Economic Ideas from Ed Dolan’s Econ Blog Do Banks Take Excessive Risks? EI 131114 November 12, 2013

1. Economic Ideas fromEd Dolan’s Econ BlogDo Banks Take Excessive Risks?EI 131114November 12, 2013 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

2. Banks are essential but risky • Banks provide essential services • Accepting deposits • Making loans • Facilitating payments • But banking is a risky business • Risk from changes in interest rates, exchange rates, or other market prices • Risk that loans will not be repaid • Risk that liquidity will dry up in a crisis Dime Savings Bank of Brooklyn, NY Economic Ideas 111314 from Ed Dolan’s Econ Blog

3. How much risk should banks accept? • Banks should not try to avoid risk • They face a trade-off: By accepting more risk, they can earn a higher return • But how much risk should they accept? Economic Ideas 111314 from Ed Dolan’s Econ Blog

4. Do banks take excessive risks? • Bank regulators fear that banks, left to their own devices, will take risks that are excessive from the point of view of the economy as a whole • Let’s look at some reasons why banks might take excessive risks: • Contagion effects • Moral hazard • Agency problems Economic Ideas 111314 from Ed Dolan’s Econ Blog

5. Contagion effects Contagion effects arise when the failure of a bank causes harm to other parties • Failure of one bank can cause bank runs as depositors take their money from other banks • Fear of more failures causes banks to stop doing business with one another, causing failures to spread • When banks fail consumers and nonfinancial businesses can’t get the credit they need to operate normally Economic Ideas 111314 from Ed Dolan’s Econ Blog

6. Moral Hazard Moral hazard arises when someone who is protected from loss fails to take measures to avoid excessive risk • The term originated in the insurance business, where people who are insured against loss fail to take measures to minimize risk • For example, people who have flood insurance may build in areas that are known to be at risk of flooding Economic Ideas 111314 from Ed Dolan’s Econ Blog

7. Moral Hazard and Deposit Insurance The purpose of deposit insurance • During a bank run every depositor tries to be first in line to withdraw funds • Deposit insurance protects against bank runs by promising to pay depositors even if not first in line. Deposit insurance and moral hazard • Without deposit insurance, depositors would be careful to put their money only in banks that were operated safely • With deposit insurance, this source of discipline disappears—even the riskiest banks can attract deposits Deposit insurance can help prevent bank runs like this one at Northern Rock bank in England Economic Ideas 111314 from Ed Dolan’s Econ Blog

8. How to avoid the moral hazard of deposit insurance • Grant insurance only to small depositors—use big depositors to provide market discipline • Rely on bondholders and other uninsured creditors of banks to restrain risk taking • Apply risk based premiums – banks with weak balance sheets must pay more to join the deposit insurance system. • Make sure the deposit system is adequately funded Economic Ideas 111314 from Ed Dolan’s Econ Blog

9. Moral Hazard: Too Big to Fail • If a bank is so large that its services are essential to the rest of the economy, the government may be forced to rescue it when it is threatened with failure • If banks know they will be rescued, they may take excessive risks—another example of moral hazard • The implicit guarantee gives the largest banks a competitive advantage over smaller banks • Result: They grow even bigger Economic Ideas 111314 from Ed Dolan’s Econ Blog

10. Ideas for limiting the TBTF problem • Establish “living wills” to guide the liquidation of even the largest banks • Make sure managers and shareholders bear their fair share of losses when the bank fails • Expose bondholders and other unsecured creditors to “haircuts” in case of failure, that is, make sure they also bear a share of losses http://commons.wikimedia.org/wiki/File:Fat_Gator.jpg Economic Ideas 111314 from Ed Dolan’s Econ Blog

11. As agents of shareholders, financial managers have a fiduciary duty to act in their shareholders’ best interests They should take prudent risks when there is a good chance of a high return for shareholders. . . . . . but they should not put their personal gain ahead of shareholder interests, or gamble with shareholders’ money Agency Problems: Fiduciary Duties of Managers Alice and Jim Walton at 2011 Walmart shareholders meeting Economic Ideas 111314 from Ed Dolan’s Econ Blog

12. Gambling with your own money When gambling with their own money, many people think the best games are ones like lotteries that • lose most of the time, but not more than they can afford • don’t win often, but have a huge payoff when they do win • These are called positively skewed risks http://blogs.guardian.co.uk/money/lottery.jpg Economic Ideas 111314 from Ed Dolan’s Econ Blog

13. Gambling with other people’s money When gambling with other people’s money, the best games . . . • win some positive amount most of the time • rarely lose, but may have very big losses when they do • Once a big loss comes, the game is over, but the gambler keeps past winnings and someone else bears the cost • These are called negatively skewed risks http://www.stockmarketinvestinginfo.com/images/floorpic.jpg Economic Ideas 111314 from Ed Dolan’s Econ Blog

14. Misaligned Incentives • Executive compensation plans are often poorly aligned with fiduciary duties toward shareholders • Bonuses for short-term performance • Lack of “clawback” provisions to recapture past bonuses in case of delayed losses • “Golden parachutes” that give large severance payments to executives even when their bad decisions cause large losses • Such bonus-based compensation plans cause managers to seek strategies with negatively skewed risks “Golden parachutes” may tempt executives to take risks that are not in the interests of shareholders Economic Ideas 111314 from Ed Dolan’s Econ Blog

15. Strategy A 5 quarters of $100 million profit 5 quarters of $10 million loss 10-quarter net for shareholders: profit of $449.5 million 10-quarter result for executive: total bonuses of $500,000 Strategy B 9 quarters of $200 million profit 1 quarter of $2,000 million loss 10-quarter net for shareholders: loss of $201.8 million 10-quarter result for executive: total bonuses of $1.8 million Hypothetical Example of misaligned incentives Assume a bonus plan that pays 0.1% of net profit each quarter, with zero bonus in case of loss and no clawback Negatively skewed strategy B has higher payoff for the executive but lower payoff for shareholders Economic Ideas 111314 from Ed Dolan’s Econ Blog

16. It is not only top managers who have opportunities to gamble with other people’s money Individual traders within banks Creditors of bankrupt firms, when they expect bailouts to shift their losses to taxpayers Bank depositors, when deposit insurance shifts losses to taxpayers Not just top managers UBS blamed trader KwekuAdoboli for $2.3 billion in losses . His defense was that supervisors encouraged him to ignore trading limits as long as he was winning. Economic Ideas 111314 from Ed Dolan’s Econ Blog

17. Why did Shareholders Let it Happen? Why do shareholders condone compensation policies that are not aligned with their interests? Some hypotheses: • There is no misalignment—shareholders are also biased toward excessive risks • Technical error: Risk models do not reveal the negative skew of strategic risks • Bidding for management talent is subject to a “winner’s curse” that leads to overly generous compensation plans • Moral hazard (expectation of bailout) • Corporate governance—shareholders don’t like compensation plans, but can’t do anything about them Economic Ideas 111314 from Ed Dolan’s Econ Blog

18. “Shocked Disbelief” . “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief” Alan Greenspan Former Federal Reserve Chairman Testimony before the House Committee on Oversight and Governmental Reform October 23, 2008 Economic Ideas 111314 from Ed Dolan’s Econ Blog