Preventive policy means targeting incentives over cycle Enrico Perotti Univ Amsterdam, DNB and DSF

Basel III From exogenous to endogenous risk control Statistical view of risk in Basel II, independent of rules and cycle No account of incentives; bank equity as pure buffer; exogenous correlation Market liquidity never a problem But risk creation evolves with risk shifting incentives

Some lessons to learn 1. When credit expands fast, incentives for more correlated investment choices Self reinforced via prices bubbles Correlation increases chance of bailout 2. Excess credit growth feeds on short term funding – Favored by reduced monitoring 3. Risk incentives not linear Once capital falls below some threshold, risk preferences jump

A preventive risk control policy must be incentive-based Ensure a opportunity cost of gambling by using risk sensitive instruments equity long term funding Induce investors to keep risk bearing as risk increases: more equity, long term debt Fully charge for risk externalities

Concrete examples Ensure countercyclical ratios at the system level Design CoCo to have early conversion thresholds Raises gambling cost in good times Slow down carry trades in exhuberant markets by taxing unstable funding

Prevent, not absorb Choose equity ratios not as buffers, but as tools to align incentives Contain risk creation early on. Trigger adjustment to funding to restore incentives when they deteriorate Measure precisely few critical risk factors, track them closely Signal early on any risk build up, enabling markets to question it before too large, least disclosure may lead to panic.

Optimal liquidity regulation Quantity versus price policy (Perotti Suarez, 2010) Price (liquidity charges): Solvent banks use too much short term funding as they do not feel all liquidity risk costs Pigouvian charges aligns private and social costs, still allows better banks to lend more Quantity (capital or funding ratios) Low charter value banks may gamble (risk shift to deposit insurance), not deterred by levies Here, better quantity constrains. Capital ratios contains risk shifting (low charter value banks)

Liquidity buffers Liquidity buffers least efficient –As ratios, disadvantages better lenders –Net liquidity risk is the same (unless liquidity costly, then it is a tax) –Main net result is subsidy to Treasury bills at cost of funding cost for banks –Keeping incentives stable requires adjusting buffers to risk spreads

Limit risk incentives with CoCos Avoid discontinuity of CoCo prices at conversion. Conversion at par is simple, harder to game, avoids multiple equilibria Conversion at market value (implying more dilution) ensures bankers will become careful earlier, contain increased risk incentives A gradual conversion scheme so that triggers occur before problem is large, limit market response

Summary Quantity instruments (capital ratios, net funding ratios) best to contain gamblers Price tools (eg liquidity charges) increase opportunity costs of strategies with externality effects Price tools easier to adjust than ratios Price tools should be used with higher frequency for preventive goals

Liquidity Risk Regulation: Quantity versus Prices Losses in liquidity crisis larger if aggregate ST funding larger (forces faster fire sales) Banks differ in –credit assessment (incentive to expand lending) –charter value (incentive to remain solvent; limits gambling) Short term funding only way to boost credit Both good credit banks and low charter banks want to expand credit more

Levies contain solvent banks Solvent banks borrow more short term than socially optimal as they do not internalize the liquidity risk externality Better banks wants to lend more An optimal liquidity charge corrects by adjusting private cost

Advantages of prices and ratios Price: Solvent banks expand loans too much as they do not feel all liquidity risk costs Liquidity charges allows better banks to lend more than others Quantity (capital or funding ratios) Low charter value banks take zero NPV gambles (risk shift to deposit insurance) Capital requirement screen out pure risk shifting banks (low charter value banks)