Comments on “Bank Liability Structure ”

1. Comments on “Bank Liability Structure” by M Suresh Sundaresan, Columbia University, and Zhenyu Wang, Indiana University By Stijn Claessens Head of Financial Stability Policy, Monetary and Economic DepartmentBank for International Settlements Disclaimer: The opinions expressed are those of the author and do not necessarily reflect views of the Bank for International Settlements.

2. Question and Answer of Paper • Q: What is the optimal bank liability structure? • With liquidity services on deposits, endogenous debt default, and in continuous time • And with a deposit insurance, regulatory closure rule • A: Bank’s choice and closure rule overlap • Maximizing bank‘s valuation overlaps with DI agency’s interests, as DIA provides value for bank owners • Suggest less conflicts, but still adverse effects • Bank offsets: higher leverage, preference for debt

3. 1. Relevance of and praise for paper • Surely a worthwhile topic, also for policy • Know too little on what drives banks’ choices in the presence of deposit insurance, even less so in infinite model • Many focused on this: banks, regulations, supervisors... • Praise and agree with main findings • Careful analysis, extending typical two period model • Results include and extend other theories, with capital adequacy requirements, taxes, liquidity benefits, etc • Calibrations show ability for close match; simulations useful • And hard to disagree after having been presented at 14 seminars and with 16 other commenters!

4. 2. Main mechanism • DI has benefits that arise via two channels: • DI makes it easier to attract deposits, as bank more secure, which increases franchise value – since deposits earn fee income and for depositors have liquidity services –and makes bank raise leverage • DIA has lower bankruptcy costs (higher recovery value) than depositor could on their own  Novation lowers bankruptcy costs • Bank internalises and then its choices and deposit insurance align • To maximise franchise value, bank takes deposits and debt, but avoids debt default before regulatory closure as then benefits lost • No conflict of interests and no insurance “subsidy,” but still higher leverage, through more deposits, compared to no insurance bank

5. 3a. Main comment: internalisation • Bank internalises the benefit of DI and DIA’s bankruptcy role • Bank prefers deposits. And avoids debt default as then DIA not involved in bankruptcy. Creates a “nice” endogenous boundary, and gets, even without tax benefits, higher leverage • But how do the modelling choices matter? Two examples: • Nature of the shocks on assets, now log-normal. Also continuous time: agents can reoptimise any time, “just in time” • All common in finance. But could imagine others, eg, jump processes  DIA cannot reprice/readjust every moment • No principal agent issues, moral hazard, information asymmetries • But likely agency and information issues, eg, management has private benefits; debt holders do not know riskiness; etc

6. 3b. Main comment: bank assets • Banks assets side ignored, focus is on deviations from M&M liabilities • Risk taking happens through maximising liabilities’ benefits. But many bank defaults consequences of risky asset choices. Results are surely not independent of endogenizing bank asset choices • Literature gives large role of guarantees on bank risk taking on assets • Typical moral hazard story, exacerbated by low interest rate • But also complex interaction with liabilities. For example, Cordella, Dell’Ariccia, Marquez: effect of government guarantees. If debt is priced at the margin, risk taking incentives increase. If not, franchise value increases which can induce more prudent behaviour • Therefore worth considering both sides of balance sheets next

7. 3c. Main comment: overall system, general equilibrium • What is DIA’s objective? What should it be? • DIA here acts microprudential, does not try to achieve social optimal, not even macroprudential, financial stability goals • But social welfare can require adaption of DIA’s goals • Here: what are “optimal” closure rules and capital requirements? • Beyond: general equilibrium impacts of DI, bank regulation and supervision on: asset prices, non-bank financial intermediation, etc • And systemic crises present real challenges • Bank runs are typically not isolated events (even Northern Rock was not); then spillovers to other banks via runs, asset prices, etc • Can one design DI rules that internalise (some of these) systemic effects? eg, are ex-ante or ex-post premiums better?

8. Minor comments • Literature, framing: could be cast broader • Other recent dynamic models of banks, with also general equilibrium (Brunnermeier-Sannikov, Begenau, De Nicole et al, etc) • Discussion on actual bankruptcy costs not so clear • Present bankruptcy costs for non-financial corporation, but these may not reflect the cost to the DIA, which are the ones modelled • Could reduce simulations as most follow logically. Instead think more on the optimal DI and regulatory designs • Minor. Not sure what a “structural” model is. And the calibrations likely “match” the real world by design 