Optimal Reserves and Short‐Term Interest Rates in a Model of Bank Runs

A global game framework of bank runs is used to analyse a bank's choice of its reserve level and short‐term interest rate. Higher level of reserves and a lower short‐term interest rate would decrease the probability of bank runs. When the bank's reserve policy is transparent, it will hold excess reserves to discourage withdrawals by patient depositors. This inefficiency of excess reserves increases with the proportion of impatient depositors. When the bank has private information about its reserve level, it will follow a more risky strategy of choosing lower reserves and higher early return than what maximizes depositor welfare and increases the probability of bank runs.     

Security Innovation on Several Assets Under Asymmetric Information

The paper examines the optimal innovation of securities by an issuer who is endowed with several risky assets and private information on one of the assets. Assuming that the degree of asymmetric information between the issuer and the outside investor is large, we show that the issuer restricts the number of securities that he creates. We also show that the payoff of the security created by the issuer is not closely correlated, and is sometimes completely uncorrelated, with the payoff of the asset that is subject to the asymmetric information, depending on the hedging needs and the accuracy of information.
JEL Classification Numbers: D52, D82, G20.     

A Bank Panic Model with a Bond Market

We have constructed a model of bank failure with monetary assets (bonds), adopting the overlapping-generations model. In it, monetary assets play a role in dispersing the credit crunch from a single bank run into a nationwide bank panic. As established by Diamond and Dybvig (1983), a single bank run is explained by a model without any monetary assets. In our model, however, the bond market is introduced to describe the process in which a bank run spreads. As a result, our model describes a general phenomenon—credit market failure—rather than a single bank run.
JEL classification numbers: G21, E40.     

Collateral rehypothecation,safe asset scarcity,and unconventional monetary policy

We build a mark-to-market model where commercial banks can enlarge their balance sheets, repledging the available collateral several times to exchange liquidity through the interbank market. In bad times, the fall of risky asset price disrupts the length of the repledging chain due to the increase of the haircut and the decrease of external assets' value. In such a scenario, the central bank can intervene implementing unconventional monetary policies by purchasing a fraction of the banking system's external assets, both safe treasury bonds, and risky asset-backed securities, to inject liquidity. Our results show that a quantitative easing policy that purchases only safe assets is highly ineffective in restoring the intermediation activity to the pre-crisis level due to its inability to sustain the risky asset price and the repledging chain of collateral. Instead, focusing on risky assets only, the monetary authority can sustain risky asset prices, avoiding the freezing of the money market.     

Regulating Exclusion from Financial Markets

We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honour their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a "fresh start" after bankruptcy then this must be balanced by enforceable provisions against fraudulent conveyance. Our optimal regulation is robust, in that it can be implemented in a way that does not require the regulator to have information about either the borrower or lender. Our results isolate the way in which specific institutions surrounding bankruptcy–namely rules governing asset garnishment and fraudulent conveyances–support loan markets in which borrowers have no collateral.     

Learning by Holding and Liquidity

A number of assets do not trade publicly but are sold to a restricted group of investors who subsequently receive private information from the issuers. Thus, the holders of such privately placed assets learn more quickly about their assets than other agents. This paper studies the pricing implications of this "learning by holding". In an economy in which investors are price takers and risk-neutral, and absent any insider trading or other transaction costs, we show that risky assets command an excess expected return over safe assets in the presence of learning by holding. This is reminiscent of the "credit spread puzzle"—the large spread between BBB-rated and AAA-rated corporate bonds that is not explained by historical defaults, risk aversion, or trading frictions. The intuition is that the seller of a risky bond needs to offer a "coordination premium" that helps potential buyers overcome their fear of future illiquidity. Absent this premium, this fear could become self-justified in the presence of learning by holding because a future lemons problem deters current market participation, and this in turn vindicates the fear of a future lemons problem.     

Financial intermediation and endogenous risk in the banking sector

The paper revisits the impact of uncertainty on the decision problem of a bank. The bank extends risky loans to private investors and sells deposits to savers at fixed rates. The uncertainty under which deposit/loan-portfolios are chosen by banks is endogenized through an information system that conveys public signals about the return distribution of bank loans. Transparency in the banking sector is defined in terms of the reliability of these signals. We find that higher transparency always raises expected bank profits, but may lead to a higher or lower expected loan volume. Moreover, higher transparency may reduce economic welfare.     

Deposit insurance and bank regulation in a monetary economy: a general equilibrium exposition

Summary. It is commonly argued that poorly designed banking system safety nets are largely to blame for the frequency and severity of modern banking crises. For example, underpriced deposit insurance and/or low reserve requirements are often viewed as factors that encourage risk-taking by banks. In this paper, we study the effects of three policy variables: deposit insurance premia, reserve requirements and the way in which the costs of bank bailouts are financed. We show that when deposit insurance premia are low, the monetization of bank bailout costs may not be more inflationary than financing these costs out of general revenue. This is because, while monetizing the costs increases the inflation tax rate, higher levels of general taxation reduce savings, deposits, bank reserves, and the inflation tax base. Increasing the inflation tax rate obviously raises inflation, but so does an erosion of the inflation tax base. We also find that low deposit insurance premia or low reserve requirements may not be associated with a high rate of bank failure.Received: 2 January 2002, Revised: 1 March 2003JEL Classification Numbers: D5, E5, G1.B. D. Smith: Sadly, our co-author, colleague and dear friend, Bruce D. Smith, died on July 9, 2002.     

Shocks to bank capital: evidence from UK banks at home and away

This article assesses how shocks to bank capital may influence a bank's portfolio behaviour using novel evidence from a UK bank panel data set from a period that predates the recent financial crisis. Focusing on the behaviour of bank loans, we extract the dynamic response of a bank to innovations in its capital and in its regulatory capital buffer. We find that innovations in a bank's capital in this (precrisis) sample period were coupled with a loan response that lasted up to 3 years. The international presence of UK banks allows us to identify a specific driver of capital shocks in our data, independent of bank lending to UK residents. Specifically, we use write-offs on loans to nonresidents to instrument bank capital's impact on UK resident lending. A fall in capital brought about a significant drop in lending in particular, to Private Nonfinancial Corporations (PNFC). In contrast, household lending increased when capital fell, which may indicate that, in this precrisis period, banks substituted into less risky assets when capital was short.     

On the road to the Golden Age

Summary To find a pattern leading to the Golden Age it is necessary to introduce a principle for the division of consumption between generations.The Golden Rule result gives the fraction of G. N. P. that each generation saves on behalf of future generations but since this fraction is constant, previous generations have made an identical sacrifice on behalf of the present one.In a similar fashion it is postulated here that every generation chooses the proportion of G. N. P. which it wishes to save while requiring previous generations to save in exactly the same way. This means that although very generations would like to increase its consumption, it does not wish earlier generations to do so since that would leave less total G. N. P. in the present.The part of G. N. P. to be invested is assumed to be a certain, to be determined, function of time. The production function is taken to be Cobb-Douglas with constant returns to scale. The optimal growth path is determined under various assumptions about labour supply. It is shown that the Golden Age results are obtained as time approaches infinity.With 1 FigureThis research has been financed by a grant from the Tri-Centennial Fund of the Bank of Sweden.     

Procyclicality and the new Basel Accord - banks’ choice of loan rating system

Summary. The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committees latest proposals, in October 2002.Received: 25 October 2003, Revised: 27 April 2004, JEL Classification Numbers: D58, E44, G28. Correspondence to: Dimitrios P. TsomocosThe authors are grateful to Pamela Nickell for carrying out some of the calculations and Nicola Anderson, Charles Goodhart, Andy Haldane, Glenn Hoggarth, Nobu Kiyotaki, William Klein, Alistair Milne, William Perraudin, Hyun Shin, Paul Tucker, seminar participants at the Bank of England XI European Workshop on General Equilibrium Theory, Federal Reserve Bank of Boston, INSEAD, LSE, the University of Oxford and especially H.M. Polemarchakis for helpful comments and remarks. However, all remaining errors are ours. The views expressed here are those of the authors and do not necessarily reflect those of the Bank of England, and the Bank of Spain.     

Sale-Backs in Bankruptcy

When bankrupt firms are sold, they are often repurchased bytheir former owner or manager. These insiders are by defaultbetter informed than outsiders about the true value of the firmor its assets, so other potential buyers must worry about overpayingif they win. The presence of insiders may thus have a chillingeffect on the bidding. We ask how insiders should be treatedin bankruptcy sales: Should they be allowed to submit bids?If so, under what conditions? We derive properties of an optimalsale procedure and show that it must be biased against insiders.Specifically, it should be harder for insiders to win with lowbids than for outsiders. We show that the "market tests" thatare routinely required in bankruptcy sales are suboptimal sincethey treat all potential buyers alike and forgo the benefitsof biasing the procedure against insiders.     

Optimal debt contracts and moral hazard along the business cycle

Summary. We analyze the Pareto optimal contracts between lenders and borrowers in a model with asymmetric information. The model generalizes the Rothschild-Stiglitz pure adverse selection problem by including moral hazard. Entrepreneurs with unequal abilities borrow to finance alternative investment projects which differ in degree of risk and productivity. We determine the endogenous distribution of projects as functions of the amount of loanable funds, when lenders have no information about borrowers ability and technological choices. Then, we embed these results in a dynamic competitive economy and show that the average quality of the selected projects in equilibrium may be high in recessions and low in booms. This phenomenon may generate (a) multiple steady states, (b) a smaller impact of exogenous shocks on output relative to the full information case, (c) endogenous fluctuations.Received: 11 June 2001, Revised: 17 June 2003, JEL Classification Numbers: A10, G14, G20, E32.Correspondence to: Pietro ReichlinPietro Reichlin acknowledges financial support from MURST and Paolo Siconolfi acknowledges financial support from the GSB of Columbia University.     

中国外汇储备投资组合选择——基于外汇储备循环路径的内生性分析

本文从中美两国经济的本质性差异出发,通过刻画中国外汇储备对外投资的"循环路径",构建了包括央行、金融市场和实体经济的斯塔克尔伯格及古诺模型,进而模拟出中国外汇储备对外投资对本国经济的间接贡献、合意的外汇储备投资组合,以及最优外汇储备投资规模。研究结果表明,中国外汇储备投资于美国风险资产的规模将影响外汇储备间接转化为美国对中国FDI的比例。同时,中国央行外汇储备规模及投资策略对危机时期的反应不足。改变外汇储备投资收益的主要方法包括降低居民的相对风险回避系数,通过政策引导促进居民消费,以及大力发展中国金融市场,降低对美国金融市场的依赖程度。     

Are incomplete markets able to achieve minimal efficiency?

Summary. We consider economies with incomplete markets, one good per state, two periods, t = 0,1, private ownership of initial endowments, a single firm, and no assets other than shares in this firm. In Dierker, Dierker, Grodal (2002), we give an example of such an economy in which all market equilibria are constrained inefficient. In this paper, we weaken the concept of constrained efficiency by taking away the planners right to determine consumers investments. An allocation is called minimally constrained efficient if a planner, who can only determine the production plan and the distribution of consumption at t = 0, cannot find a Pareto improvement. We present an example with arbitrarily small income effects in which no market equilibrium is minimally constrained efficient.Received: 26 November 2002, Revised: 28 May 2003, JEL Classification Numbers: D2, D52, D61, G1.We are grateful to an anonymous referee for very valuable comments. E. and H. Dierker would like to thank the Institute of Economics, University of Copenhagen, for its hospitality and its financial support.     

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     

Risk allocation and uncertainty: some unpleasant outcomes of financial innovation

Financial innovation introduces the possibility of exchange on wider time-events sets. In this way, market incompleteness should be reduced with an overall advantage. The existence of this advantage also depends on other elements, like the degree of market competition, the level of information, and the presence of inefficiencies generated by moral hazard. One kind of behavior which has been widely common among banks consists in the reduction of risk taking in relation to credit activity. Credit risk tends to be covered through the packaging of credits into securities. This situation means that since the bank is not shouldering the risk, it does not invest in the acquisition of knowledge regarding the borrower, but only regarding his/her generic characteristics which are reflected in the evaluation of the assets in which the credits are packaged. Moreover, financial innovation was developed, in particular by investment banks, with non-standardized products, exchanged over-the-counter, and substantially lacking secondary markets. The greatest problems derive from the low liquidity of these products and from the uncertainty over their returns. This is why it would be good to stimulate the introduction of standardized products, whose risks are easy to determine, to be exchanged on organized markets, instead of complex products, which are substantially illiquid and exchanged over-the-counter.

Will Self‐Managed Superannuation Fund Investors Survive?

The relative risk aversion coefficient that characterises the representative self‐managed superannuation fund (SMSF) investor reveals not only how much that investor dislikes risk but also other information about the investor's economic characteristics, including how his or her allocations to risky assets change as his or her wealth changes. Determination of the relative risk aversion coefficient for the average SMSF investor reveals a value of 5.05. This value is too high to be consistent with logarithmic utility. This is significant because it implies that SMSF investors may be too risk averse to maximise the expected growth rate of wealth share accumulation. We are left to consider a very important question: Will SMSF investors survive?     

Over-the-counter loans,adverse selection,and stigma in the interbank market

We study a model of interbank credit where physical and informational frictions limit the opportunities for intertemporal trade among banks and outside investors. Banks obtain loans in an over-the-counter market (involving search, bilateral matching, and negotiations over the terms of the loan) and hold assets of heterogeneous quality that in turn determine their ability to repay those loans. When asset quality is not observable by outside investors, information about the actions taken by a bank in the loan market may influence prices in the asset market. In particular, under some conditions, borrowing from the central bank can be regarded as a negative signal about the quality of the borrower?s assets and banks may be willing to borrow in the market at rates higher than the one offered by the central bank.     

Life‐cycle asset accumulation and allocation in Canada

Abstract.  This paper documents the life‐cycle patterns of household portfolios in Canada, and investigates several hypotheses about asset accumulation and allocation. Inferences are drawn from the 1999 Survey of Financial Security, with some comparisons to earlier wealth surveys from 1977 and 1984. I find cross‐sectional evidence for asset decumulation at older ages when annuitized assets like pension wealth are included in the analysis. I also find that the portfolio share of financial assets increases sharply with age, while indicators of risk tolerance appear to decrease. This is consistent with families' desiring more liquid and less risky assets as they age. JEL classification: D31, E21, G11