1. Discussant: Carmelo Salleo*
Financial Innovation
For Rent Extraction
By A. Korinek
Discussant: Carmelo Salleo*
European Central Bank
*The views expressed do not necessarily represent those of the ECB or of the ESCB.
IADI - Basel, 1-2 June 2017

2. Main Conclusions of the Paper
Innovation allows financial institutions to extract rents from public safety nets and bailouts.
Innovation for rent extraction increases profits for financial institutions in good times.
Rent extraction increases real economy volatility.
Enforcing limited liability during bailouts curtails risk taking effectively.

3. Intuition and examples
Innovation allows financial institutions to monetize the put option implicit in government guarantees. Real life examples:
Shifting from interbank loans to repos makes deposits more junior. This is not priced in deposit insurance, but banks enjoy cheaper funding.
Securitization allowed banks to circumvent capital adequacy rules.
The pricing policies of Fannie and Freddie did not take into account the higher risk of borrowers with lower equity and two mortgages.

4. The Regulatory Response So Far
Limitation of bailouts. In Europe: BRRD and State Aid rules make them almost impossible.
Tightening of credit standards. The Basel framework closed some loopholes and will rely less on internal models in the future.
Development of state-contingent securities, clarification of pecking order in bail-in and TLAC/MREL should reduce mispricing of risk.

5. More Regulatory Responses (within the model)
The author could consider also the following policy options, some of which have been enacted or considered in the past:
Bailouts accompanied by nationalisation.
Personal sanctions for bankers in case of bailout.
Progressive taxation of profits.

6. Where Is Innovation Going?
Artificial intelligence + Big Data + increase in computing power => markets will become more complete.
If idiosyncratic risks will be hedged more effectively, returns will depend more on systemic risk => more incentives to invest in it.
Large scale and network economies => markets will be more concentrated.

7. How Will It Interact with Rent Extraction?
More complete markets should protect households also from rent extraction – if regulators make sure that contracts are designed properly.
An economy with a balance tilted more towards systemic risk and less towards idiosyncratic risks will require stronger macroprudential frameworks.
Concentrated markets can generate endogenous cycles => competition and macroprudential policies should be integrated as concentration magnifies TBTF issues.

8. Conclusion
Externality justifies (state-contingent) public subsidy, innovation allows banks to cash in.
In the arms race between banks and regulators the latter will always lose unless they use innovation to their advantage.
Innovation can reduce externalities generated by the financial sector and therefore reduce the need for public intervention, and it can help regulators design better instruments.
Systemic concerns should be at the heart of any regulation and supervisory practice, also to avoid rent extraction.