Discussion of Allen, Carletti, Goldstein & Leonello „ Government Guarantees and Financial Stability“ Gerhard Illing LMU Munich University/CESifo Norges Bank Workshop on Understanding Macroprudential Regulation 29 November, 2012

Central issues How to cope with Moral Hazard effects of public interventions (deposit guarantee schemes)? Optimal design of Financial Safety Nets? Challenge: Distinguish between fundamental and panic driven runs (runs due to coordination failure) Insolvency vs. illiquidity Panic driven runs: Multiple equilibria ~ how to handle indeterminacy? Elegant model. Tractable Structure But only first step – some key issues not yet solved

Summary – Model setup Modeling Strategy: Analyze Public Guarantuee Schemes in Goldstein /Pauzner version of Diamond/Dybvig model Model allows for both fundamental and panic driven bank runs Model determines strategies of depositors and banks endogenously Indeterminacy of multiple equilibria solved by Global Game approach (Goldstein /Pauzner) Depositors receive noisy signals about fundamentals Inefficiency if runs are panic driven; Public support improves outcome, but may increase region with fundamental runs beyond “efficient” level

Summary – Model setup Diamond Dybvig type Deposit contract High return R>1 with p(θ) at date 2 θ: state of the economy Depositors get noisy signal: x i = θ+ε i θ high: Good fundamentals - no run (upper dominance); θ≤θ low: bad fundamentals - always run (lower dominance) intermediate range: multiple equilibria; panic runs Goldstein/Pauzner Global games solution: Critical θ*: no run above some threshold θ*! Both θ and θ* are increasing in c 1 In the range θ≤θ≤θ* panic driven runs  Interventions can prevent panic runs encourage insurance (higher c 1 ) Moral Hazard: Support may induce „excessive risk“ - shifting θ(c 1 ) upward beyond some optimal level.

Comments Laissez Faire solution: Banks determine θ*(c 1 ) such that Marginal gain from better risk sharing (higher c 1 for early consumers) equals Marginal loss from increased probability of runs (higher θ*(c 1 ) )  c 1 D (Constrained) efficient solution: prevent panic runs  only fundamental runs;  threshold θ(c 1 )  c 1 SP >c 1 D Problem: How to avoid panic runs? Costless insurance against panic runs? Implementation mechanism left unclear in the paper: Insure depositors only for θ<θ(c 1 ). Resources needed? Announcement to repay depositors only if θ <θ(c 1 ) won’t help if private agents cannot observe θ General Critique: Clear-cut regions of fundamental and panic runs implausible ~~ Too simplified view: In reality, signals provide noisy information about true state of the world  alpha error vs. beta error

Comments Social planner allows transfer of resources from some public good Idea: Real deposit insurance in period 1: Guarantee c 1 SPI >1 in the case of fundamental runs (θ<θ(c 1 )) Paid out from funds g available for public goods Ad hoc modeling strategy Since risk averse agents prefer some insurance, why not insure depositors with c 1 SPI >1 in all states θ? Why not also insure against bad realization in period 2? Crucial issue: Resources g modeled as exogenously given; corner solutions g not properly modeled (deus ex machina): Partial equilibrium! Determine investment in g endogenously ex ante (distortionary taxes) Strong incentives to provide insurance pool against systemic risks Why no private insurance (investment in safe assets; equity funds)?

Comments Inefficiencies from public guarantee schemes Guarantuees induce moral hazard (excessive risk taking): c 1 GG >c 1 SP θ(c 1 GG )>θ(c 1 SP ). Externality: Government provides insurance funds without adequate „pricing,“ taking private deposit contracts c 1 GG as given;  overinsurance In line with intuition, but not worked out properly: Characterise efficient pricing strategy as benchmark case ~ not done convincingly in the paper (only a first step) Key argument: Cannot prevent banks to offer contracts c 1 GG >c 1 SPI Simple mechanism: Provide deposit insurance only for banks offering contracts with payout c 1 ≤ c 1 SPI Other available options : capital adequacy; liquidity requirements No role in your set-up ~ strong limitation

Comments Comparison of different public deposit insurance schemes All transfer resources from some given public good g to depositors 1) Pay out c 1 D to depositors only at t=1 2) Pay out c 1 D to depositors both at t=1 and t=2 3) Insure all deposit claims fully at t=1 and t=2 Key insight: Optimal scheme depends on size of g If g is large, full insurance more efficient than moderate intervention With tight budget (small g), limited intervention allowing panic runs is preferred Limited insight - Puzzle: How to determine optimal size g? Very preliminary work

Suggestions Key problem: Dynamic inconsistency of conditional guarantee schemes: Incentives to renege on commitment not to intervene Cao/Illing (2011), JICB Endogenous exposure to systemic risk Banks have incentives to invest excessively in activities prone to systemic risk Allows to model different regulatory designs  Liquidity (and capital adequacy) requirements can address these incentives Diamond/Dybvig framework less suitable – Sequential Service constraint: Optimality of deposit contracts?

Minor comments: Analysis incomplete: Compare c 1 SPI relative to c 1 SP ? Upper dominance region: Same return R at date 1 and 2 ~ contradicts initial claims