Deregulation
• Deregulation will lead to
– More competition
– More efficiency
– More welfare
– More innovation
– More risk
• Deregulation always requires reregulation of
the new risks
Crisis in the financial system
The traditional banking model
• Distribute and hold
– banks have financed mortgage lending through
deposits (originate and hold)
– Limit to the amount of mortgage lending.
– Loans and default risk appear on the balance
sheet
– Bank needs capital to cover its risk
– Screening, monitoring and information processing
are of the essence
The new model of banking
• Originate and distribute model
– Brokers sell the mortgages
– Banks provide financing for the loan
– But then repackage the loan and sell it to bond
markets.
– Hence the rise of new financial instruments
– This process is called securitisation
Economic advantages of originate and
distribute model
– Securitisation enhances secondary market for
loans, which will enhance the credit supply
– Investors get broader risk-return opportunities
– Risks (theoretically) spread more broadly (system
more capable of absorbing “stress”)
– Research suggests that securitisation leads to
lower spreads in consumer credit and softens
interest-rate shocks for banks
Risks of
originate and distribute model
Structured finance: instruments

RMBS – Residential Mortgage Backed Securities

CMBS – Commercial Mortgage Backed Securities

MBS – Mortgage Backed Securities

ABS – Asset Backed Securities

CDO – Collateralised Debt Obligations

CDS – Credit Default Swaps
7
The magic of CDO’s
• Mortgage-backed securities (MBS) and other
structured credit were repackaged in CDO’s
– Banks create special purpose vehicle (SPV)
• Asset side: MBS
• Liability side: Collateralized debt obligations (CDO)
– Cut MBS in risk tranches, repackage them and sell as bonds
(CDO)
– Make even further derivatives (CDO’s of CDO’s)
• Rating agencies rate these CDO’s, but nobody has a
clue of their real value
Cashflow waterfall origin
Cash waterfall destination
Why are banks interested in distribute and
hold model?
• Business proved extremely profitable for
banks:
– Banks get more balance-sheet flexibility which
allows them to economize on capital (BIS rules)
– They can lend without raising deposits or capital
and without the cost of screening and monitoring
– The risk does not appear on their balance sheet
– They earn a fee for each mortgage they sold on.
– They urged mortgage brokers to sell more and
more of these mortgages.
– All competitors do so, rational herdin.
Why do banks take the bite I?
• Lack of basic understanding of risks
– Liquidity risk
– Counterparty risk
• Disaster myopia
– Subjective probability of crisis depends on the
frequency of an event
– Subjective probabilities may be off mark with low
frequency events and long time lapses
– Certainly if there is a threshold heuristic
Disaster myopia
Subjective probability of disaster
(Tverksy and Kahneman)
Real probability
Treshold heuristic
Last crisis
time
How disaster myopia works?
• How to compete with myopic banks in the
absence of a crisis
• This is almost impossible
• So banks mimic each other’s behavior
• So at the next crisis, the market is often
dominated by myopic banks
Herding behavior
This may even be rational
Implication
• In the presence of competition, financial markets
will always be driven to instability
• This means we need
– Buffers in the form of capital rules
– Limits on bank models in the form of leverage and
liquidity rules
– Not too much deposit insurance, because this only
reinforces the moral hazard problem
– A resolution mechanism that actually kills the myopic
banks if a crisis strikes