Abstract
The recent financial crisis generated a great deal of debate about the necessity for, and the quantum of, bailouts. There is also a wide-ranging acknowledgment that prudential regulation is necessary to minimize the frequency and intensity of such systemic failures in the future. However, the existing analytical and policy studies tend to deal with these two aspects in isolation. By way of contrast, this study sets up an analytical framework to endogenously determine the requisite regulatory practices and bailout instruments to overcome the liquidity problems and the associated solvency problem on a long-term basis. Such efficient choices have been structured to resolve the trade-off between growth and stability by maximizing the welfare of all the parties. Prior knowledge that a well-defined bailout policy operates if they adhere to clearly specified regulatory norms signals to the financial institutions that keeping risks within bounds will be in the overall interests of all concerned.
This chapter is derived in part from an article published in Macroeconomics and Finance in Developing Market Economies, 2010, © Taylor and Francis, available on line: http://tandfonline.com, DOI: 10.1080/17520843.2010.498131
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Notes
- 1.
Securitization is at the apex of this problem. The activities of credit rating agencies that support their activity have also come under scrutiny. The riskiness of the securitized pool, in itself, is not the major cause of the recent financial crisis. Instead, a reduction in the overall economic activity resulted in the inability to pay back loans. Similarly, Hull et al. (2004) suggested that credit rating agencies cannot anticipate external exigencies that bring down the value of securitized assets. They can only react to them by downgrades when information is available. Even if such arguments are circumscribed, it will be difficult to eliminate securitization and/or credit ratings since they are well entrenched. This may suggest that bailouts are justified. However, there is hardly any support to conceptualize bailouts. Whalen (2009, p. 3) offered the most compelling reason for this. As he put it, “the crucial quality of the derivative mindset that enabled the multiplication of risk that now threatens the entire global market place (is that) the principal purpose was speculation rather than investment.” Instead, a significant restructuring in the use of these instruments is under way. IIF (2008) put the argument succinctly. “Resolution of liquidity issues of current market stress will depend on sound internal risk management decisions by firms; principles based regulation focusing on outcomes rather than quantitative requirements; and ongoing attention by the central banking community to liquidity in an internationally integrated, market based system.” A representative sample of the analytical debates consists of Congleton (2009) and Eichengreen (2009). Note that regulatory practices should keep three dimensions in perspective. First, in general, the SPVs do not have the financial structure or stability to absorb risks. It is therefore necessary to define the obligations of the originator more precisely and inclusively. See also Acemoglu (2009). Second, observe that securitization is a complex, individual, requirement-centered instrument. As such, no single measure of risk may be adequate from a regulatory perspective. Third, we do not as yet have a credible framework of the desirable characteristics of a robust securitization model. Perhaps, dimensions, other than risk characteristics, need attention. This study will not pursue this aspect any further.
- 2.
This may be looked upon as having two dimensions. First, it should be possible to utilize the existing capital stock in various sectors to generate production. This may, in itself, generate adequate income and demand for goods and services. Second, consumer credit and demand for goods and services may have been affected due to the liquidity crisis. Reviving the demand side will also be necessary. In this context, a bailout, an increase in liquidity per se, or lower interest rates may not have the desired effect. The flight to capital, or the lookout for more promising assets for investment purposes, necessitates fiscal action to revive economic activity before bailouts can succeed. See, for instance, Kriegel (2009). This aspect will not be considered in the present study.
- 3.
The tainted assets are generally held by a trust which exercises a put option once the value of assets improves. The government then recovers its bailout amount. See, for instance, Poole (2008).
- 4.
The efficacy of the ad hoc nature of the bailouts has been in doubt. First, Palma (2009), among others, argued that bailing out all the losses in a hurry to restore liquidity creates an incentive to remain careless. Second, the FIs do not reveal their true types when they accept a certain bailout. Improvements in social welfare resulting from such bailouts tend to be small because there will be no fundamental change in the decisions of the FIs. They argue that a private insurance mechanism may have better information content. Third, Kriegel (2009) pointed out that banks did not want to lend the extra liquidity because, at low interest rates, the administrative costs of extending loans have been prohibitive. The central banks paying interest on the deposits that banks hold with them only aggravated the problem. On the other hand, banks could not lend because borrowers did not have the necessary collateral. Further, a Keynesian type of liquidity trap is operating in the sense that borrowers did not find many investment opportunities to use the excess credit available. Given this milieu, he argues that monetary policy is ineffective. He, therefore, suggests that fiscal action to increase aggregate demand will have a superior impact by improving the demand for credit and activating the financial system at large.
- 5.
It must be noted that even the recent G20 summit advocated restructuring global financial institutions in the hope that, once they are in place, the FIs will make wise decisions.
- 6.
The typical approach to regulation has been advocating the following. The FIs will take great risks if there is no regulation. They may succeed in maintaining systemic stability. Such stable epochs tend to underestimate the inherent moral hazard associated with financial intermediation and minimize the role of the regulator. But excessive risk taking leads to a crisis once the liquidity constraint is binding. See, for instance, Mendoza (2008). The greater the cost of a crisis, the greater will be the call for regulation. It is then essential to specify a proper information system and minimum prudential regulation. On the other hand, strict regulation that succeeds in preventing crises may stifle private entrepreneurial initiative to a point where there is little risk in the system. However, note that the efficient design of regulation is generally considered to be independent of bailout policy.
- 7.
Some authors, notably Borio (2009), Davis and Karim (2009), and Farhi and Tirole (2009), advocate this approach. The World Bank has been consistently taking the position that the problems of adverse selection can be avoided altogether if the larger corporate firms know that it would be much more difficult for them to get any bailouts and that penalties for misdeeds are hefty. See, for example, Ratnovski (2009).
- 8.
Most of the analysis of this study pertains to bailout of the financial sector alone. Many authors have been suggesting that other sectors should not be bailed out. Financial institutions are catalysts on which all real sectors depend. Since they borrow for a short time horizon and lend for a longer term, the confidence of the depositors that they can recover their money is crucial. The significant interrelationships between financial institutions and the real sector in the process of intermediation are the compelling reason for providing them bailouts in the context of a financial crisis. The real sectors should not be bailed out simply because their failure is a result of the financial crisis and not its cause. In effect, the real sectors can be expected to bounce back if the financial markets can be restored to their normal functioning. From a political economy perspective, the objection is basically that taxpayer’s money should not be utilized to bail out the well-to-do sectors that made enough profits while the economic environment was favorable. In general, bailout of the IT sector and other service activities like airlines has not been favored. Refer to Palma (2009). However, there is a wide-ranging debate about the desirability of extending bailouts to nonfinancial activities. The following analytical perspective applies equally efficiently in both these cases.
- 9.
Some observers suggest that the original borrowers should get the bailout and, as a corollary, bear the cost of administering the bailout for, after all, equity demands that the assets they acquired with the loan should belong to them. This may be justified if their default is purely accidental because of exogenous economic conditions. The case of bailouts for housing loan defaults in the USA has been dealt with in this manner for an attempt was made to restructure mortgages by reducing interest rates and reducing EMI by extending the duration of loans.
- 10.
Note that the bailout may be in the form of credit created by actions of the central bank. It need not be in the form of a fiscal policy action from budgetary resources of the government. The efficiency of one of these routes against the other is also an important issue for the choice may not depend only on considerations of liquidity and solvency. Larger macroeconomic issues like recessionary trends and demand-side management may prevail.
- 11.
Bailouts cause moral hazard problems reflected in lower levels of effort. But they also provide incentives to reveal the risk types and mitigate adverse selection problems created by information asymmetry. The present study attempts to define acceptable risk endogenously in such a way as to maximize the net benefit to the society.
- 12.
Actually the managerial compensation mechanisms have been of this nature for, while they receive bonuses in good times, they are not penalized for erroneous decisions. McAfee and McMillan (1991) argued that asking them to make an initial deposit is an efficient mechanism against such opportunism.
- 13.
Another possibility presents itself from an analytical perspective. Confronted with frequent crises and the need to administer bailouts, the regulator may be relatively more risk averse. By way of contrast, the FIs may consider the a priori bailout mechanism in place to be a sufficient license for them to take more risks. That is, in comparison, they appear risk neutral. Identically, the same results can be developed for this variant of the principal agent model.
- 14.
Note that highly inefficient FIs make the costs of bailouts excessive to a point where y 2/2δ > y. Bailouts cannot be justified under these conditions. From an analytical viewpoint, the model described here will be applicable only if N > 0.
- 15.
It will be presently argued that, under certain conditions, higher bailouts can be justified when λσ 2 increases.
- 16.
In a more general model, there is a possibility that multiple equilibria exist. Some of them may represent a low-level trap, some may be unstable, and yet others are high growth indicators. In the short run, small increases in liquidity cannot move the system out of the low-level equilibrium trap.
- 17.
The regulator is dealing with many FIs. Their efficiencies with respect to loan recoveries differ. But it would be far more efficient from an administrative viewpoint if the regulator defines one value of p and allows the FIs, who wish to remain in business, to self-select. This argument suggests that the FIs will adjust their δ to an exogenously determined λσ 2. This can be shown to result in the choice of p independent of λσ 2. An argument of this nature was advanced in Jullien et al. (1999) in the context of fairly general contractual arrangements.
- 18.
From a practical standpoint, the FIs may take a myopic view and consider the costs of due diligence represented here exceed the expected gains of bailouts in case of distress. The system will be out of control if self-regulation is expected. The necessity for regulatory action will then be reinforced. Essentially, it must be acknowledged that the necessity for regulation is indicated even in the most favorable case that is presented here.
- 19.
If the FI is a bank, this is clearly analogous to the Basel II norms. The basic difference is that it is made proportional to loans instead of deposits that they receive. Rao (2009) argued that, if the capital adequacy norm is pivoted to deposits, the banks may adhere to it and yet provide many risky loans. Hence, even in that context, capital adequacy must be defined as a proportion of loans. In the context of FIs, there is no lender of last resort. They can, however, be asked to keep such reserves with themselves.
- 20.
Acharya (2009), in particular, argued that a systemic specification of k and p would be superior to leaving them as functions of δ and λσ 2 for capital adequacy requirements based on each FI’s risk fail to mitigate aggregate risk-shifting incentives and accentuate systemic risks. The arguments pertaining to macroprudential norms are similar in spirit.
- 21.
The assets of an FI may consist of assets other than those for which they extended loans. They may take the form of land and buildings, equity of other firms, and so on. Morris and Shin (2008) argued that there should be some regulation regarding the composition of assets, their financing, and the loans offered on a given asset base. Rao (Rao 2009, 2010) contains a more general analysis in a somewhat different analytical framework. It is possible to extend the efficient bailout and regulation argument of this section further.
- 22.
Diamond and Rajan (2009) argued that the economic downturn may have deeper effects than the solvency crisis in itself. In that case, restoring the assets to the FIs will not be adequate to pull the economy out of the low-level equilibrium. Improving the aggregate demand becomes a necessity.
- 23.
In parallel to the liquidity crisis, situation bailouts reduce the cost of capital to the borrower and entice him to make larger investments than are socially desirable. This viewpoint cannot be sustained if achieving a higher growth rate through acceptable risk taking is considered desirable.
- 24.
Bailouts will be conditioned by the remaining value of assets. This was the reason for not bailing out Lehman Brothers. Second, it is generally recognized that the financial system per se will not buy these assets. Fiscal action through the government budget is indicated. Third, one of the adverse effects of a bailout is that asset restructuring, which is the only long-term solution, gets delayed. A bankruptcy filing, as in the Lehman Brothers case, is the more efficient option. These arguments are now commonplace. However, notice that the endogenous determination of bailout, as specified here, overcomes many of these problems.
- 25.
This analysis therefore suggests that the regulator may adopt another strategy. To begin with, they may offer a low, or limited, bailout. The FIs may also be informed a priori that they will be offered larger bailouts and allowed to take more risks provided they can convince the regulator that they exhibit the expected diligence. Reduction in the initial bailout and preference for extended bailouts also suggest a risk sharing arrangement for the FIs may reduce the caution exercised if the original bailout is high. Anticipating this, the regulator may decide to ascertain the risk type of the FIs by offering a lower bailout and extending it to the more diligent among them as reflected in their choices.
- 26.
In Rao (2009), the same model was utilized with an emphasis on regulatory policy alone.
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Rao, T.V.S.R. (2016). Financial Crisis and Regulatory Policy. In: Risk Sharing, Risk Spreading and Efficient Regulation. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2562-1_12
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