ECON M831
CORPORATE FINANCE AND FINANCIAL INTERMEDIATION
PART 1 : CORPORATE FINANCE
Chapter 5 : Financial Crises
Alain de Crombrugghe
10-17 March 2017
How can vulnerable assets or liabilities hurt a firm
(a bank, a country) and spread contagion?
1
Outline
PART I : CORPORATE FINANCE
• Chap. 1 : Perfect Markets (Modigliani & Miller)
• Chap. 2 : Imperfect Markets
• Chap. 3 : Imperfect information
• Chap. 4 : Practical paradigms of financing
• Chapter 5 : Financial crises
–
–
–
–
–
1. Typology and role of asymmetric information
2. Bank run : Liability side (Diamond & Dybvig)
3. Debt run : interest channel (Calvo)
4. Asset run (Diamond & Rajan)
5. Bank resolution issues
and the Bank-Government doom loop.
PART II : FINANCIAL INTERMEDIATION AND BANKING
2
1 Typology of crises
• Causes :
– « Fundamental » : deterioration of assets (possibly
after overvaluation),
– « Self-fulfilling » : multiple equilibria, expectations.
• Side of balance sheet :
– Liability side : creditors withdraw confidence,
– Asset side : depreciation of assets or of collateral.
• « Run » or « Panic » :
– Run : individual crisis
– Panic : contagion, systemic crisis.
3
1. Typology : Minsky buildup of debt
• Opportunity to build up debt:
– Favorable economic growth for a long while.
• 3 steps (type of loans) to the « Minsky moment » :
– A. « Repayment » : Lending against collateral : principal
repayment and future income guaranteed,
– B. « Debt service » : Only the interest payment is foreseen,
principal will be rolled over (provided it doesn’t
depreciate),
– C. « Capital gains » : Debt service can only come from
appreciation of the assets or from new deposits (Pyramid,
Ponzi-scheme).
• Minsky Moment :
– People understand unsustainability of asset appreciation
or of further debt accumulation,
– Rush to the « exit » : fire sale of assets.
Source : De Tijd : 15 Feb. 2012
4
1. Typology : Deflationary spiral
•
•
•
•
•
Assets hurt by sale (cfr Minsky)
Assets affect ability to borrow (of firms or banks)
Liquidity shortage
Higher interest rate (to get liquidity)
Further Depreciation of assets (sold to get liquidity or
net present value depreciated by higher interest rate),
…
Liquidity
shortage
Real Interest
Increase (or
risk premium)
Bank run
(or lack of loans)
Asset value
decrease
Source : Freixas and Rochet (2008), p. 236; Mishkin and Eakins .
5
1. Typology of crises
Minsky buildup followed by deflation
• Leverage – Crisis – Deleverage
Leveraging
Deleveraging
Investors allowed to
increase leverage
Investors required to
reduce leverage
They buy more assets
They do this by selling
assets
Asset prices increase
Asset prices decline
Leverage of investors
decreases
Leverage of investors
increases
Source : Hull, John C. (2009) Risk Management and Financial Institutions, 2nd Edition, Pearson, Fig 19.2 and 19.3. (Chap.
19 = Liquidity risk)
6
1. Typology of crises
Worsening of asymmetric information
• Cfr. chapter 3 on asymmetric information.
• Asset depreciation changes incentives :
– More gambling for resurrection.
• High interest rates changes pool of borrowers and
incentives :
– High interest rate eliminates prudent applicants, attracts
more gamblers (in project-based lending).
– High interest rates reduces incentives for high effort (or
room for incentives) against moral hazard (Moral hazard
increases, unless loans are renegotiated (cfr « IC debt
restructuring »)).
• Asset depreciation reduces the pool of borrowers :
– Less collateral, thus less « asset based » lending.
7
Source : Mishkin and
Eakins.
MISHKIN, F. & EAKINS, S. (2000)
Financial Markets and Institutions
(3d. Ed.), Reading (Mass.): Addison
Wesley. Chap. 14.
Asym Info Problems increase,
Economic Activity Decline
8
Typology : procyclicality of ratings
(depreciation of assets)
9
Typology : other effects :
macroeconomics
• Risk aversion increases, required returns up, stock
market down (and access to equity),
• Flight to safety,
• « Savings paradox » individually rational to save,
collectively harmful and cyclical (Keynes),
• Credit falls : credit channel beyond interest rate effect,
more credit rationing… « balance sheet » lending and
« project lending » are hurt.
• « Financial accelerator » theory.
• Government hurt : directly by bank resolution costs,
indirectly by flight to safest governments…
10
2. Bank run : liability side
• Motivation (Diamond and Dybvig (1983) )
– 1. Banks as providers of mutualized liquidity (welfare gain)
– 2. Banks vulnerable to runs (multiple equilibria)
– 3. Possible solutions to bank runs.
• Assumption 1 : Timing
2 Periods, 3 dates (Time 0, 1, 2) :
Investment decision at time 0 without knowing date of consumption,
Date of consumption revealed at time 1 (consume at time 1 or at time 2).
• Sources :
Diamond, Douglas W. & Dybvig Philip H. (1983) “Bank runs, Deposit
insurance and liquidity” Journal of Political Economy, 91, 3, 401-419.
Freixas and Rochet (2008) Microeconomics of Banking, Chapter 2, section
2 and Chapter 7, section 1.
11
2. Bank run : liability
Diamond & Dybvig
• Assumption 2 : 2 technologies :
2 Technologies :
Time 0
-
1
Technology
Liquid
Illiquid
Time 1
1
0
Transfer
No
continues
Time 2
0
R>1
• Assumption 3 : 2 types of consumers – depositors :
2 Types of agents :
Time 0
Type
unknown,
Proportion
 known
Type
1=
Impatient
2=
Patient
Proportion
1
2
=1-1
Time 1
C1 1
Time 2
0
0
C2 2
12
2. Bank run : liability
Diamond & Dybvig
• Assumption 4 : Objective : Expected Utility :
Max U(C1,C2;) = 1U(C1) + 2U(C2)
Utility concave, risk aversion,
Agents may be willing to give up some income of period 2 (which is high
given R), to increase income in period 1 : see graph next slide.
Discount factor =1 without loss of generality.
• Assumption 5 : Endowment and Investment :
Endowment = 1,
Invest D in illiquid technology and 1-D in liquid.
Investment happens at t=0, D is then illiquid.
Assumption 5A : fully illiquid, untransferable to T=1
Assumption 5B : partly illiquid, tranferable to T=1 in proportion s<1.
• Study 3 cases :
A – Autarky
B – Financial market : « arms-length trade »
C – Financial intermediation : « mutualisation »
13
2. Bank run : liability
Diamond & Dybvig :
Decreasing marginal utility of income
• Expected Utility of income < Utility of expected income
U(C)
U
U(C0)
E(U(C1, C2,Z))
E(U(1,R,Z))
0
1
C11*
E(C0) =(C1+C2)/2
or E(C0) =1C1+2C2
C22*
R
C
14
2. Bank run : liability
Diamond & Dybvig : Autarky
A. Autarky :
• Assume liquidation of D (illiquid) at rate s<1,
 C1 = 1-D+sD = 1 – D (1-s) < 1
 C2 = 1-D + RD = 1 + D (R-1) > 1 and < R
• Inefficient :
– Destruction of resources C1<1 and C2< R
because consumers don’t know their type at T=0, hence
D>0 for Type 1 consumer and D<1 for type 2.
– Expected consumption < endowment :
1C1 + 2C2/R < 1.
15
2. Bank run : liability
Diamond & Dybvig : Market
B. Financial market (no mutualisation) :
• Assume sale of RD by impatient agents at time 1 at price p<1,
 C1 = 1-D+pRD
pR>s (autarky rate)
 C2 = ((1-D)/p)) + RD = (1/p) (1-D+pRD) = (1/p) C1 ;
patient agent sells 1-D against pRD of impatient agent.
• Equilibrium price p :
–
–
–
–
p ≤ 1 otherwise D = 1
C2 = C1/p and resource constraint is 1 = 1-D+pRD, hence
p = 1/R.
NB : Excess supply or excess demand of bonds otherwise :
D = 1 if p>1/R, and D = 0 if p<1/R.
• Improvement on autarky :
 C1 = 1
 C2 = R
 D = 2.
16
2. Bank run : liability
Diamond & Dybvig : Bank
C. Bank (mutualisation) :
• Assume a bank collecting all endowments and paying C1* to impatient
agents and C2* to patient agents.
• Assume agents tell their true type and
• Utility maximizing solution :
Max U(C1,C2;) = 1U(C1) + 2U(C2)
C1, C2, D
Under constraints : 1C1 = 1-D and + 2C2 = RD ,
hence C1 and C2 are replaced by their value in D, and Max w.r.t. D only :
• FOC (on D) : - u’(C1) + Ru’(C2) = 0
MRS (C1,C2) = MRT = R.
By « decreasing marginal utility » : u(1)<u(R) and u’(1)>u’(R).
• If “by accident” u’(1) = Ru’(R), then C1=1, C2=R.
• If “in general” u’(1) > Ru’(R), then Pareto « optimum » u’(C*1) = Ru’(C*2) :
 C*1 > 1
 1 < C*2 <R
 D < 2 to ensure C*1 > 1 , which is OK given C*2 < R.
17
2. Bank run : liability
Diamond & Dybvig : Bank
• Bank mutualization improves welfare
– Transfers low marginal utility income of period 2 to high marginal utility
consumption in period 1
– Bank balance sheet :
Assets
Reserves
Investments
1C1
D
Liabilities
Deposits
1
• TWO equilibria
– Good (Pareto efficient) Nash equilibrium : C*1, C*2.
(assuming that patient investors cannot access a financial market or
investment technology at time 1)
– Bad (inefficient) Nash equilibrium : early withdrawal by agents of type 2.
(C1>1 increases incentive to withdraw, especially under assumption 5B.)
Some agents of type 1 may lose their money (under assumption 5).
18
2. Bank run : liability
Diamond & Dybvig : Bank
• Two Nash equilibria :
– Reminder 1 : Definition : Best response to best response.
– Reminder 2 : Multiple : Example : small and big wild hunting (or hunting and
cattle farm) :
Player 1
Cattle farm
Hunting
Player 2
Cattle farm
Hunting
3, 3
0, 2
2, 0
1, 1
– Both equilibria may be stable. Coordination can happen on one or the other
(cfr assumption 5).
– Variation on assumption 5 : D is set aside at Time 0, but not fully illiquid,
then one withdrawal by an agent of type 2 at Time 1 is enough to reduce the
resources for Time 2 and induce withdrawals by all agents of type 2.
• Bad Nash Equilibrium : withdrawal
• Solutions (if true 1 is known) :
– Closing banks and limiting withdrawals to 1 agents (announced);
– Deposit insurance funded by contributions on deposits .
19
2. Bank run : liability
Diamond and Dybvig
• Solutions to inefficient early withdrawals (continued)
• If true 1 is unknown
– Announced closure inefficient (announced limit   1 ),
– Deposit insurance funded by ex-post tax on withdrawals (not preannounced rate). The more withdrawals, the higher the tax : this
discourages withdrawals by type-2 agents. (restores « autarky » )
• Source : Freixas and Rochet (2008) : 7.2.3.
• NB.1. : Seignorage or currency devaluation are a form of ex-post
tax on deposits.
• NB.3. : Tax on some deposits : not just an equity motive also a
incentive motive.
• NB.2. : some trades possible, e.g. in case of limit on amounts
instead of on number of agents : cfr. « market » solution (B.
above).
20
2. Bank run : liability vulnerability
Diamond and Dybvig
Conclusions :
• Banking « mutualisation » Pareto superior to
Market and to Autarky : The bank’s value added is
« liquidity » and « risk reduction ».
• Banking mutualisation is « vulnerable » to unique
liability side with differentiated asset side :
multiple equilibria.
– Pure « liquidity risk », no « solvability risk ».
• Solutions : Limited withdrawals, tax or Deposit
insurance.
21
2. Bank run : liability
Examples
•
Cyprus 17 March 2013 (EU and euro member) :
– Package €10 Bn EU + 5,8 Bn Cyprus :
– Recapitalize banks (Assets = 800% GDP, e.g. depreciated Greek government debt, Deposits at
high interest rates from Russia + UK)
– Tax Deposits above 100.000 at 9,9%, below at 6,75% .
– Debate in parliament, banks closed for 1 week.
•
Comment :
– Tax below 100.000 € wrong : deposits were guaranteed, guarantee is part of mutualisation of
liquidity (Diamond & Dybvig) role of banks,
– Tax above 100.000 € OK but risky : can withdrawals be stopped or faced (recapitalization not
credible, assets illiquid) ?
– Devaluation (leaving the euro) could be equivalent to tax and even more universal, but risky
for other Euro members (gives bargaining power to Cyprus).
– No pure liability side problem, partly an asset side problem (Greek debt) and a deposit rate
problem.
– ECB cannot ensure liquidity if it is partly an asset-side and deposit rate problem of banks not
controlled by the ECB (no EU supervision yet) and there is no reason for EU-wide seignorage
tax.
•
•
Ireland 2008-2010 : full guarantee, costly for taxpayers, EU loans no grants.
Iceland 2008 ? (non-EU, non-euro) : no guarantee of foreign accounts, full default.
22
3. Interest rate vulnerability
Calvo (1988)
• Motivation
– Multiple equilibria : high R, low R
– Self-fulfilling expectations : Repudiation expected  high R  high cost of
debt  repudiation
• Assumption 1 : Debt issue (Time 0)
– Time 0 : debt b issued at interest factor Rb, while market interest is R.
– Interest factor compensates for partial repudiation , hence
(1- )Rb=R
(1)
• Assumption 2 : Budget constraint (Time 1) :
– Tax revenue x, exogenous expenditure g, repudiation penalty abRb :
x = (1-)bRb + g + abRb :
(2)
hence repudiation is bRb = (bRb+g-x)/(1-a).
(3)
• Assumption 3 : Objective function : consumption :
– Consumption c, affected by tax distorsion z(x), tax x, capital income Rk,
interest income (1-)bRb , endowment y :
c = y – z(x) – x + kR + (1-)bRb
(4)
Source : Calvo, G. (1988) « Servicing the public debt : the role of expectations »
American Economic Review, 78, 4, 647- 661.
23
3. Interest rate
Calvo
• Optimization : 1° choice of x* :
– Maximize consumption c with respect to tax x,
– Take distorsion (deadweight loss) function into account
z(x)
(5)
– Take budget constraint as function of x under form (3) (repudiation),
hence
– max c(x) = y – z(x) – x + kR + bRb - (bRb+g-x)/(1-a)
(6)
hence set x* such that -z’(x) + a/(1-a) = 0
(7)
• Optimization : 2° public expenditure reaction function to R :
– Public expenditure between g + full debt service bRb and g+ full
repudiation (=1) abRb :
g+abRb ≤ x ≤ g + bR
(8)
– Optimal tax x* independent of R
– Rection function on figure 1
24
3. Interest rate
Calvo
• Reaction function x (R) : Figure 1
25
3. Interest rate
Calvo
• Optimization : 3° Time consistency condition on x(R) given E():
– Expenditure at time 1 depends on actual debt service, thus on actual Rb,
given b and given expected repudiation share  at time of issue of b (Time 0)
In Budget constraint (2) x = (1-)bRb + g + abRb ,
set by arbitrage equation (1) (1-)Rb=R or  = 1-(R/Rb),
x = bR + g + a(1-(R/Rb))bRb
x = (1-a)bR + g + abRb .
(9)
• Equilibrium condition : Reaction function = Consistency condition
– Tax and interest must satisfy optimization at time 1 (reaction function) and
consistency from Time 0 .
– See figure (2) (next slide)
• Multiple equilibria :
– (1) No repudiation (low R) : Taxation below maximum and optimum x* ;
– (2) Repudiation of a share  of the debt b : high Rb > R : Maximum taxation x*
(on reaction function) is reached by consistency condition : Self-fulfilling
expectations : Repudiation expected  high R  high cost of debt 
repudiation
26
3. Interest rate
Self fulfilling expectations : Calvo
• Equilibrium : Optimization and time consistency
27
3. Interest rate
Multiple equilibria : Calvo
• Illustration : Euro-area sovereign debt crisis :
–
–
–
–
Interest rate Spain > UK
Debt/GDP Spain < UK
Expected default from Spain, not from UK ?
De Grauwe’s claim : UK borrows in own currency, Spain in euro (no
expected depreciation of UK pound in RUK ? )
Source : De Grauwe, Paul (2011) « The Governance of a fragile eurozone » KULeuven and CEPS working paper.
28
3. Interest rate
Multiple equilibria : Calvo
Comparative statics
• Effect of an increase in the repudiation cost a :
– Assume z(x) = ex, hence x* = ln (a/(1-a)) : higher x* with higher a,
– Compute set x* in consistency, write as a function of Rb and derive w.r.t. a
– Higher repudiation Rb, but still multiple equilibria.
Source : Bouchat, Caroline
(2012) « Helping the debtor
or the creditor : the case of
the European Debt crisis »
Master thesis, Namur, June.
29
3. Interest rate
Multiple equilibria : Calvo
Comparative statics
• Effect of an increase in the inital debt b :
– Larger interest rate range of multiple equilibria (left)
– Shift of the consistency condition (lower crisis Rb).
30
3. Interest rate
Multiple equilibria : Calvo
Comparative statics
• Effect of an increase in the exogenous expenditure g :
– Increased vulnerability (lower crisis Rb).
31
3. Interest rate
Multiple equilibria : Calvo
Application : link sovereign  banks
• Sovereing spread applies to domestic banks, also within Euro-area. Weak
sovereign kills banks and domestic credit and recovery …
http://www.voxeu.org/article/banking-union-eurozone :
Giovanni Dell'Ariccia, Rishi Goyal, Petya Koeva-Brooks, Thierry Tressel, 5 April 2013 A banking union for the Eurozone , Vox EU.
Figure 2. Bank CDS spreads cluster along country lines during crisis1
Source: Bloomberg and IMF staff calculations
Notes: 1The sample includes all 31 banks in the 2010 EU-wide EBA stress test for which CDS data (end of month) were available in Bloomberg.
Available data for Greece in 2012 are not plotted due to being far away from the rest of the sample (the CDS spreads of two Greek bank spreads
were 1990 bps and 2027 bps, and the sovereign Greek CDS spread was 8711 bps as of May 2012).
32
4. Asset run
• Sources of asset run :
– Worsening of quality of assets (Subprimes 2007-2009, Lehman
Brothers bankruptcy 15 sept 2008, Insurance companies like
AIG, MBIA failing)
– Worsening of asymmetric information,
– Fire sales by illiquid institutions,
– Freezing of interbank market (2008-2009)
• References :
– Diamond, Douglas W.; Rajan, Raghuram G.(2011) “Fear of fire sales,
illiquidity seeking and credit freezes”; Quarterly Journal of Economics,
May, pp. 557-91
– Diamond, D., and Rajan, R. (2005) “Liquidity shortage and banking
crises” Journal of Finance, 60, 2, 615-647. (Freixas and Rochet 2008,
chap 7, sec 6, asset side of crisis) (High interest rates are contagion
mechanism, while Diamond-Rajan 2011 has low price of assets as
contagion mechanism and credit freeze).
33
5. Bank intervention issues
5.1. General framework of intervention
• Liquidity : Central bank lending of last resort
• Solvability : Bail in, Bail out, government intervention.
• Motivation:
– Protection of depositors, protection of the system against bank
runs,
– Multiple equilibria, panics, may destroy good banks and good
assets,
– Interconnection of banks,
– Other reasons …
• Risks:
– High cost for taxpayer,
– Rewarding poor management,
– Postponement of clean up, postponement of new loans :
diversion of funds to old activities instead of to new ones.
34
Bank intervention issues
5.2. Liquidity provision : Lending of last resort
• Lending of last resort (Liquidity)
– Bagehot (19th century) : « lend freely at penalty rate against good
collateral » : currently rather low rates for all but « collateral »
issue remains.
– In 2008-2009 Central banks have enlarged accepted collateral.
– Liquidity problem sometimes hard to distinguish from solvability
(quality of collateral?) and can turn into solvability problem due
to discount on fire sale of assets (especially if massive).
• Control and intervention
– Will central bank transfer problem bank to other authority ?
• Too early : hurts the bank
• Too late : hurts the creditors and the taxpayers.
35
Bank intervention issues
5.3. Bank solvency issues
• Resolution techniques
– Asset side :
• Guarantee on assets
• Repurchase of assets (at which price?) – Transfer to a « bad bank »
for liquidation (sale) of impaired assets.
• Shared liquidation of assets and shared profit and losses (to be well
designed) .
– Liability side :
• Guarantee of (some debts),
• Bail in of (some) creditors – contingent claims  Equity
(motivation : see e.g. “Incentive-compatible debt restructuring”)
• Loans with call on shares (at low price?) : transfer of ownership if
the bank doesn’t recover (ING, KBC Oct 2008).
• Takeover and sale.
• Examples and effects in the 2007-2012 crisis
36
Bank intervention issues
5.4. Debtors
Alternative route : helping debtors ?
• Subprime : banks helped, debtors not : all gain for banks ?
(foreclosure enables the bank to seize the house mortgaged for the subprime loan;
the borrower may walk free, the bank takes the loss if the value of the house is not
sufficient. The borrower loses the house and his contributions to it).
• GM helped (2009, US Government recapitalizes),
• Brady plan Latin America (1989-1992) : « haircut » : banks helped if
partial debt relief granted. Helps creditors too. New bonds partly
guaranteed by US treasury. « Menu » approach : banks choose type
of relief. Shared cost and benefit, limited perverse effects on
countries, interest rates fall.
• Greece 2010 : Greece helped (new loans, « throwing good money
after bad ») to continue to pay banks. Interest rate doesn’t fall,
Greece doesn’t recover. Excessive debt burden for Greece. (Wyplosz 2011 *
claimed that Greece should have defaulted on its private debt, obtained confirmation, and that EU governments should have transferred
money to banks in trouble, not to Greece, respecting both the initial Maastricht treaty and the national rules of intervention in banking).
• Greece 2012 : Debt relief, Public, then private. Large losses for
private debt holders. Side effect on Cyprus banks ?
* Wyplosz, Charles (2011) « They still don’t get it » Vox EU 25 Oct. 2011 http://www.voxeu.org/article/eurozoneleaders-still-don-t-get-it
37
Bank intervention issues
5.5. The vicious link of banks and sovereigns
• Case 1 : Direct :
Through public debt sensitivity of banks
• Solution : Avoid costly bail-out, enter the crisis with low initial
public debt, get credibility to lower interest rates, enter the crisis
with cautious and well capitalized banks... Or just default…
Banking
bankruptcies
SHOCK
Asset
depreciation
Government
Assistance to
banks ( bail out)
Doubts about
support of the
sovereign for the
banks
Public debt
High interest
rates
38
Bank intervention issues :
The vicious link of banks and sovereigns
• Case 2 : Indirect :
Trough public debt and economic activity
• Solution : avoid bail out or limit their cost or enter the crisis with
low debt and high credibility or with small and healthy banks and
with few interest-sensitive businesses…
Bank troubles
Asset depreciation
(private and public)
SHOCK
Bank bail-out by
the government
Falling tax
revenue
Public debt
High interest
rate
Weaker economic
activity (AD)
Budget cuts
(« austerity »)
39
Bank intervention issues – The bank-sovereign link
The case of the Greek banking closure (July 2015)
• (1) Normal bank liquidity problem :
Deposit Bank (DB)
Central Bank (CB)
Assets
Liabilities
(Credit to C)
(Debt to DB)
Loan to DB
Cash
Collateral
Loan
Assets
Liabilities
(Credit to C)
Equity
Debt (to CB)
Cash (+)
Deposits
Deposit bank facing deposit withdrawals (or interbank payment problems) can borrow
cash at the central bank against good collateral (credits to customers C, private or
public). Withdrawals often stop thanks to restored confidence.
If the deposit bank cannot return the cash to the CB to repay its loan, it repays with
the collateral (valued with a “haircut”).
At the end, in either case, the total assets and liabilities are unchanged. No money
creation (provided the credits to customers are safe and bring cash back to the CB and
out of circulation, when they are repaid or when the CB sell them to a cash-rich DB).
40
Bank intervention issues
Greek banking closure July 2015
• (2) Normal bank solvability problem : Direct cash assistance
Deposit Bank (DB)
Assets
Liabilities
(Credit to C)
Equity
Debt
Cash (+)
Deposits
Government (G)
Rescue
Assets
Liabilities
Assets,
property rights
Debt
Deposit bank facing a weak credit portfolio (not accepted by
CB as collateral for a liquidity providing loan), and facing
high interest rates on the debt market (bonds or interbank),
can borrow cash from the Government (G) (in exchange for
debt or equity) at high but sustainable interest rates (or
equity dilution). The Government itself borrows the
necessary amount from private lenders, at low interest rate,
because government bonds are perceived as liquid and “risk
free”.
Loan
Private lenders
October 2008:
-Netherlands : ING,
- Belgium : KBC.
41
Bank intervention issues
Greek banking closure July 2015
• (3) Normal bank solvability problem : Indirect cash assistance
Rescued Deposit Bank (DB)
Assets
Private Investors (+1)
Liabilities
Central Bank (CB)
Credit to C (- 5) Equity(-2 + 1)
Gov. Bonds (+ 3) Debt (+x)
Cash (+1+x)
Deposits
Exchange at a discount (3 to 5)
Assets
Liabilities
(Credit to G)
(Debt to DB)
Loan to DB (+x)
Cash
Government (G)
Resolution Fund (« Bad Bank »)
Assets
Liabilities
Credit to C(+3)
Equity(+1)
Debt to G(+2)
Assets
Risk
Liabilities
property rights (+1) Debt (+3)
Loans (+2)
Sweden 1990, Poland 1992-95, …
« Rescued » deposit bank gets « safe » , central bank eligible, government bonds.
It takes losses on old credits and transfers them to the resolution fund. Private
investors recapitalize part of the losses. All operations are joint and conditional.
42
Bank intervention issues
Greek banking closure July 2015
• (4) Bank Government doom loop problem :
Deposit Bank (DB)
Assets
Liabilities
(Credit to C)
Credit to G
Equity
Debt
Cash (+)
Deposits
Government (G)
Rescue 1
Assets
Liabilities
Assets,
property rights
Debt
Rescue 2
When the government itself faces borrowing problems, it
borrows from its own banks.
Neither the deposit banks nor the government can create
cash (money) to satisfy depositors (or “outside” banks).
Usually government bonds are accepted as collateral at the
central bank. But there may be limits, certainly for Greece
(in default at the IMF) in the Euro area. The ECB doesn’t
want to create extra cash (liquidity side).
Loan
Private lenders
Greece 2015,
Congo 1993, with
cash for deposit
exchange rate <1!
43
Bank intervention issues
Greek banking closure July 2015
• (5)Bank Government doom loop problem and money creation :
Deposit Bank (DB)
Assets
Liabilities
(Credit to C)
Credit to G
Equity
Debt to CB
Cash (+)
Deposits
Government (G)
Rescue 1
Central Bank (CB)
Assets
Liabilities
(Credit to G)
(Debt to DB)
Loan to DB
Cash
Liabilities
Assets,
property rights
Debt
Rescue 2
Loan
Collateral
Assets
When the CB provides liquidity (cfr (1)) to
the DB on the basis of credit to an
insolvent G as collateral, it cannot hope
that the G bonds will return the money
nor can the CB sell these bonds against
money. There is net money creation.
If the CB refuses, then the DB and the G
must rely on “current” cash to operate.
44
Bank intervention issues
Greek banking closure July 2015
• (6) Breaking the doom loop problem :
Deposit Bank (DB)
Assets
Liabilities
(Credit to C)
Credit to G
Equity
Debt
Cash (+)
Deposits
Government (G)
External
Rescue
Assets
Liabilities
Assets,
property rights
Debt
Default and
renegotiation
New shareholders,
In a monetary union, money creation, bank rescue
possibly another
and government debt renegotiation could get
bank
separate treatment:
* Bank solvability is monitored and rescued by a
Limits on loans to G?
banking union (for bank supervision and
In a monetary union!
resolution or rescue),
* Government debts are limited or can default.
No « perfect » solution, US-style
Liquidity is ensured by a fund, but solvability is
immunity, without « fiscal union »
market risk.
45
Bank intervention issues :
The vicious link of banks and sovereigns
Consequences and Examples
• Monetary Union vs. Domestic currency :
– Domestic currency : inflationary
– Monetary union : inflation spillover in proportion of size of country or debt
spillover in proportion of the needed liquidity provisions (to countries : Ireland
2011, Spain 2013) or of the needed recapitalizations (of banks : Greece 2015 ?
Cyprus 2013 ? ).
• Public debt growth :
Spain 2007 : public debt about 50% of GDP
Spain 2012 : public debt about 90% of GDP + need of ESM (European
Stability Mechanism) rescue program for its banks (credit line 100 Bn, used
60Bn).
• Portfolio of public debt in banks :
2007 : EU-wide diversified in each bank,
2012 : Share of domestic public debt has increased (fear of default of foreign
countries, less leverage of the bank on government to be rescued)
• Size of country, size of bank and troubles :
Ireland, Belgium, Netherlands strongly hit by banking crisis in 2008 : small
countries with large banks, the sovereign cannot guarantee its banks… 46
The SBBS proposal
Ref : Brunnermeier, Langfield et al. 2017
Brunnermeier, M. K., Langfield, S., Pagano, M., Reis, R., Van Nieuwerburgh, S., & Vayanos, D. (2016). ESBies: Safety in the tranches.
Economic Policy 2017
• SBBS = Sovereign Bonds Backed Securities
• Tranches : Senior – Mezzanine – Equity (junior)
• Composition : Euro area government bonds in
proportion of capital ECB
• Motivations
– Common liquid Euro safe asset
– Flight to safety across tranches instead of across countries.
• Needed step : regulation
– Currently structured products, subordinated tranches are
not accepted as collateral and have high equity
requirements for holders.
– Transparency, label ? But no « guarantee »
47
• Bank risk and sovereign risk :
BANKS
Sovereign risk
Assets
Liabilities
Loans to the economy 
Equity 
Sovereign Bonds 
Deposits
Eco growth  Tax 
Bail out cost
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SBBS comments
• Possibly good for banks portfolio (diversification)
• MM argument : no change in assets, no change in value of
bonds ?
• Issuers may gain if aggregate risk falls, especially flight to
safety risk premium, link banks – sovereign risk premium.
• Treatment of mezzanine and equity tranches in portfolio’s ?
Who holds ? Increased volatility (concentration of risky
issues of bonds, despite aggregate composition across 3
tranches equal to capital weights of ECB).
• Composition : Why not equal to outstanding bonds ?
• Need of a lively bond market for underlying bonds (price
discovery, arbitrage).
49
Financial crises
6. Conclusions
• Vulnerabilities
– Asymmetric information (worsening adverse selection and moral
hazard),
– Maturity pooling and transformation (Diamond & Dybvig)
– Multiple equilibria (bank run or not, self-fulfilling risk premium or not,
fire sales or not…)
• Interventions
– Liquidity provision (against multiple equilibria),
– Recapitalization (against solvency problems)
? Of whom by whom ?
– Risk of forebearance, roll-over, debt accumulation, misallocation of
credit…
– Risk of a Bank-Sovereign doom loop, worsened in a Monetary Union.
50