Deregulation

1
Deregulation

• Deregulation will lead to
• More competition
• More efficiency
• More welfare
• More innovation
• More risk
• Deregulation always requires reregulation of the
  new risks

2
Crisis in the financial system
3
The traditional banking model

• Distribute and hold
• banks have financed mortgage lending through
  deposits (originate and hold)
• Limit to the amount of mortgage lending.
• Loans and default risk appear on the balance
  sheet
• Bank needs capital to cover its risk
• Screening, monitoring and information processing
  are of the essence

4
The new model of banking

• Originate and distribute model
• Brokers sell the mortgages
• Banks provide financing for the loan
• But then repackage the loan and sell it to bond
  markets.
• Hence the rise of new financial instruments
• This process is called securitisation

5
Economic advantages of originate and distribute
model

• Securitisation enhances secondary market for
  loans, which will enhance the credit supply
• Investors get broader risk-return opportunities
• Risks (theoretically) spread more broadly
  (system more capable of absorbing stress)
• Research suggests that securitisation leads to
  lower spreads in consumer credit and softens
  interest-rate shocks for banks

6
Risks of originate and distribute model
7
Structured finance instruments

• RMBS Residential Mortgage Backed Securities
• CMBS Commercial Mortgage Backed Securities
• MBS Mortgage Backed Securities
• ABS Asset Backed Securities
• CDO Collateralised Debt Obligations
• CDS Credit Default Swaps

7
8
The magic of CDOs

• Mortgage-backed securities (MBS) and other
  structured credit were repackaged in CDOs
• Banks create special purpose vehicle (SPV)
• Asset side MBS
• Liability side Collateralized debt obligations
  (CDO)
• Cut MBS in risk tranches, repackage them and sell
  as bonds (CDO)
• Make even further derivatives (CDOs of CDOs)
• Rating agencies rate these CDOs, but nobody has
  a clue of their real value

9
Cashflow waterfall origin
10
Cash waterfall destination
11
Why are banks interested in distribute and hold
model?

• Business proved extremely profitable for banks
• Banks get more balance-sheet flexibility which
  allows them to economize on capital (BIS rules)
• They can lend without raising deposits or capital
  and without the cost of screening and monitoring
• The risk does not appear on their balance sheet
• They earn a fee for each mortgage they sold on.
• They urged mortgage brokers to sell more and more
  of these mortgages.
• All competitors do so, rational herdin.

12
Why do banks take the bite I?

• Lack of basic understanding of risks
• Liquidity risk
• Counterparty risk
• Disaster myopia
• Subjective probability of crisis depends on the
  frequency of an event
• Subjective probabilities may be off mark with low
  frequency events and long time lapses
• Certainly if there is a threshold heuristic

13
Disaster myopia(Tverksy and Kahneman)
Subjective probability of disaster
Subjective probability f(time since last crisis)
Real probability
Treshold heuristic
time
Last crisis
14
How disaster myopia works?

• How to compete with myopic banks in the absence
  of a crisis
• This is almost impossible
• So banks mimic each others behavior
• So at the next crisis, the market is often
  dominated by myopic banks
• ?Herding behavior
• ?This may even be rational

15
Implication

• In the presence of competition, financial markets
  will always be driven to instability
• This means we need
• Buffers in the form of capital rules
• Limits on bank models in the form of leverage and
  liquidity rules
• Not too much deposit insurance, because this only
  reinforces the moral hazard problem
• A resolution mechanism that actually kills the
  myopic banks if a crisis strikes