Monitoring, liquidity provisions, and financial crises Gabriela Mundaca Johns Hopkins University, USA April 20th, 2009

Introduction This paper analyzes an optimal policy on the provision of emergency funding to financial institutions (or commercial firms) in distress. This paper emphasizes on the importance of monitoring by the central bank when liquidity provisions are given conditional on performance and not only on a bad shock occurring. B. Gabriela Mundaca

Introduction In my paper the roles of the central bank as both Lender of Last Resort (LOLR) and supervisor are linked as follows: As LOLR, it should have incentives to engage in monitoring that is sufficient to reduce moral hazards; and as supervisor , it should be able to provide assistance only to deserving banks. B. Gabriela Mundaca

Introduction I consider two policies: The central bank acts with discretion when deciding on the level of liquidity provision and monitoring and after the shock occurs and private agents make decisions. (Ex-post measures) Policies on monitoring and liquidity provision have rule-like features, and are made public information before private agents make decisions. They are determined after minimizing moral hazard problems and costs of liquidity provision. (Ex-ante measures) B. Gabriela Mundaca

Introduction Understanding that policymakers may be inconsistent over time, it is crucial that monitoring and liquidity provision policies are not only made public but institutionalized so that the central bank can enforce the rule and be obliged to monitor and avoid discretionary decisions. B. Gabriela Mundaca

Preview to Results I find that with ex-ante measures, it is optimal for the central bank to monitor more and provide lower emergency funding than when it acts with discretion. Ex-ante measures also i) effectively allows the central bank to implement conditionality and determine which bank or firm is the deserving candidate to obtain liquidity; ii) induces exerting higher effort; and iii) dissuades policymakers from implementing discretionary policies and being inconsistent over time. B. Gabriela Mundaca

Preview to Results I show that ex-post measures do not resolve private agents’ uncertainty regarding the level of monitoring, and they do not necessarily induce good behavior. This is mainly because private agents’ decisions are taken as given by the central bank. Certain recent actions taken by governments around the world to rescue firms in distress can be well described as being discretionary: they are ex-post measures. With ex-post measures, there will be multiple equilibria. With ex-ante measures, equilibrium is unique. B. Gabriela Mundaca

Related literature Acharya and Yorulmazer (2007) model the effects of “too-many-to-fail” guarantees as an ex-post policy, while Acharya and Yorulmazer (2008) consider ex-post liquidity provision policies for surviving banks to enable them to acquire failing banks. They do not consider any monitoring policy. They find that these ex-post measures give banks incentives to herd, or result in highly correlated portfolios, encouraging “too-many-to-fail” guarantees. They also find that ex-ante regulation can be time-inconsistent if costs of providing liquidity become too high as a result of high bank failure rate. An important issue is the application of their analysis to the current financial situation. B. Gabriela Mundaca

Related literature Many economists are still much against bailing out on the grounds of all the moral hazard it creates, and the burden to the tax payers. OLD BELIEFS OR ARGUMENS: At the microeconomic level, it used to be argued (still?) that there is no need for a LOLR or any type of intervention. Why? Because there are repo markets, deposit insurance, strict regulation of solvency capital and real time payment systems that facilitates monetary transfers from one institution to another. (Did any of these worked during 2008 and now?) B. Gabriela Mundaca

Related literature Is the non-intervention policy a credible one? We have recently experienced significant consistency problems in such policy. Few general rules have been devised in anticipation to such crises. The literature (and policymakers) is still considering the LOLR’s or regulator decisions to any intervention ex-post. Moreover, to my knowledge, very few papers have considered the role of monitoring in the way I do it here. B. Gabriela Mundaca

Objectives of this paper In contrast to the papers above (and others), the central bank’s objective here is to reduce the incidence of financial crises rather than merely provide an optimal level of emergency liquidity. The regulator is concerned not only with minimizing the different costs of intervening, but also moral hazard problems. B. Gabriela Mundaca

Main features of the model The players are the central bank (who acts as regulator and LOLR) and the banks. A shock occurs at the last stage of the game. A “bad” shock, Sb, occurs with probability q, while a “good” shock, Sg, occurs with probability (1-q). Such distribution becomes known at the first stage. If shock Sb occurs, banks’ returns are negative and may become insolvent if there is not intervention. B. Gabriela Mundaca

Main features of the model 4. Liquidity provision is given under two conditions: A bad shock Sb occurs. Banks have no moral hazard problems. 5. There are two types of banks: n1 banks always avoid moral hazard and are transparent, type NT; while n2 banks decide on investment and effort depending on their anticipated liquidity provision and monitoring, are not transparent and behave strategically, type NS. 6. We say that a bank has moral hazard problems if its decisions depend on the anticipated bailout in the bad state. B. Gabriela Mundaca

Main features of the model 7. With discretionary policies, banks need to form expectations about the central bank’s possible actions in addition to the occurrence of a shock. 8. A bank’s investment activities and effort yield certain return, and is private information to each bank. 9. The statistical distribution of the returns in the population of banks in each group is however common knowledge. B. Gabriela Mundaca

Distribution of Returns in the bad state for both types of banks A B B. Gabriela Mundaca

Main features of the model 10. The central bank needs to invest in a monitoring technology to detect banks with moral hazard. 11. The central bank determines optimally which fraction Φ of the banks’ losses it will bail out, and the monitoring intensity, m. 12. Certain monitoring intensity m by the central bank gives certain probability (m) of detecting a bank with moral hazard problems. Such probabilities are common knowledge. B. Gabriela Mundaca

Banks’ problems Bank with no moral hazard problems: Banks with moral hazard problems: B. Gabriela Mundaca

Banks’ problems (explicitly) Bank with no moral hazard problems Banks with moral hazard problems B. Gabriela Mundaca

Moral hazard effects of providing liquidity and monitoring B. Gabriela Mundaca

The central bank’s problem The discretionary policy The central bank makes decisions about liquidity provision and monitoring in the last stage of the game. Its payoffs when a bad shock occurs is: B. Gabriela Mundaca

2. Policies are made public information and have rule-like features The government maximizes its expected payoffs, before banks form expectations. B. Gabriela Mundaca

The three-stage sequential game Shock occurs, central bank moves, and outcomes Stage 1 Central bank moves, and distributions are known Stage 2 Banks form expectations and make optimal decisions n1+ (1-) n2 banks get bailout. n2 ρ banks loose charters. Sb Central Bank announces policies. Distributions of shock and monitoring effectiveness becomes known Bank return distributions become known Monitoring is expected Sg Banks keep charters. No bailouts. Banks form expectations and decide on effort and investment Sb All banks are bailed out No monitoring is expected No bailouts. Banks keep their charters Sg B. Gabriela Mundaca

First-order conditions for Φ with ex-post measures and ex-ante measures With ex-ante measures: B. Gabriela Mundaca

First-order conditions for Φ with ex-post measures and ex-ante measures With ex-ante measures: B. Gabriela Mundaca

Results Policies are made public information and have rule-like features: It is optimal to have more monitoring than when there is not commitment. The optimal bailout will be smaller. There will be one single equilibrium with fewer insolvent banks. B. Gabriela Mundaca

Conclusions I share the worries of people who emphasize the moral hazard problems created by excessive bailouts. But here, we show that the optimal bailout should be one that minimizes moral hazard problems. The banks’ performance needs to be monitored. We find that either with ex-post or ex-ante measures, there will be more moral hazard problems if there is little or not monitoring. We also find that it is optimal to decrease liquidity provision when monitoring decreases, even when the central bank acts with discretion. B. Gabriela Mundaca

Conclusions Compensation of high levels of effort and success is important. It is only under such circumstances that liquidity provision will not cause moral hazard problems. B. Gabriela Mundaca