1. Moral Hazard in Banking: Debt as a Disciplining Device Systemic Risk and Financial Regulation Bonn 2015, Lecture 6 MPI Collective Goods Martin Hellwig

2. An alternative view of demandable debt  Diamond-Dybvig: Demandable debt provides insurance against uncertainty about timing of consumption needs when the bank cannot observe the needs themselves  Alternative view: Demandable debt provides financiers with a threat against the banker: If the banker does not behave, funds will be withdrawn, and his business will be closed  Calomiris – Kahn, Diamond - Rajan

3. Policy relevance  Calomiris (1998, 1999): Require banks to have a certain amount of short-term subordinated debt that needs to be constantly rolled over  Squam Lake Report (2010), Rajan (2013): Do not raise equity too much. Debt imposes discipline on bankers. With too much equity, managers misbehave because shareholders cannot discipline them. Use co-cos (contingent convertible securities) instead.

4. Runs and Information  Calomiris-Gorton 1991:  Runs do not occur out of the blue but are triggered by new information.  Maybe runs are a way to usefully exploit that information  Make better use of the bank‘s assets  Discipline managers

5. Calomiris-Kahn 1991  Consider a manager with a project that requires funding, without any wealth  There are two states of nature, good and bad, with probabilities , 1-, and returns T g > T b  The manager can abscond with the money at a cost AT.  He will do so, unless he prefers the share of returns he is given under the contract.  Incentive concerns impose constraints on the payment promises he can credibly make to investors.

6. Calomiris-Kahn 1991, ctd.  Constraints on payment promises may mean that payment promises will not cover the opportunity costs of investors‘ funds. In this case, the project will not be undertaken. If its expected return exceeds the opportunity cost of funds, this is an efficiency loss.  Conditions relaxing those constraints may enlarge the scope for projects that are undertaken.

7. Calomiris – Kahn 1991, ctd.  Suppose states are not verifiable, so payment promises cannot be made contingent on them.  Promise a state-independent payment P.  Tradeoff: If P<AT b, he will not abscond in the bad state, but the expected value of the payment may not cover the opportunity cost of funds. If AT b <P<AT g, the manager will abscond if he receives information that the state is bad.  If the project costs more than AT b, and more than  At g, the project cannot be funded.

8. Calomiris-Kahn 1991, ctd.  A version with a single investor.  The investor can pay a cost to receive a signal on what the state is likely to be.  Suppose that this investor can be given the right to interfere if he receives a bad signal.  Suppose also that, if he interferes, he can prevent the manager from absconding and get an amount equal to min[(1-L)T, M], where L<A and AT b <M<AT g.  This makes it possible to condition payments on signals, P g,P b, subject to feasibility, P b <= M.

9. Calomiris-Kahn 1991, ctd.  Return to investor: Pr(state, signal good) x P g + Pr(signal bad) x P b  Costs from type 1 and type 2 errors, interference if the signal is bad and the state good, lack of interference if the signal is good and the state bad .... are small if the signal is not very noisy, i.e. highly correlated with the state In this case, return is approximately  x P g + (1-) x P b

10. Calomiris-Kahn 1991, ctd.  Demand deposits: If the signal is not verifiable (like the „type“ in Diamond-Dybvig), then the „on demand“ clause in the debt contract provides a substitute for conditioning the creditor‘s action on the signal.  If the cost of the signal is small and the signal is very precise, then, for some parameter constellations, a demand deposit contract can be optimal.  If the project cannot be funded under this contract, it cannot be funded at all.

11. Other contracts  If the cost of the project is very low, a noncontingent, nonliquidating contract is optimal.  For somewhat higher values of the cost, a noncontingent liquiditating contract is optimal.  For yet higher values, a „nuisance contract“ is optimal – so named because it does not fit into the program.  „Nuisance contracts“: Payments P g, P b are made contingent on the signal, but there is no liquidation.  For yet higher values, a demand deposit contract is optimal

12. „Nuisance“ – Noncraziness condition  Jensen-Meckling (1976) research program: explain what we see as solutions to incentive or information problems.  J&M: explain the funding mix of a firm in terms of a tradeoff between agency costs of effort (associated with outside equity) and risk choices (associated with debt). Hellwig (2009): a mix of debt and equity may be dominated by something „crazy“.  Should we eliminate strange contracts, which do not fit our hypotheses, by imposing a noncraziness condition?

13. Calomiris-Kahn 1991, ctd.  Suppose there are n investors and each one has a noisy signal.  The aggregate of their signals contains better information about the state than any one signal on its own  The banker will optimally hold cash reserves to be able to satisfy some investors.  If sufficiently many investors want their money back, that may be an indication that the state is really bad. ... Or that they are affected by a sunspot and run!?

14. Calomiris-Kahn, assessment  Calomiris-Kahn do not actually eliminate the possibility of multiple equibria (sunspots); the part of the payoff matrix for the withdrawal game that is relevant did not fit on the page, but that does not mean that it is irrelevant.  Demandable debt introduces fragility, here as in Diamond-Dybvig.

15. Calomiris-Kahn, assessment, ctd.  Calomiris-Kahn assume that intervention prevents damage, improves value of assets for investors; often runs destroy assets (as in Diamond and Dybvig)  Calomiris-Kahn also assume intervention before managerial misbehaviour; what about prior misbehaviour, such as too little effort or too much risk taking?  „Time consistency“/ credibility problem

16. Calomiris-Kahn, assessment, ctd.  Suppose the problem is one of excessive risk taking; by the time investors learn about managerial choice, that choice has been taken and cannot be undone.  Should they intervene ex post?  Ex ante, threatening intervention is desirable if th ethreat is deemed to be credible.  Ex post, carrying it out may just do additional damage

17. Calomiris-Kahn, assessment  With a single investor, in this case, the threat is not credible  With multiple investors, it may be credible. In the absence of coordination, the individual investor runs because he expects other investors to run.  The inefficiency of Nash equilibria in subgames may make the threat of runs credible and enhance ex ante efficiency.

18. A Query  Why are banks exposed to macro risks, e.g. interest rate risk or business cycle risk?  Macro variables are observables and either verifiable or proxiable.  There are no information constraints that would prevent contracts from conditioning on them.  Calomiris&Kahn, like Diamond&Dybvig or Diamond, is about micro risk.  Crises are driven by macro risks.

19. Variations on the theme  Diamond – Rajan 2001  A bank manager in relationship banking may have to renegotiate loan contracts with his debtors; he likes to be soft ex post,but this is inefficient because, if the debtors expect him to be soft, they will misbehave  If he is funded by demand deposits, he must fear he may be run upon.  If depositors run when they see the manager being soft and do not run when they see him being tough, an efficient outcome is implemented.

20. Variations, ctd.  Diamond Rajan, 2002  Bank manager can also be prevented from extracting a higher salary from the bank if he must fear that otherwise he will be run upon  Question: What about the risk-taking incentives from the use of debt? There is no risk choice in the model. Would the threat of a run prevent excessive risk taking  Question: Why do other companies not use this panacea to eliminate all moral hazard?

21. Fragility  Diamond – Rajan 2001 assume complete information, runs off the equilibrium path, no runs on the equilibrium path  Calomiris-Kahn assume that signals are very precise, so inefficiency from runs on the equilibrium path can be neglected  Diamond – Rajan 2000 allow for (a small amount of) incomplete information of depositors and develop a theory of „bank capital“ – efficient equity funding as a response to the tradeoff between false positives and false negatives  No sunspot runs allowed!

22. Incomplete Information  Incomplete information can eliminate equilibrium multiplicity  Morris-Shin AER 1998, Goldstein-Pauzner JF 2005, Rochet – Vives JEEA 2004  Bank solvency depends on a fundamental, the return on investment.  Each investor has noisy private information about the fundamental  Equilibrium is unique, with a run if the fundamental is bad, no run if it is good.  Equilibrium is NOT efficient

23. Who has information?  Suppose information must be acquired at a cost  What are incentives to acquire information?  Free-rider problem: If I acquire information and my use of this information improves efficiency, all other investors benefit  Distribution externality: If my use of the information makes other investors worse off, I benefit at the expense of others  „Optimal n“ – tradeoff between the two externalities?

24. Outside equity  The models of demandable debt do not have outside equity.  This is counterfactual  If there is outside equity, who has the greater incentive to invest in information, shareholders or debt holders?  Debt is „information insensitive“, equity „information sensitive“  The stock price allows debt holders to free ride on the shareholders‘ information

25. Reality check  2004-2007/8: buildup of positions, expansion funded by short-term debt (repo)  2008: collapse of Bear – Stearns and Lehman Brothers involved reppo runs, initially triggered by adverse movements in share prices  Did short-term debt as a disciplining device?

26. An alternative view of short-term debt  Time inconsistency in financing decisions: Make promises today, renege on them tomorrow  Promise today‘s lenders they will always be senior  Issue additional debt tomorrow, junior, but of shorter maturity = de facto senior  Maturity rat race (Brunnermeier-Oehmke)

27. Is contracting efficient?  Contract theory: Interpret what we see as efficient relative to some set of incentive constraints  What are the constraints?  Time inconsistency has to do with commitment technologies  Efficiency relative to given technologies may be inefficient relative to better commitment technologies, including technologies provided by the law, courts and regulators