financial institutions that engage in “maturity transformation”: • Banks borrow short-term (a breve termine) • Banks lend long-term (a lungo termine) • Diamond-Dybvig model – banks are unstable (two Nash equilibria). • Potential solutions: • Central bank intervention (Bagehot) • Deposit insurance

4. What else is important about banks? Banks engage in maturity transformation. Another important feature of banks: Banks are leveraged. Nb other institutions are leveraged too:

5. A very simple model of a bank’s balance sheet

6. A More Detailed Model of a Bank Balance Sheet

7. Difference between equity and depositors/bondholders. • Depositors and bond-holders (should) have no risk. • They should not get back less than they deposit plus interest (no downside risk); • They will not get back more than they deposit plus interest (no upside risk). • Equity holders (sometimes referred to as capital): • Should bear all of the risk (upside and downside risk); • They get the residual (= profit).

8. Contrast this model with basic money supply model of banking (implications for macroeconomic models such as IS-LM)

9. A mutual fund (“unit trust” in the UK)

10. Selling short on equity (eg hedge fund)

11. Losses and leverage • Suppose a firm is levered by a factor of ten. • The firm can bear losses of up to 10% (=1/10) before equity is exhausted. • If leverage is twenty then the firm can only bear losses of 5%. • Leverage in 2007: • Goldman Sachs 25 • Lehman Bros 29 • Merrill Lynch 32

12. Trends in leverage in USA and UKSource: Turner Report

13. Is Leverage a “Good” or “Bad” Thing? Greater leverage allows more investment. Leverage allows risk to be shared in a particular way (equity bears more risk, bonds bear less risk) If assets are over-priced then short-selling helps correct the price – but short selling typically involves leverage. Too much leverage means that bond-holders are exposed to risk (which they are trying to avoid). Leverage results in limited liability for the equity holders: downside risk is borne by bond holders (or government). Leverage endogenises risk (Shin, 2009)

14. Risk aversion: concave preferences

15. Limited liability and risk aversion: U = ln(W) In the bad state of the world the payoff to the risky investment is 1.1 – e. This might be less than one (negative return). But our utility function is not defined for negative utility (perhaps because consumption cannot be negative).

16. Risk aversion with limited liability

17. Limited liability and risk aversion: U = ln(W)

18. Limited liability and risk aversion • Even risk-averse agents may like riskier investments if they have limited liability. • Banking: excessive risk means bad outcomes fall on bondholders, depositors and the government (via insurance). • Limited liability may be one of the causes of the financial crisis (faulty incentives or bankers). • BUT: • Perhaps bankers are risk-neutral or risk-loving; • Perhaps bankers are irrational.

19. Reducing risks in banks • Banks might be required or choose to self-insure. • Ownership structure (partnerships) and competition. • Separate retail and investment banking: • USA: Glass-Steagall Act (1933), repealed 1999 • USA: Frank-Dodd Act (2010) • UK: Vickers Commission proposal (2010) • Capital requirements (Basel I, etc) • Supervision or Regulation • Modelling / measuring risk (Basel II, second tier) • Making information publicly available (Basel II, third tier)

20. Capital Requirements: Basel I, II, III Basel I: International agreement of 1988: implemented in 1990s. Capital requirement of 8% so leverage of 12½. Leverage is defined as ratio of capital (equity) to risk-weighted assets. The risk weights depend upon credit ratings, determined by credit rating agencies. Basel II and III changed the weights and ratios. USA introduced the “recourse rule” rather than Basel II (very similar).

21. Basel I and Basel II capital requirements

22. Three sorts of capital requirement

23. Credit Ratings e.g. Moody’s

24. Problems with the credit rating industry • Ratings agencies have quasi-official status • ie when a bank justifies the risk on its balance sheet to a regulator it uses a recognised agency’s ratings. • Very few firms (Moody’s, Fitch, Standard & Poors) • Reputation • Needs to be officially recognised. • Too much reliance on ratings agencies. • Agencies are paid by the issuer of an asset (ie the borrower) not the purchaser of the asset (the lender). This creates an incentive problem.

25. Reducing Leverage • Both the regulated and the shadow banking system were constrained by lack of equity. • Savings glut from China, etc: large amounts of funds to invest. • Solutions: • Create new safe assets to put on balance sheet (securitisation: buy CDOs) • Move assets off balance sheet (conduits, sell CDOs) • Move risk off balance sheet by buying insurance (Credit Default Swaps)

26. Securitisation: Mortgages • US market is very different to Europe (where little securitisation) • Prime mortgages • Sold with strict underwiting standards; • Passed on to Fannie Mae / Freddie Mac (state sponsored); • Then sold as agency RMBSs. • Sub-prime mortgages • Sold with weaker underwriting; • Bundled together into securities by investment banks. • Sold on as RMBSs. • Difficult to work out quality of underlying mortgages.

27. Creating “safe” assets: Collateralised Debt Obligations (CDOs) Collateralised debt obligations are similar to SIVs except they lend long and borrow long (no maturity transformation); they are not open ended. Tett describes how these were pioneered by JPMorgan. When based on mortgages referred to as Collateralised Mortgage Obligations (CMOs) or Residential Mortgage-Backed Securities (RMBSs).

28. Reasons for creating Collateralised Debt Obligations (CDOs) (Simple situation) The bank acts as an intermediary but neither the asset nor the liability appear on the balance sheet. Therefore, this avoids capital requirements. The bank can create new financial assets with differing levels of risk (securitisation; tranching)

29. Simple Model • In this model there are two borrowers, X and Y. • Each borrower will either • Repay a loan of £100 (probability of 0.9) • Default and repay nothing (probability of 0.1) • (This model is not very realistic, but the maths is simple.) • We start by assuming that whether or not X repays is independent of whether or not Y repays.

30. Simple Model (continued) So there are three possibilities: Both borrowers repay (probability 0.81) Just one borrower repays (probability 0.18 = 0.09 + 0.09) Both borrowers default (probability 0.01)

31. Saving and borrowing without risk pooling (no FI) Loan Y has the same characteristics as Loan X.

32. Saving and borrowing with risk pooling (mutual fund) Each saver gets half of the money paid into the mutual fund.

34. Saving and borrowing with tranching (securitisation) So long as there is money available, the senior tranche gets paid (i.e., senior tranche gets paid first). The junior tranche only gets paid after the senior tranche

37. Discussion of Model • By pooling risky assets it is possible to reduce overall risk. • The underlying mortgage had a st.dev. of 30 • A mutual fund of two mortgages had a st.dev. of 21 • The senior tranche of a securitised CMO had a st.dev. of 10. • In the example the risky assets were uncorrelated. It is still possible to reduce risk in a mutual fund (equal sharing of assets) even if assets are positively correlated (so long as they are not perfectly correlated). The effect of correlation on the value of tranches is more complicated.

38. Risk pooling with differing degrees of correlation

39. Securitisation • Pool a group of risky assets into a Special Purpose Vehicle. • The payouts of the SPV are then tranched: • Tranche 1 (Super-senior) gets first call on assets • Tranche 2 (Senior) goes next • Tranche 3 (Mezzanine) goes next • Tranche 4 (Junk) gets anything left. • Possible to create AAA-rated assets from underlying assets with a much lower credit rating. US: Special Purpose Entity; Eire: Financial Vehicle Corporation

40. Securitisation: Mortgages • US market is very different to UK (where little securitisation) • Prime mortgages • Sold with strict underwiting standards; • Passed on to Fannie Mae / Freddie Mac (state sponsored); • Then sold as RMBSs. • Sub-prime mortgages • Sold with weaker underwriting; • Bundled together into securities by investment banks. • Sold on as RMBSs. • Difficult to work out quality of underlying mortgages. • Pricing of any RMBS depends upon the correlation.

41. Insurance

42. Credit Default Swaps: part (i)

43. Credit Default Swaps: part (ii)

44. Nationwide House PricesRatio of first-time buyer houses to earningsSource: http://www.nationwide.co.uk/hpi/

45. Ratio of house prices to average earningsSource: Nationwide, National Statistics, author’s calculations

46. Measuring risk – Value at Risk (VaR) Obvious measure of risk is variance (or standard deviation). But that is a general measure – we want to deal with downside risk (when things go wrong).

47. Difficulty of estimating VaR from data

48. Leverage and endogenous risk (Shin)

49. Endogenous risk – the crash As asset prices fall (losses mount) leverage rises. Firms sell assets to reduce leverage. Firesale prices are an externality to other banks’ balance sheets (especially with mark-to-market pricing).