Bailouts, Bail-ins and Resolution
Saturday, Jan. 5, 2019 12:30 PM - 2:15 PM
- Chair: John C. Driscoll, Federal Reserve Board
Financial Innovation for Rent Extraction
AbstractWe show that financial innovation greatly increases the scope for rent extraction from public safety nets, and this may generate a large redistribution of wealth from the public purse to the financial sector and a stark misallocation of real resources. We develop our results in a model in which bailouts arise endogenously: when financial sector capital is low, it is cheaper for the rest of the economy to provide a bailout than to suffer from a large credit crunch. It is well known that bailouts distort incentives to invest in risky securities. We show that bailouts also provide incentives to create new securities that crystallize risk-taking on states of nature in which bailouts will be obtained. This allows for more efficient rent extraction on a significantly larger scale. The incentives for rent extraction are mediated through market prices and do not require that the agents who engage in risk-taking are aware that they are extracting rents from public safety nets, as long as their creditors are. In aggregate, the described behavior leads to large financial sector profits during good times, higher consumption volatility, greater economy-wide risk premia and stark misallocations in real investment.
May the force be with you: Exit barriers, governance shocks, and profitability sclerosis in banking
AbstractWe test whether limited market discipline imposes exit barriers and thereby poor profitability in banking. We exploit an exogenous shock to the governance of government-owned banks: the unification of counties. County mergers lead to enforced government-owned bank mergers. We compare forced to voluntary bank exits and show that the former cause better bank profitability and efficiency at the expense of riskier financial profiles. Regarding real effects, firms exposed to forced bank mergers borrow more at lower cost, increase investment, and exhibit higher employment. Thus, reduced exit frictions in banking seem to unleash the economic potential of both banks and firms.
Contagious Bank Runs and Dealer of Last Resort
AbstractIn a global-games framework, we show how a dealer-of-last-resort policy can promote financial stability while traditional lender-of-last-resort policies are informationally constrained: Central banks and private investors can be uncertain whether banks selling assets to fend off runs are insolvent or illiquid. Such uncertainty leads to asset price collapses and runs and restricts central banks' role as a lender of last resort. In the presence of aggregate uncertainty, contagion and price volatility emerge as a multiple-equilibria phenomenon despite the global-games refinement. A dealer-of-last-resort policy that requires no information on individual banks' solvency can contain contagion and stabilize prices at zero-expected costs.
- G1 - General Financial Markets