Download “Bailouts and Financial Fragility” by Todd Keister

“Bailouts and Financial Fragility” by Todd
Keister
Discussion by Giovanni Calice
University of Southampton and University of Bath
Oslo - September 3, 2010
My Foremost Comments
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The purpose of the paper is to provide a further step towards evaluating the
desiderability of bank bailouts and their effects on financial stability
Trying to investigate the effects of bailouts in formal economic models is a very
worthwhile undertaking
- It is clear that much effort has gone into the writing of this paper. It is a
promising piece of work
- My comments are really all in the spirit of “what would I change to make the
paper more convincing to the reader”
There is a great deal to be learned from studying this type of literature. And the
non-specialist reader (such as myself) can gain a great deal of insight
- Consequently, I will try to identify the limitations that underlie this research,
particularly with respect to the approach taken
Discussion
Overall
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The paper uses the classic approach put forth in the work of Diamond and
Dybvig (1983, JPE) to develop a model of financial intermediation and fragility
- The paper examines the economic effects of public sector bailouts of banking
institutions in an environment with idiosyncratic liquidity risk and limited
commitment
This paper is in the fine tradition of the well thought out highly intuitive
banking policy and financial fragility literature in the mould of work by
luminaries such as Diamond and Dybvig (1983, JPE)
- Previous works have examined the incentive effects of financial sector bailouts
and optimal regulatory policy (see, e. g., Chari and Kehoe (2009), and Green
(2010, FRB, EQ)
The model deviates from the studies by Gale and Vives (2008, WP) who study
dollarization as a device fir limiting a central bank’s ability to engage in
bailouts, Fahri and Tirole (2009, NBER) who focus on the strategic
complementarities generated by indiscriminate bailouts
- The focus of the paper is in fact on the related concepts of “illiquidity” and
“financial fragility” and on mechanisms of public intervention such as
government ad-hoc “bailouts”
The theme of the paper hence is closely related to both the literature on the
incentive effects of bailout policies and the literature on financial stability
- Overall, this is a valuable extension to the existing literature, although subject
to a few limitations
Discussion
Contributions (Scheme and Findings)
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The paper represents an instalment on a very important research agenda
Simple measure, some elegance in the sense that the structure of the model is
used to derive the q-efficient allocation of resources
- Key novelty of the paper is simply to assess the trade-offs between
discretionary government-orchestrated bailouts and commitment to not
rescue financial institutions and their implications on financial stability
- To shed some light on the optimal policy arrangements, the paper presents
the allocation of resources that emerges in equilibrium welfare under 2
asymmetric policy regimes (1. discretion; 2. committing to no-bailout)
This particular instalment offers some interesting new “facts”
- In the big picture of understanding the effects of public-sector bailouts on
the efficient allocation of resources and financial stability, the author reports
on some significant and “innovative” findings
1. The insurance provided by a bank bailout can have a stabilizing effect on
the financial system
2. Perhaps surprisingly, the commitment to a no-bailout policy would make
the financial system even more fragile and thus lessen the aggregate welfare
3. Imposing ex-ante a Pigouvian tax on short-term liabilities (the maturity
transformation function of intermediaries) can be an effective policy measure
to offsetting the bailout distortionary effects on ex ante incentives
Discussion
Comments
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I have some relatively minor concerns about specific aspects of the analysis
The paper is primarily a theoretical exercise
In general, the relationship between government’s bailout policies and
financial fragility is very complex
The approach is based on this one assumption that the distortions created by
the bailout policy cause intermediaries to become too illiquid
- The paper thus does not cater to the intellectual foundation of capital as
buffer against insolvency (to promote safety and soundness of banks) and as
incentive device against excessive risk taking or stopgap measure providing
room for supervisory intervention
Possible limitations
- Goodhart’s repeated liquidity conundrum: Think about also the inclusion of
capital requirements (in period one as well as subsequent periods)
- Why not to incorporate explicitly in the model a role for central banks (A
dynamic model of central bank intervention)?
- After all central banks act as a lender of last resort to the banking sector
during times of financial crisis
Systemic Risk Considerations
- A special regime for systemically important financial institutions?
- Would a bankruptcy procedure be appropriate instead?
- See the recent paper by Ayotte and Skeel Jr. (2009, JCL)
Discussion
Comments
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The author identifies the degree of illiquidity as the ratio between short-term
liabilities and short-run value of banks assets. So he assumes that this
indicator has information (which is true) as we all know that maintaining a
balance between short-term assets and short-term liabilities is critical
I should say that Proposition 3 is beautifully simple and intuitive and for once
you do not feel that any nasty assumptions have been made to obtain this
solution
However, what about the cost of liquidity (illiquidity)?
- A bank can attract significant liquid funds, but at what cost?
- Lower costs generate stronger profits, more stability, and more confidence
among depositors, investors, and regulators
Is this the right apparatus to assess the relationship between illiquidity and
financial fragility?
- Is financial instability related to idiosyncratic or aggregate shocks?
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- Are we sure that only liquidity really matters? What about insolvency?
Moreover, I see the need to include some structure on the liability side
Section 4 is probably the weakest and I assume that more work will be done
here
- The author’s objective is obvious, build a structural model from which the
elements of the equilibrium allocation of resources can be determined
Discussion
Comments
The work is somewhat difficult to interpret
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This is not a criticism
- However, there is a lack of much of an overall conceptual framework to help
us to understand the possible sources of connections between changes in
expected market tail risk (e. g. Bearn Stearns default) and the array of public
policy interventions
- Put differently, we need to consider the sources of heterogeneity in macro
adjustments at the most basic level and how this heterogeneity is likely to
interact with changes in financial fragility
An additional query is with the comparative statics, which seem a bit light, if
for example the author wished to target a big hit such as Economic Theory
Could the model be extended to consider also the portfolio asset allocation
strategies of financial institutions?
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Models that combine:
- Asset volatility
- Liability structure
- Market measures
- And sensitivity to macro conditions
are pretty much the only “full spectrum” solutions
Discussion
Conclusions
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Frontier paper
- Nice theoretical framework
- Punch-line is well taken and convincing
- Interesting findings (new facts)
Impressive paper
A pleasure to read
To get a big hit, it needs that sections 4 and 5 spruced up and a bit of cleaning
in terms of the writing
The paper provides a basis also for future empirical work
- We need more structure and further analysis to interpret and understand
these new facts
- More theoretical and empirical work is required to have a broader view of
which market failures are important (Ex: recapitalization costs in downturns
vs. moral hazard in upturns) and which regulations are needed to address them
There is much promise in this line of work
In sum:
- The paper by Keister considers an interesting and important topic (especially
for policymakers and regulators)
- It makes only a start on this topic
- I very much look forward to a more comprehensive analysis in his future
research
Discussion