1. A Model of a Systemic Bank Run by Harald Uhlig Discussion by Elena Carletti European University Institute

2. The 2008 crisis: stylized facts One of the puzzles of the current crisis is that the “toxic assets” held by banks seem to be “underpriced” How can this be explained? How can underpricing last for so long? 2

3. How can we explain underpricing? There is a lack of liquidity in the market so that assets are determined by “cash-in-the market pricing” (various works of Allen and Gale) – Crucial to this is the idea of limited participation: liquidity is costly and potential buyers must be given incentives to hold liquidity and buy assets on sale – This leads to price volatility and in particular to low prices when there are many assets on sale (that is, in bad aggregate states) 3

4. How long can underpricing last? The toxic assets seem to have been underpriced for a long time and we would have expected liquidity to have entered these markets by now Why is this not happening? – Limits to arbitrage (Allen and Carletti, 2008) – Other factors lie behind the underpricing? There is enough liquidity but investors are not willing to buy the assets on sale – This paper (There may be now solvency problems beside liquidity problems) 4

5. The paper aims to capture… 1.Withdrawal of funds is done by other financial institutions such as money market funds 2.The troubled financial institutions hold asset- backed securities rather than underlying projects 3.These securities are traded and are “underpriced” 4.Large pool of investors with funds to buy 5.But investors are willing to buy only at low prices 6.The larger the share of troubled institutions, the steeper the required discounts 5

6. Key elements of the model - Standard banking model with t = 0, 1, 2 Depositors Local Banks Core Banks Outside Investors -All deposits promised uncontingent repayment in t = 1 - Boom and bust state, where problems may emerge 6 Market for asset- backed securities Deposits

7. Core banks invest in long-term projects and turn their t=2 payments into long-term securities In the bust state, each long-term security offers a safe return R, but these returns are heterogenous and distributed according to F in the interval Core banks know the type of long-term securities in their portfolios, but investors may not know it 7

8. Three cases 1.Benchmark: Risk neutral outside investors and core banks that bundle mortgages uniformly 2.Uncertainty Aversion: The non-expert investors are willing to pay is a multiple of the lower bound of the perceived returns, ßR 3.Adverse Selection: Risk neutral outside investors and core banks can choose the bad securities to sell 8

9. Results Uncertainty aversion and adverse selection versions are both consistent with observations 1-5. However, uncertainty aversion is consistent with 6 while adverse selection is not Policy implication is that the government can buy the asset backed securities at prices that are higher than the market and still make a profit 9

10. Comments Very interesting theory to explain persistent underpricing of toxic assets It provides an alternative explanation for underpricing relative to the limited participation story – Large pool of uncertainty averse investors versus limited participation Which of the two explanations is more plausible? – Apart from one being more micro and one more macro... 10

11. Both theories explain underpricing and its severity depending on the size of share of assets on sales What about the persistence of underpricing? – Limited participation: Is liquidity really limited? Why doesn`t liquidity re- enter? – Uncertainty averse investors: Constant through time but then why do not we always see underpricing? There are no „endogenous“ dynamics in the model Are there other historical episodes of underpricing that are consistent with the model? 11

12. Make clearer the economic rationale for having core banks. They pool risks by having mortgages from all over the country. But why can’t the local banks hold asset backed securities? Who are exactly the core banks and the local banks in the current crisis? 12