class: center, middle, inverse, title-slide # Theory and evidence on <br>moral hazard in banking ## The roles of deposit insurance,<br> bail-out and bail-in ### Dr. Silvio Petriconi, Bocconi ### Probevorlesung IWH Halle & FSU Jena<br> 29. Mai 2020 (updated: 2020-05-26) --- class: inverse, mline, center, middle <style type="text/css"> .remark-slide-content { font-size: 25px; padding: 1em 4em 1em 4em; } .thankyou { font-size: 50px; } </style> # Deposit Insurance and Bail-outs ### • Reminder: Why Deposit Insurance? ### • The Problem of Moral Hazard ### • Bail-outs --- # Reminder: Why Deposit Insurance? Last class we discussed the bank run model of [Diamond and Dybvig (1983)](#refpage1). Quick reminder: - Consumers were ex-ante uncertain whether they prefer to consume _early_ (t=1) or _late_ (t=2). - Restricted asset space: * (liquid) _short asset_: matures every period, zero return * (illiquid) _long asset_: matures in t=2, positive return but early liquidation only at loss relative to purchase price - In autarky, no consumer would hold the long asset. - Banks offer consumers liquidity insurance: * issue demand deposits, redeemable anytime * invest in a mix of short and long asset * depositors share surplus from long asset investment * Pareto improvement! --- # Reminder: Why Deposit Insurance? What was the problem? -- __Bank runs!__ Model has multiple equilibria: 1. _"Good equilibrium"_: If depositors expect everyone to withdraw according to their type, late types don't withdraw early and the Pareto optimum is attained. 2. _"Run equilibrium"_: If depositors expect some late consumers to withdraw "early" in t=1, banks' costly premature liquidation of the long asset will inflict losses on whoever withdraws late!<br> `\(\Rightarrow\)` Late consumers will want to withdraw early <br> `\(\Rightarrow\)` _Bank run_<br> `\(\Rightarrow\)` Inefficient liquidation of long asset. Pareto inferior. Remedy: __Deposit insurance__ --- # Deposit Insurance To break the logic of panic-based runs in [Diamond-Dybvig (1983)](#refpage1), deposit insurance can help: * Insured depositors always get paid in full:<br> insurance covers eventual shortfall if bank can't pay. * No incentive for late consumers to withdraw early, even if they think that other late consumers will withdraw in t=1. * Eliminates Pareto-inferior bank run equilibrium completely! Indeed bank runs, once a common phenomenon all over the U.S., have practically disappeared following the introduction of deposit insurance: * FDIC: 1933 Banking Act, * NCUA: 1934 Federal Credit Union Act. --- # Moral Hazard: Risk Shifting But we shouldn't conclude that all is great: deposit insurance opens up an obvious new channel of moral hazard: depositors no longer demand compensation commensurate to bank risk! Consider a bank that runs for one period, zero interest on deposits, liquidates fully in t=1: .pull-left[ .center[__t=0__] | Assets | Liabilities | | -------------------- | ----------- | | Loans L | Deposits D | | Insurance Premiums P | Equity E | ] .pull-right[ .center[__t=1__] | Assets | Liabilities | | -------------------- | ----------- | | Loans `\(\tilde L\)` | Deposits D | | Insurance Payments `\(\tilde S\)` | Liq. value `\(\tilde V\)` | ] --- # Moral Hazard: Risk Shifting * At date 1, insurance pays `\(\tilde S = \max(0, D-\tilde L)\)` * So liq. value of bank is `\(\tilde V = \tilde L -D + \tilde S\)` * Combining the two, we have `$$\tilde V = \tilde L - D + \max(0, D-\tilde L)$$` * From balance sheet identity in t=0, we know that `\(D=L+P-E\)`, so `$$\tilde V = E + (\tilde L - L) - P +\max(0, D-\tilde L)$$` We interpret this that the banks' liquidation value is initial equity plus value gain `\(\tilde L - L\)` in loans plus a term `$$\max(0, D-\tilde L)-P$$` `\(\Rightarrow\)` reads like a put option on bank assets `\(\tilde L\)` at strike `\(D\)`! --- # The Classic Risk Shifting Problem This equivalence between deposit insurance and a put option on bank assets was first recognized in a seminal paper by [Merton (1977)](#refpage2). * to maximize bank value, one --- # Cross Country Evidence [Demirgüç-Kunt and Detragiache (2002)](#refpage1) present a cross-country empirical study of deposit insurance moral hazard: * gradual introduction of deposit insurance in 61 countries over the time period 1980-1997 * around half of the 898 observations fall into periods in which deposit insurance is available They ask: * With deposit insurance, are there more or fewer banking crises? * Does banking crisis probability depend on specific deposit insurance design features, e.g. government involvement, funding status, coinsurance, coverage limits? * In all this, does quality of (legal) institutions matter? --- # Cross Country Evidence (cont.) Key Findings: * Detrimental effect of explicit deposit insurance on banking stability * Effect more pronounced where institutions are weak * Higher coverage caps, more credible pre-funding of deposit insurance and presence of government in deposit insurance scheme increase the risk of crisis. --- # Bail-Outs and Moral Hazard Expectations that a bank will receive a bail-out generates analogous moral hazard channel as deposit insurance. However, there are important differences: * Whilst all banks have deposit insurance by law, bail-outs are discretionary. * Receiving a bail-out may depend on political connections, systemic relevance of the institution etc. * Asymmetric coverage by bail-out implies that competitors of banks that are under the umbrella of bail-out stand in the rain, facing fiercer competition for depositors, market share; this damages their charter value. * Consequence [(Hakenes and Schnabel, 2010)](#refpage2): bail outs increase risk in competitors!! * Empirically holds, see [Hakenes, Schnabel and Gropp (2010)](#refpage2). --- class:inverse,center,middle,mline #Promise vs. Reality of Bail-ins --- # Bail-in as solution? **"Let private money pay for the next bail-out"...** * Bail-in regimes give regulators the power to declare at their discretion the bail-in of some (typically subordinated) debt. The debt is written off / converted to equity to relieve the ailing financial institution. * In theory, these risky debt claims are thought to impose discipline on institutions because their risk _is_ priced. * In reality,use of this instrument complicated, much to be learned: - banks used intentional misselling of bail-in debt to particularly vulnerable groups as to force bail-out - Cyprus bail-in gave equity (and thus control) into hands of people who (due to proximity to Kremlin) would never have been granted a banking license. --- name:refpage1 # References __Dam, L. and Koetter, M.__ (2012), "Bank Bailouts and Moral Hazard: Evidence from Germany", _The Review of Financial Studies_ 25(8), pp. 2343–2380 [[link]](https://doi.org/10.1093/rfs/hhs056) __Demirgüç-Kunt, A. and Detragiache, E.__ (2002), "Does deposit insurance increase banking system stability? An empirical investigation", _Journal of Monetary Economics_ 49, <br> pp. 1373–1406 [[link]](https://doi.org/10.1016/S0304-3932%2802%2900171-X) __Diamond, D. and Dybvig, P.__ (1983), "Bank Runs, Deposit Insurance, and Liquidity", _Journal of Political Economy_ 91 (3), <br> pp. 401-419 [[link]](https://www.jstor.org/stable/1837095) --- name:refpage2 # References __Gropp, R., Hakenes, H. and Schnabel, I.__ (2011), "Competition, Risk-shifting, and Public Bail-out Policies", _Review of Financial Studies_ 24(6), pp. 2084–2120 [[link]](https://doi.org/10.1093/rfs/hhq114) __Hakenes, H. and Schnabel, I.__ (2010), "Banks without parachutes: Competitive effects of government bail-out policies", _Journal of Financial Stability_ 6 (3), pp. 156-168 [[link]](https://doi.org/10.1016/j.jfs.2009.05.006) __Merton, R.__ (1977), "An analytic derivation of the cost of deposit insurance and loan guarantees: An application of modern option pricing theory", _Journal of Banking and Finance_ 1 (1), <br> pp. 3-11 [[link]](https://doi.org/10.1016/0378-4266%2877%2990015-2)