Why banks should keep secrets

Summary. We show that it is sometimes efficient for a bank to commit to a policy that keeps information about its risky assets private. Our model, based upon Diamond-Dybvig (1983), has the feature that banks acquire information about their risky assets before depositors acquire it. A bank has the option of using contracts where the middle-period return on deposits is contingent on this information, but by doing so it must also reveal the information. We derive the conditions on depositors preferences and banking technology for which a bank would prefer to keep information secret even though it must then use a non-contingent deposit contract.Received: 5 November 2002, Revised: 19 December 2004, JEL Classification Numbers: D8, G21, G28.I would like to thank an anonymous referee, Sudipto Bhattacharya, Ed Green, Chandra Kanodia, Andy McLennan, Arijit Mukherji, Bradley Ruffle, Neil Wallace, Warren Weber, and especially Nobu Kiyotaki for useful comments and suggestions.     

Aggregate risk sharing and equivalent financial mechanisms in an endowment economy of incomplete participation

Summary. A pure endowment overlapping generations economy can be inefficient because of insufficient risk sharing. The introduction of an outside asset by a government or the existence of a clearing house can remedy the inefficiency by allowing some intergenerational risk sharing. While the typical outside asset is fiat money, many alternative financial mechanisms, such as social security, risk-free government bonds, mispriced deposit insurance, and income insurance can serve the same function as fiat money. Hence there are many equivalent financial mechanisms that provide intergenerational insurance. In the presence of uncertainty, there are several concepts of Pareto optimality that can be appropriately applied in an overlapping generations setting. I examine the risk-sharing arrangements associated with two different concepts of optimality, including how these arrangements are financed. The results are related to, and in some instances an extension of, the equivalence results obtained by Chamley and Polemarcharkis (1984), Weiss (1977), and Wallace (1981).Received: 4 March 2003, Revised: 30 January 2004JEL Classification Numbers: E40, E44, D51.P. Labadie: I would like to thank the participants of the Economic Theory Symposium Recent Developments in Money and Finance at Purdue University, May 2-4, 2003 and an anonymous referee for comments on this version. I am grateful to Bruce Smith for comments on an earlier version.     

Regulatory Monitoring,Closure Costs and Bank Moral Hazard Behavior

We theoretically analyze the efficacy of close regulatory monitoring and early bank closure policies, introduced by the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA), in reducing the FDICs losses and curbing bank moral hazard behavior induced by mis-priced deposit insurance. Contrary to conventional wisdom, we demonstrate that continuous bank monitoring and early closure may in fact exacerbate the moral hazard problem if bank shareholders face a penalty upon closure. Moreover, if reputational disincentives and monitoring costs prevent the regulator from implementing timely closure then the banks moral hazard incentives are significantly altered. These results suggest several new policy implications.     

Optimal taxation in a monetary economy with financial intrmediaries

The problem of optimal taxation when the government must levy distorting taxes to meet its revenue needs is considered for a monetary economy with financial intermediaries. In contrast to most other studies of optimal taxation in a monetary economy, money is treated as an intermediate good which is held because doing so economizes on the scarce resources that must be devoted to the exchange process. Attention is focused on the roles of the inflation tax, reserve requirements, and deposit taxes. The key result is that revenue considerations do not justify taxing cash and deposits. That is, the optimal tax structure calls for adopting the optimum quantity of money rule and setting deposit taxes to zero. When the optimal tax structure is in place, reserve requirements turn out to be irrelevant from both the fiscal and welfare perspectives.     

Market Structure and Risk Taking in the Banking Industry

We demonstrate that the common view according to which an increase in competition leads banks to increased risk taking fails to hold in an environment where homogeneous loss averse consumers can choose in which bank to make a deposit based on their knowledge of the riskiness incorporated in the banks outstanding loan portfolios. With an exclusive focus on imperfect competition we find that banks incentives for risk taking are invariant to a change in the banking market structure from duopoly to monopoly. Finally, we show that deposit insurance would eliminate the gains from bank competition when banks use asset quality as a strategic instrument.revised version received October 15, 2003     

Delay determinants of European Banking Union implementation

Most countries in the European Union (EU) delay the transposition of European Commission (EC) directives, which aim at reforming banking supervision, resolution, and deposit insurance. We compile a systematic overview of these delays to investigate if they result from strategic considerations of governments conditional on the state of their financial, regulatory, and political systems. Transposition delays pertaining to the three Banking Union directives differ considerably across the 28 EU members. Bivariate regression analyses suggest that existing national bank regulation and supervision drive delays the most. Political factors are less relevant. These results are qualitatively insensitive to alternative estimation methods and lag structures. Multivariate analyses highlight that well-stocked deposit insurance schemes speed-up the implementation of capital requirements, banking systems with many banks are slower in implementing new bank rescue and resolution rules, and countries with a more intensive sovereign-bank nexus delay the harmonization of EU deposit insurance more.     

Regulation, Risk and the Pricing of Australian Bank Shares, 1957–1976*

Recent contributions to the theory of regulation have suggested the possibility of discriminatory regulation affecting risk and profits of firms subject to public intervention. This paper examines risk and wealth effects associated with Australian banking regulation. Support is found for the Peltzman and Edwards and Heggestad hypothesis that regulation reduces risk and for Johnson's hypothesis that statutory reserve deposit requirement policy involves an implicit tax on bank shareholders.     

On the impact of a tax shock in Portugal

In 1999, Cavaco Silva, the Portuguese Prime Minister from 1985 to 1995, proposed a comprehensive tax reform package, which is to this day the basic reference in the tax policy debate in Portugal. A tax shock would consist of 4pp cuts in the corporate income tax and in the firms social security contribution rates, and a 5pp reduction in the highest personal income tax rate. These cuts would be financed by combating tax evasion, curbing wasteful public expenditure and, if necessary, by increasing the VAT rate by up to 2pp. Using a dynamic general equilibrium model to evaluate the effects of this tax shock, we find that the long-term GDP gains would be between 0.72% and 2.91% while the effects on lifetime private welfare would range between -0.99% and 0.9%. The efficiency of this tax reform package depends critically on the way the tax cuts are financed to ensure deficit neutrality. Because investment is subject to adjustment costs, to alleviate the long-run trade-off between GDP and welfare, tax policy changes must induce a significant increase in net labor income.Received: July 2001, Accepted: March 2002, JEL Classification: C68, D58, E62, H21, H30Correspondence to: Alfredo M. PereiraA previous version of this paper was presented at the Society of Computational Economics and SPiE conferences. Thanks are due to Fernando Chau, Emanuel Santos, and two anonymous referees for very insightful comments and suggestions. The views in this article are of the authors alone and do not reflect the position of the Portuguese Ministry of Finance.     

WHAT SHOULD BANKS REALLY DO?

With banking currently in turmoil, a new formula for bank structure and activities, for deposit insurance, and for bank regulation is necessary. This paper reviews the dilemmas of the current structure of banking in the United States and explains how the banking sector arrived at its current state of crisis. It then suggests three alternative formulas, along with their advantages and disadvantages, that could provide the future framework for banking, deposit insurance, and regulation.     

Was the Argentine corralito an efficient measure?: A note

Theoretical banking literature has largely explored the role of financial intermediaries in the economy, market failures (banking panics) in the banking sector and the need for bank regulation. However, most models of banking panics and regulation have not been empirically tested.The Argentine 2001 crisis, with a large deposit withdrawal and the regulation introduced (suspension of convertibility) constitutes a scenario in order to apply some of the theoretical predictions.In particular, the paper applies Samartín [Samartín, M. (2002). Suspension of convertibility vesus deposit insurance: A welfare comparison. European Finance Review, 6(2), 223–244] to the particular case of Argentina. After the estimation of the most important parameters, the model predicts that suspension of convertibility seems to have been the most efficient intervention measure to stop the massive deposit withdrawals.     

Monetary Policy and Market Power in Banking

Applying a spatial competition model to banking, we analyze the effects of the choice of a monetary policy rule by the central bank on banks market power as measured by the Lerner index. We show that a procyclical monetary policy may reinforce the countercyclical movement of the Lerner index. That is, this measure of competitiveness of the banking sector may vary more over the business cycle due to the monetary policy rule.JEL classification: G21, E52, L13.Acknowledgements The author thanks Hans Degryse, Hans van Ees, Marco Haan, Eko Riyanto, Bert Schoonbeek, Elmer Sterken, three anonymous referees, and participants of the EARIE 2001 conference (Dublin), the NAKE Day 2002 (Amsterdam), and a seminar at Ghent University for their constructive comments.revised version received November 11, 2003     

A model of takeovers of foreign banks

This paper investigates the determinants of the takeover of a foreign bank by a domestic bank whereby the former becomes a branch of the latter. Each bank is initially supervised by a national agency that cares about closure costs and deposit insurance payouts, and may decide the early closure of the bank on the basis of supervisory information. Under the principle of home country control, the takeover moves responsibility for both the supervision of the foreign bank and the insurance of the foreign deposits to the domestic agency. It is shown that the takeover is more likely to happen if the foreign bank is small (relative to the foreign banking market) and its investments are risky (relative to those of the domestic bank). Moreover, the takeover is in general welfare improving for both countries.     

Attitudes Towards Paying Taxes in Austria: An Empirical Analysis

People mostly pay their taxes although there is a low probability of getting caught and being penalized. Thus, new attempts in the tax compliance literature try to go beyond standard economic theory. This paper examines citizens attitudes toward paying taxes – what is sometimes termed their tax morale, or the intrinsic motivation to pay taxes. Tax morale may be a key determinant to explain why people are honest. However, there are very few papers that explore the concept of tax morale theoretically and empirically. This study, based on the World Values Survey and the European Values Survey, therefore attempts to fill this gap in the literature, focusing on tax morale in Austria. Societal variables such as trust or pride have been identified as key determinants that shape tax morale in Austria. Furthermore, a lower perceived compliance leads to a decrease of tax morale, which indicates that social comparisons are relevant. The results also show a decrease of tax morale between 1990 and 1999, although Austrias taxpayers still have a very high tax morale compared to other European countries.     

U.S. DEPOSIT INSURANCE REFORM

Congress, late in 1991, enacted a banking reform measure that (i) authorizes $70 billion of additional FDIC funding, (ii) enhances bank regulation and supervision, and (Hi) adopts a "trip wire" system for increasingly severe regulation based on a bank's capital. Congress rejected a number of key elements of the Treasury proposal submitted early in 1991, such as interstate banking and expanded bank powers. The Congressional action does not end the debate over banking reform. In due time, other attempts likely will be made to restructure the banking system along the lines of the Treasury proposal.
The Treasury proposal's positive points failed to offset its fundamental problems. The Congressional action, though not subject to the Treasury proposal's problems, falls short of complete deposit insurance reform. Both proposals fail to recognize that regulatory oversight is a poor substitute for market discipline in the current financial environment.
This paper reviews problems with the financial reform process and failure of the Treasury proposal to recognize these problems. It also reviews alternative approaches to deposit insurance reform.     

From “tax state” to “debt state”

The paper is motivated by Joseph A. Schumpeter's The Crisis of the Tax State. It inquires whether the buildup of government debt in peacetimeprosperity is a threat to the stability, existence or creation of viable tax states. The paper begins by setting out Schumpeter's conception of the tax state and the nature of recent political-economic events which have reinvigorated the concept. Next the paper sets out some simple debt dynamics and sketches a debt-induced business cycle arising from heavy reliance on debt finance in peacetimeprosperity. Finally, the paper assesses threats to the tax state in light of recent work on path dependence and positive feedback. An attempt is made to throw some light on whether the plethora of new, and often small, states spawned by the demise of communism can be viable tax states.Essay on Government, the Tax State and Economic Dynamics submitted to the Third Schumpeter Prize Competition.     

Optimal Regulation of a Fully Insured Deposit Banking System

We analyze risk sensitive incentive compatible deposit insurance in the presence of private information when the market value of deposit insurance can be determined using Merton's (1977, 3-11) formula. We show that, under the assumption that transferring funds from taxpayers to financial institutions has a social cost, the optimal regulation combines different levels of capital requirements combined with decreasing premia on deposit insurance. On the other hand, it is never efficient to require the banks to hold riskless assets. Finally, chartering banks is necessary in order to decrease the cost of asymmetric information.     

Inflation,growth and exchange rate regimes in small open economies

Summary. This paper compares the merits of alternative exchange rate regimes in small open economies where financial intermediaries perform a real allocative function, there are multiple reserve requirements, and credit market frictions may or may not cause credit rationing. Under floating exchange rates, raising domestic inflation can increase production if credit is rationed. However, there exist inflation thresholds: increasing inflation beyond the threshold level will reduce domestic output. Endogenously arising volatility may be observed independently of the exchange rate regime. Private information - with high rates of domestic inflation - increases the scope for indeterminacy and economic fluctuations.Received: 26 March 2002, Revised: 29 October 2002JEL Classification Numbers: E32, E44, F33.P.L. Hernandez-Verme: I would like to thank Leonardo Auernheimer, Valerie Bencivenga, Dean Corbae, Scott Freeman, Todd Keister, Beatrix Paal, and Maxwell Stinchcombe for very helpful comments and suggestions. Very special thanks are due to Bruce D. Smith. The paper also benefited from the discussions in the seminars in CIDE, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, Indiana University, ITAM, Purdue University, the Second Annual Missouri Economics Conference, Texas A&M, the University of Missouri and the University of Texas at Austin.     

Interest expectations and exchange rates news

Using a new survey data set ofmatched exchange rate and interest rate expectations for eight currencies relative to the German mark, we examine empirically the relationship between exchange rate returns, news and risk premia. News on interest differentials enters significantly in equations for the difference between the spot rate and the lagged forward rate for the British pound, Japanese yen, Spanish peseta and the US dollar. An unexpected rise in the interest rate differential tends to strengthen the domestic exchange rate. For each of these currencies, we also find significant effects of our ex-ante measure of the risk premium. In addition, we investigate the effect of lagged interest rate differentials as proxy for the risk premium and find that they do not capture time-varying risk premia as is widely suggested in the literature, but probably capture a peso-problem, learning about a policy change, a market-inefficiency or a combination of these factors.     

The greenhouse effect: Damages,costs and abatement

The buildup of so-called greenhouse gases in the atmosphere — CO₂ in particular-appears to be having an adverse impact on the global climate. This paper briefly reviews current expectations with regard to physical and biological effects, their potential costs to society, and likely costs of abatement. For a worst case scenario it is impossible to assess, in economic terms, the full range of possible non-linear synergistic effects. In the most favorable (although not necessarily likely) case (of slow-paced climate change), however, it seems likely that the impacts are within the affordable range, at least in the industrialized countries of the world. In the third world the notion of affordability is of doubtful relevance, making the problem of quantitative evaluation almost impossible. We tentatively assess the lower limit of quantifiable climate-induced damages at $30 to $35 per ton of CO₂ equivalent, worldwide, with the major damages being concentrated in regions most adversely affected by sea-level rise. The non-quantifiable environmental damages are also significant and should by no means be disregarded.The costs and benefits of (1) reducing CFC use and (2) reducing fossil fuel consumption, as a means of abatement, are considered in some detail. This strategy has remarkably high indirect benefits in terms of reduced air pollution damage and even direct cost savings to consumers. The indirect benefits of reduced air pollution and its associated health and environmental effects from fossil-fuel combustion in the industrialized countries range from $20 to $60 per ton of CO₂ eliminated. In addition, there is good evidence that modest (e.g. 25%) reductions in CO₂ emissions may be achievable by the U.S. (and, by implication, for other countries) by a combination of increased energy efficiency and restructuring that would permit simultaneous direct economic benefits (savings) to energy consumers of the order of $50 per ton of CO₂ saved. A higher level of overall emissions reduction — possibly approaching 50% — could probably be achieved, at little or not net cost, by taking advantage of these savings.We suggest the use of taxes on fossil fuel extraction (or a carbon tax) as a reasonable way of inducing the structural changes that would be required to achieve significant reduction in energy use and CO₂ emissions. To minimize the economic burden (and create a political constituency in support of the approach) we suggest the substitution of resource-based taxes in general for other types of taxes (on labor, income, real estate, or trade) that are now the main sources of government revenue. While it is conceded that it would be difficult to calculate the optimal tax on extractive resources, we do not think this is a necessary prerequisite to policy-making. In fact, we note that the existing tax system has never been optimized according to theoretical principles, and is far from optimal by any reasonable criteria.During the academic year 1989–90 Dr. Ayres was at the International Institute for Applied Systems Analysis (IIASA), Laxenburg, Austria.During the summer of 1989 Mr. Walter was a member of the Young Scientists' Summer Program at IIASA.     

Deposit insurance and regulation in a Diamond-Dybvig banking model with a risky technology

Summary Three deposit insurance schemes are studied in a version of the Diamond-Dybvig banking model with a risky technology. The schemes include a full deposit guarantee and two alternatives which people have suggested as ways to limit the moral hazard problem of deposit insurance: deductible and coinsurance. Regulation to suppress the moral hazard problem under each scheme takes the form of solvency and incentive compatibility constraints. When the regulation is relaxed slightly, as it might be under regulatory error, the insurer's payout is lower under the alternatives than under the full guarantee. However, the coinsurance and deductible schemes are less effective at preventing bank runs than the full guarantee. Moreover, in some environments, even the full guarantee itself does not provide enough reassurance to rule out bank runs.I am indebted to Neil Wallace, John Kareken, Ed Green, Nobuhiro Kiyotaki, Andy McLennan, Mike Stutzer, Jan Werner and an anonymous referee for their helpful comments.