Riding for a fall? Concentrated
banking with hidden tail risk
Marcus Miller, Lei Zhang and Han Hao Li
University of Warwick
1
Independent Commission on Banking (ICB):
background and mandate
• ‘The global financial crisis that began in 2007 has exposed
fundamental weaknesses in banking systems and related
financial markets. Major financial institutions, including in the
UK, were saved from failure only by massive government
support schemes. Others were taken over by competitors, or
collapsed. ‘
• ‘Securing a stronger and better functioning financial system is
the goal of a range of public policy initiatives.’
• ICB established June 2010 to make recommendations by Sep
2011 on ‘measures to promote stability and competition in
banking for the benefit of consumers and businesses
2
ICB :Call for Evidence
• Warwick group of 5 – including Sayantan Ghosal,
Peter Hammond and Michael Waterson as well
as two of the current authors - responded to the
‘Call for Evidence’ last year.
• 150 Submissions available on ICB website.
• What follows is based on the paper attached to
our Evidence - revised for presentation at RES
Conference in April.
• Comments and suggestions welcome !
3
Financial crisis and support packages, Haldane (2009)
UK GDP in $ is $2.28 trillions approx.
Exchange rates used: FSR Euro / US dollar exchange rate of 0.710.
Sterling / US dollar exchange rate of 0.613.
4
How UK banking sector grew from half
to five times annual GDP
5
How leverage has increased from 20 to 40
Total Assets Risk W Assets

 0.08
Capital
Total Assets
6
Evidence of a “productivity miracle” in
finance?
The share of banking in Gross Value Added rose from 5% in 1970 to 8% in 2008, but the
share of profits in economy-wide profits rose 10 fold (from 1.5% to 15%).
7
Outline of argument
UK Banks
Excess risk-taking
(‘gambling’)
Concentration
Franchise Value
Too Big To Fail
?
‘Skin in the
game’
Capital buffers +
Competition
8
Money Matters
– how and why?
I. Fisher 1847-1947
K. Marx 1818-1883
M. Friedman 1912-2006
J. Stiglitz, born 1943
J. M. Keynes
1883 – 1946
Diamond & Dybvig / Allen & Gale
workhorse model of competitive banking – and bank runs
Two period endowment economy, short and long assets and early and late consumers with
preference uncertainty.
Proposition 1: The optimal competitive banking contract

satisfies the first order condition for inter-te mporal efficiency,

satisfies the zero profit condition,
This contract has the feature that:
,
.
.
(for convenience, we assume risk aversion to be greater than 1).
NOTE : The Modigliani-Miller Theorem applies : so capital structure may be varied without any
implications for the asset side of the balance sheet:
10
Inter-temporal
efficiency
Competitive
banking
Market
equilibrium
R
A
Iso-EU
Participation
constraint
1
Figure 1. Competitive banking: Diamond & Dybvig, Allen & Gale
11
Inter-temporal
efficiency
Competitive
banking
Market
equilibrium
R
A
Iso-EU
y
x
1
Figure 3. Competitive banking: Portfolio allocation
12
Monopoly bank that does not gamble but widens
its spread on intermediation
Proposition 2:
The optimal monopoly banking contract

satisfies the FOC for inter-temporal efficiency,

satisfies participation constraint,
This contract exists if and only if
,
.
and it must satisfy
.
13
Inter-temporal
efficiency
Competitive
banking
Market
equilibrium
S
R
A
B
‘Monopoly
Profit’
Monopoly
bank
Iso-EU
Participation
constraint
1
Figure 2. Competitive and monopoly banking with no gambling
14
Monopoly bank: comparative statics
Proposition 3:
(1) An increase in
will increase the value of the outside option. Consumption at date 2,
increases, with a rising spread between
and
,
.
(2) An increase in , the fraction of early consumers, has no effect on the outside option. So
down and
goes
goes up.
(3) An increase in the utility,
, associated with the outside option will result in an increase in
consumption in both dates.
In their chapter entitled ‘ What is the contribution of the financial sector? in The Future of
Financ, Haldane et al (20100 consider two different interpretations of the` sharp rise in value added
in banking: Miracle or Mirage?
15
A positive productivity shock!
Inter-temporal
efficiency with R’>R
Inter-temporal
efficiency with R
New market
equilibrium
R’
N’
Productivity
miracle
A’
B’
N
R
New
participation
constraint
A
B’’
B
Participation
constraint
1
16
Monopoly bank that gambles with “fake
alpha” investment*
Proposition 4:
(1) If the bank uses the risky technology, and if
contract is a solution to
(2) If
and
, then the optimal
.
, the optimal deposit contract is the same as that in Proposition
1.
Note: Because it assumes no tax distortions, transactions costs, agency problems, or asymmetries of
information, Modigliani and Miller theorem (1958) does not apply.
* As in Rajan (2005, 2010), and Foster and Young (2010).
17
A productivity ‘mirage’: monopoly banking with tail risk
S
Market
equilibrium
Inter-temporal
efficiency
condition
A’
N
R
B’’
Monopoly with
tail risk
A
B
Participation
constraint
1
18
Mixture of miracle and mirage
Inter-temporal
efficiency with R’>R
Inter-temporal
efficiency with R
New market
equilibrium
R’
N’
Productivity
mirage
Productivity
miracle
A’
B’
N
R
New
participation
constraint
A
B’’
B
Participation
constraint
1
19
Rising incomes in financial services and inequality
1
P
Cumulative
fraction of
income
O
Cumulative fraction of population from lowest to highest incomes
1-σ
1
Figure 4: Gambling and Gini Coefficient: Miracle or Mirage
20
No Gambling Condition: and ‘mimicking’ as in
Foster and Young (2010)
Taking on ‘tail risk’
Gambling
Figure 4. No-gambling-condition (NGC) and the mimicking constraint
21
Capital Buffers, Franchise Value and Gambling
Capital
buffers
L
No
Gambling
Higher tail risk
Gambling
N'
M
Franchise value
22
Impact of “Too Big To Fail”
R
Capital
Buffers
No
Gambling
L
Gambling
N'
Gambling
UK
TBTF
Concentration
Figure 6. How bailouts increase the risk of imprudent banking
23
Steps to promote competition and stability
R
Capital
Buffers
Gambling
No
Gambling
L
Resolution
N'
Gambling
Re-regulation
TBTF
UK
Concentration
Figure 6. How bailouts increase the risk of imprudent banking
24
Martin Hellwig et al. (2010)
• Banks’ high leverage, and the resulting fragility
and systemic risk, contributed to the near
collapse of the financial system. Basel III is far
from sufficient to protect the system from
recurring crises. If a much larger fraction, at
least 15%, of banks’ total, non-risk-weighted,
assets were funded by equity, the social
benefits would be substantial. And the social
costs would be minimal, if any.
25
David Miles et al (2010)
• It is remarkable to note that our central estimate
for the marginal cost and benefit of higher capital
suggests an optimal capital ratio of about 50% of
risk weighted assets – which might mean a capital
to total assets ratio of around 17% and leverage
of about 6. This would be about 5 times as much
capital – and one fifth the leverage – of banks
now.
(Setting aside risk of GDP fall, our central estimate
of optimal capital is 19% of risk-weighted assets. )
26
Need for reform: Diane Coyle (2011).
• ‘The truth is that banks are again doing well
out of banking, but businesses and consumers
are not... Bonuses are back... they are a
measure of monopoly rents in the business, it
does not take great talent to make a profit by
taking excessive risk, safe from effective
competition and sure of a bail-out if needed.’
27
Haldane on the history of banking*
• ‘In the Middle Ages… the biggest risk to the
banks were from the sovereign. Today,
perhaps the biggest risk to the sovereign
comes from the banks.’
Andrew Haldane is Director of Financial Stability
at the Bank of England
*P. Alessandri and A. Haldane (2010) ‘Banking
on the state’, Bank of England
28
Structure of paper
Market conditions
This paper
Market structure
Usual assumptions
(DD&AG)
Competition
Concentration
Information
Symmetric
Asymmetric
Liabilities
Competition – and
monopoly
Symmetric – and
Asymmetric
Retail Deposits: short
and long
Retail or wholesale
Retail Deposits: short Deposits: retail and
and long
interbank deposits
Loans
Retail lending
(Household and SME)
and Wholesale
Bank runs
Bank runs (e.g.
Bank runs
Northern Rock)
N/A
Excessive risk taking Gambling with
asymmetric
information
N/A
Low capital buffers,
Insolvency, bailouts
insolvency followed
and capital buffers
by bailout and/or
nationalisation
Assets
Market failure:
multiple equilibria
Market failure:
agency problem
Policy
Footnote: liquidity problems sidestepped
29
Banks v Hedge Funds : battle of the giants
Deposits
Banks
Insured deposits
Hedge funds
Investment by qualified
investors with limited
partnership
Liability
Limited Liability
Leverage
High: 30 -40
Profits
(net, 2010 H2)
FT Wed March 2, 2011.
$26b
(Goldman Sachs, JPMorgan,
Citi, Morgab Stanley, Barclays,
HSBC)
Partners with unlimited
liability
Low: less than a tenth of that
of the largest global banks*
$28b top 10
(inc Quantum, Paulson)
* Source: Haldane (2009, p. 9)’Banking on the state’, Bank of England, who comments:
(a) the structure of the hedge fund sector has emerged in the absence of state regulation and
supports ;
(b) it might be that the structure of this sector [has]delivered greater systemic robustness than
could be achieved through prudential regulation.
30
Karl Marx
Mike Artis
31
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Riding for a fall? Concentrated banking with hidden tail risk