What Do Banks Do? Delegated Monitoring Systemic Risk and Financial Regulation Bonn 2015, Lecture 3 MPI Collective Goods Martin Hellwig

The lack of bank equity – a factor in the crisis  Typically 2-3% of total assets with US investment banks and with European banks  Deleveraging multipliers for fire sales very large (30 – 50)  Solvency concerns arise quickly – breakdown of interbank markets, repo runs  Admati – Hellwig: Much more equity is required, 20 – 30 % of total assets, as they used to have before WW I – and as they require e.g. From hedge funds

Debate on bank equity  Counterargument: „20 – 30 % equity is fine for nonfinancial firms (which have banks lending to them), but banks are different“  In what sense are they different?  Banks have always funded with much more debt than other firms – why?  Is there something essential about banking that requires them to have a lot of debt?  What do banks do?

Intermediation and delegated monitoring  Frictions in external finance: information asymmetries and moral hazard endanger the financier‘s position; if financiers are (too) apprehensive, many productive projects will not get off the ground.  Financial intermediation can reduce frictions: Monitoring by the intermediary screens out bad projects and prevents moral hazard  What about information asymmetry and moral hazard in the relation between the intermediary and the his financiers?

The paradox of intermediation  Intermediation lengthens the chain of transactions  How can it reduce transactions costs?  How can it reduce moral hazard?

Transactions costs (Hellwig 1998)  If m final investors invest in diversified portfolios involving n nonfinancial firms, there are mn transactions.  If m final investors invest in a bank and th ebank invests in n nonfinancial firms, there are m+n transactions. For m>2 and n>2, m+n < mn.

Frictions  Information asymmetries  Ex ante: How good is the firm‘s project?  Ex interim: how is the firm doing?  Ex post: What has the firm earned?  Moral hazard  Effort: Is the entrepreneur putting in proper effort  Project choice: Is he investing in the right project (issue of excessive risk taking, private benefits)

Verification problems and debt  If returns cannot be verified ex post, a debt contract is the only way of raising outside funds  Townsend (1979), Gale-Hellwig (1985): Standard debt contract: Fixed obligation; this is paid if and only if it can be paid; if it cannot be paid, there is costly state verification (bankruptcy), and confiscation of remaining assets  Diamond (1984): If state verification is impossible, use nonpecuniary penalties

Moral hazard and security design  Jensen and Meckling (1976):  External finance by equity is bad for incentivizing effort  External finance by debt is bad for incentivizing risk choices  „Optimal debt – equity ratio“ determined by the tradeoff between the two  For a formal analysis see Hellwig (JFI 2009) – JM analysis requires „noncraziness condition“

Banking as delegated monitoring (Diamond 1984)  Model with state verification ex post only if someone has paid an inspection cost upfront  Without monitoring, optimal external finance takes the form of debt  Incentive compatibility is achieved by nonpecuniary penalties (prison, torture)  These penalties are socially inefficient (unless investors are sadists)

Banking as delegated monitoring (Diamond 1984), ctd.  Suppose the inspection cost is lower than the expected value of the nonpecuniary penalty under direct finance. Can we get something better than direct finance with penalties?  Version 1: All final investors inspect. Inefficient if m is large. (also think of free- rider problems)  Version 2: m investors, one bank, one firm. Inefficient because the contract with the bank involves the same nonpecuniary penalty as a direct contract.

Banking as delegated monitoring (Diamond 1984), ctd.  Version 3: m final investors, one bank, n firms with stochastically independent returns  If n is large enough, this can be better than direct finance. Economies of scale and scope  Argument:  If n is large enough, then, on a per firm basis, the bank‘s return is approximately riskless. Hence the expected value of the nonpecuniary penalty for the bank is small relative to n  Then the total agency cost per firm is lower than under direct finance.

Banking as delegated monitoring (Diamond 1984), ctd. Assessment:  No analysis of strategic interaction. How does the efficient outcome come about? Yanelle RES 1997  Risk neutrality... Can be replaced by risk aversion, Hellwig RES 2000

Banking as delegated monitoring (Diamond 1984), ctd.  Model predicts banks having only debt, no equity, banks providing firms with equity, rather than debt; both is counterfactual  Analysis of moral hazard can be extended to a version where bank effort choice matters; the banker is residual claimant  Analysis cannot be extended to a version where risk choice matters. Moral hazard with respect to risk choice is the key problem with debt finance and the key problem in banking. See the S&L‘s in the mid eighties.

Banking as Delegated Monitoring (Diamond 1984) ctd.  Hellwig (1998): If banks have a choice between many small and a few large projects, they will tend to underdiversify. Fixed monitoring costs plus constant returns to investment imply no diversification at all. No intermediation!  Stochastic independence is assumed; what if returns are not independent?  Why are banks so much exposed to contractable shocks? If aggregate shocks are observable and verifiable, contracts should condition on them – why do they not do so? And why are their positions correlated?

Alternative versions  Von Thadden RES 1995: Banks monitor ex interim. This tells them that they are dealing with a good entrepreneur who has chosen a long-term project rather than a bad entrepreneur. Assurance of continued finance makes the entrepreneur to invest in profitable long-term projects even though they return less in the short run. (see also Gerschenkron 1962, Mayer EER 1988).

Alternative versions ctd.  A single bank renegotiating ex interim is in a strong position if it has an information advantage over others. Prospects of this happening motivates entrepreneur and bank to engage in an exclusive relation ex ante Gerschenkron, Mayer, Sharpe JF 1990, Edwards and Fischer, Cambridge UP 1994)  Problems:  Power can be abused (Rajan JF 1992, Weinstein- Yafeh JF 1997)  Competition ex interim can erode power (Edwards- Fischer)

Where has all the lending gone?  Empirical observation: For large banks, the role of lending to firms has decreased a lot over the last two decades; JPMorganChase lends less than the take in in deposits; only one third of their total assets are in loans  Scalability in trading versus nonscalability in lending  Regulation is biased against lending