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Bailouts, Moral Hazard and Banks' Home Bias for Sovereign Debt
... Higher taxes reduce the incentive to invest as profits will be lower. Bailouts financed by new debt issuances simply imply a risk transfer from banks to the sovereign, as the government's financial support translates into a higher debt level (Gaballo and Zetlin-Jones 2016). As a result, while financial distress in the banking sector is relieved through the bailout, the default risk might be transferred to the public sector. ...
This paper exploits a panel of 28 European Union (EU) countries between 1995 and 2016 to analyze whether higher debt resulted in lower private investment – the so called debt overhang effect. We deal with the potential endogeneity between private investment and other macroeconomic determinants by applying an instrumental variable approach (GMM). Our results support the debt overhang hypothesis and indicate that this relationship only works through the public debt channel. In our baseline regression, a 10 percentage point increase in public debt reduced private investment by €18.32 billion, given the levels of private investment prevalent in 2016. By contrast, private debt does not appear to be a significant determinant of private investment. These results hold after controlling for a number of factors that might have caused public debt to increase and private investment to decrease. While our analysis focuses on the financial sector channel, we find no evidence that public debt tightens the credit constraints for private firms or worsens the public debt overhang. We also show that government bailouts of the financial sector, which could alleviate financial distress and boost credit provision, do not appear to be effective in mitigating the public debt overhang effect. Finally, we find evidence that the financial openness of a country does alleviate the negative impact of public debt on private investment. This might suggest that attracting foreign capital compensates for a contraction in the domestic pool of financial resources due to higher public debt levels.
... Related literature: A voluminous literature examines moral hazard in a variety of contexts, including banking(Chari and Kehoe (2013),Cordella and Yeyati (2003), Freixas (1999),Holmstrom and Tirole (1997),Keister (2010),Mailath and Mester (1994), and many others), yet this literature contains very little discussion of network formation. In examinations of bailouts and systemic risk, authors such asCaballero and Simsek (2013),Elliott, Golub, and Jackson (2014),Freixas, Parigi, and Rochet (2000),Gaballo and Zetlin-Jones (2015),Leitner (2005), andRochet and Tirole (1996b) analyze networks of bilateral exposures. But in these analyses, which contrast with mine, network architecture is not endogenously formed by firms and moral hazard arises from individual choices about excessive risk taking, bankers' decision to shirk, lack of monitoring among banks, etc. ...
In the aftermath of the financial crisis of 2008, many policy makers and researchers pointed to the interconnectedness of the financial system as one of the fundamental contributors to systemic risk. The argument is that the linkages between financial institutions served as an amplification mechanism: shocks to smaller parts of the system propagate through the system and result in broad damage to the financial system. In my dissertation, I explore the formation of networks when agents take into account systemic risk. The dissertation consists of three complementary papers on this topic. The first paper titled ``Network Formation and Systemic Risk'', joint with Professor Rakesh Vohra. We set out the framework and construct a model of endogenous network formation and systemic risk. We find that fundamentally `safer' economies with higher probability of getting good shocks generate higher interconnectedness, which leads to higher systemic risk. This provides network foundations for ``the volatility paradox'' arguing that better fundamentals lead to worse outcomes due to excessive risk taking. Second, the network formed crucially depends on the correlation of shocks to the system. As a consequence, an observer, such as a regulator, facing an interconnected network who is mistaken about the correlation structure of shocks will underestimate the probability of system wide failure. This result relates to the ``dominoes vs. popcorn'' discussion by Edward Lazear. He comments that a fundamental mistake in addressing the crisis was to think that it was ``dominoes'' so that saving one firm would save many others in the line. He continues to argue that it was ``popcorn in a pan'': all firms were exposed to same correlated risks and saving one would not save many others. We complement his discussion by arguing that the same mistake might have been the reason behind why sufficient regulatory precaution was not taken prior to the crisis. The third result is that the networks formed in the model are utilitarian efficient because the risk of contagion is high. This causes firms to minimize contagion by forming dense but isolated clusters that serve as firebreaks. This finding is suggestive that, the worse the contagion, the more the market takes care of it. In the second paper, titled ``Network Hazard and Bailouts'', I ask how the anticipation of ex-post government bailouts affects network formation. I deploy a significant generalization of the model in the first paper and allow for time-consistent government transfers. I find that the presence of government bailouts introduces a novel channel for moral hazard via its effect on network architecture, which I call ``network hazard''. In the absence of bailouts, firms form sparsely connected small clusters in order to eliminate second-order counterparty risk: expected losses due to defaulting counterparties that default because of their own defaulting counterparties. Bailouts, however, eliminate second-order counterparty risk already. Accordingly, when bailouts are anticipated, the networks formed become more interconnected, and exhibit a core-periphery structure (many firms connected to a smaller number of central firms, which is observed in practice). Interconnectedness within the periphery leads to higher extent of contagion with respect to the networks formed in the absence of intervention. Moreover, solvent core firms serve as a buffer against contagion by increasing the resilience of the many peripheral firms that are connected to the core. However, insolvent core firms serve as an amplifier of contagion since they make peripheral firms less resilient. This implies that in my model, ex-post time-consistent intervention by the government, while ex-ante welfare improving, increases systemic risk and volatility, solely through its effect on the network. A remark is that firms, in my model, do not make riskier individual choices regarding neither their choice of investment risk, nor the number of their counterparties they have. In this sense, network hazard is a genuine form of moral hazard solely through the formation of the detailed network. On another note, the model can also be viewed as a first attempt towards developing a theory of mechanism design with endogenously formed network externalities which might be useful in various other scenarios such as provision of local public goods. In the final paper, titled “Network Reactions to Banking Regulations”, joint with Professor Guilermo Ordonez, we consider the role of liquidity and capital requirements to alleviate network hazard and systemic risk. In the model, financial firms set up credit lines with each other in order to meet their funding needs on demand. Accordingly, higher liquidity requirements induce firms to form higher interconnectedness in order to be able to find deposits as needed. At a tipping point of liquidity requirements, the network discontinuously jumps in its interconnectedness, which contributes discontinuously to systemic risk. On the other hand, the reaction to capital requirements is smooth. Capital requirements indirectly work as an upper bound in the interconnectedness firms would form. This way, interconnectedness can be effectively reduced to a desired level via capital requirements. Yet capital requirements cannot be used to induce higher interconnectedness. Thusly, in times of credit freeze, capital requirements may not help promote circulation of credit. A conjunction of both liquidity and capital requirements is more effective in promoting desired circulation while reducing systemic risk. The work in this dissertation suggests that endogenous network architecture is an essential component of the study of financial markets. In particular, network hazard is a genuine form of moral hazard that will be overlooked unless network formation is taken into account, while it has implications about systemic risk. Moreover, this work illustrates how the reaction of networked financial markets to both fundamentals of the economy and to the policy can be non-trivial, featuring non-monotonicity and discontinuity.
We use sign‐identified macroeconomic models to study the interaction of financial sector and sovereign credit risks in Europe. We find that country‐specific financial sector bailout shocks do not generate strong international spillovers, because they primarily transfer private sector risk onto the local sovereign. By contrast, sovereign risk shocks generate substantial spillovers onto the global financial sector and for international sovereign debt markets. We conclude that any financial sector bailout policy that undermines the creditworthiness of the affected sovereign is likely to exacerbate global credit risk. Our findings highlight the unintended global consequences of country‐specific financial sector bailout programmes.
We make three points. First, ex ante e¢ cient contracts often require ex post ine¢ ciency. Second, the time inconsistency problem for the government is more severe than for private agents because …re sale e¤ects give governments stronger incentives to renegotiate contracts than private agents. Third, given that the government cannot commit itself to not bailing out …rms ex post, ex ante regulation of …rms is desirable. Chari, and Kehoe thank the National Science Foundation for …nancial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
20th century growth has been an exceptional period in the history of mankind, relying mostly on increase in total factor productivity (TFP). Using a 1890-2013 17-OECD country database, this paper improves the measurement of TFP by taking into account production factor quality, i.e. the education level of the workingage population for labor and the age of equipment for the capital stock. However, our main contribution is to assess the role of technology diffusion to TFP growth through two emblematic general purpose technologies, electricity and information and communication technologies (ICT).
Using both growth decomposition methodology and instrumental variables estimates, this paper finds that, among factor quality, education levels have posted the largest contribution to growth, while the age of capital has a significant, although limited, contribution. Quality-adjusted production factors explain less than half of labor productivity growth in the largest countries but Japan, where capital deepening posted a very large contribution. As a consequence, the “one big wave” of productivity growth (Gordon, 1999), as well as the ICT productivity wave for the countries which experienced it, remains only partially explained by quality-adjusted factors, although education and technology diffusion contribute to explain the US earlier wave in the 1930s- 1940s. Finally, technology diffusion, as captured through our two general purpose technologies, leaves between 0.6 and 1 point of yearly growth, as well as a large share of the two 20th century technology waves, unexplained. These results support both a significant lag in the diffusion of general purpose technologies and a wider view on growth factors, encompassing changes in the production process, management techniques or
financing practices.
Conventional wisdom says that, in the absence of default penalties, sovereign risk destroys all foreign asset trade. We show that this conventional wisdom rests on one implicit assumption: that assets cannot be retraded in secondary markets. Without this assumption, foreign asset trade is possible even in the absence of default penalties. This result suggests a broader perspective regarding the origins of sovereign risk and its remedies. Sovereign risk affects foreign asset trade only if default penalties are insufficient and secondary markets work imperfectly. To reduce its effects, one can either increase default penalties or improve the working of secondary markets. (JEL F34, G12, G15)
This paper addresses a basic, yet unresolved, question: Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the state have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means? In our model, firms can meet future liquidity needs in three ways: by issuing new claims, by obtaining a credit line from a financial intermediary, and by holding claims on other firms. When there is no aggregate uncertainty, we show that these instruments are sufficient for implementing the socially optimal (second-best) contract between investors and firms. However, the implementation may require an intermediary to coordinate the use of scarce liquidity, in which case contracts with the intermediary impose both a maximum leverage ratio and a liquidity constraint on firms. When there is only aggregate uncertainty, the private sector cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income. Government bonds command a liquidity premium over private claims. The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government-supplied liquidity and for its active management.
Demandable-debt finance by banks warrants explanation because it entails costs of bank suspension, liquidation, and idle reserve holdings. An explanation is developed in which demandable debt provides incentive-compatible intermediation where the banker has comparative advantage in allocating investment funds but may act against the interests of uninformed depositors. Demandable debt attracts funds by giving depositors an option to force liquidation. Its usefulness in transacting follows from information-sharing between monitors and nonmonitors. Copyright 1991 by American Economic Association.
This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts. This article is reprinted from the Journal of Political Economy (June 1983, vol. 91, no. 3, pp. 401--19) with the permission of the University of Chicago Press. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. ...
We propose a model of collateral choice by banks to quantify how changes in the haircut policy of the central bank affect the collateral used by banks and the funding cost of banks. We estimate the model using data on assets pledged to the European Central Bank from 2009 to 2011. Our results suggest that an increase in the haircut on low rated collateral by 5 percentage points would have reduced the use of this collateral by 10% but would have increased the average funding cost spread between high yield and low yield countries by 5% over our sample period.
This paper analyses the determinants of euro area non-financial corporate bonds over the last decade. We decompose the spread between the yield of German, French, Italian and Spanish corporate bonds vis-a-vis the German Bund of similar maturity into country, credit and duration risk premia components via dummy regressions. We highlight three main findings. First, the initial phase of the financial crisis (2008-2009) caused an overall increase in credit risk premia. Since the beginning of 2013 credit risk premia are back to levels comparable to those preceding the financial crisis. Second, at the height of the euro area sovereign crisis (2011-2012), high credit risk premia were accompanied by strong and persistent signs of market fragmentation in Italy and Spain (but not in France). This fragmentation has reached its peak in the second half of 2012 and has started to recede only after the announcement of the OMT. Third, we provide a simple measure of financial integration across the big 4 member states of the euro area.
We study residential investment over GDP in 20 OECD countries since 1980, and show that it is closely associated with the growth dynamics of population aged 20-49. We develop a new method to uncover the causal effect of the growth of the 20-49 age group. Using past demographic data as an instrument to avoid potential endogeneity between migration and the housing cycle, we find that a 1% increase in the population aged 20-49 increases the residential investment rate by 1.3 pp. Demographic changes are a better predictor of the residential investment rate than any macroeconomic or financial variable we control for.
We present a factor-proportions trade model in which heterogeneous firms can offshore intermediate inputs subject to fixed offshoring costs. In the skill-abundant country, high-productivity firms offshore a larger range of labor-intensive inputs to the labor-abundant countries than low-productivity firms. Differently from the traditional versions of factor-proportions trade theory, Heckscher-Ohlin forces operate at the within-industry level, leading to endogenous variation in skill intensity across firms that is positively correlated with firm productivity. Using French firm-level data for the years 1996 to 2007, we provide empirical support for the factor proportions channel through which offshoring to labor-abundant countries affects the firm-level skill intensities of French manufacturers.
This paper argues that the European banking crisis can in part be explained by a “carry trade” behavior of banks. Factor loading estimates from multifactor models relating equity returns to GIPSI (Greece, Ireland, Portugal, Spain and Italy) and German government bond returns suggest that banks have been long peripheral sovereign bonds funded in short-term wholesale markets, a position that generated “carry” until the GIPSI bond returns deteriorated significantly inflicting significant losses on banks. We show that the positive GIPSI factor loadings reflect actual portfolio holdings of GIPSI bonds in the cross-section of banks; and, the negative German loading reflects funding risk (flight away from bank funding to German government bonds), a risk that is increasing in the US money market mutual fund exposures of European banks as well as various proxies for bank short-term debt. Large banks and banks with low Tier 1 ratios and high risk-weighted assets had particularly large exposures and even increased their exposures between the two European stress tests of March and December 2010 taking advantage of a widening of yield spreads in the sovereign bond market. Over time, there is an increase in “home bias” – greater exposure of domestic banks to its sovereign’s bonds – which is partly explained by the European Central Bank funding of these positions. On balance, our results are supportive of moral hazard in the form of risk-taking by under-capitalized banks to exploit low risk weights and central-bank funding of risky government bond positions.
This paper examines empirically how industry-level wage floors are set in French industry-level wage agreements and how the national minimum wage (NMW) interacts with industry-level wage bargaining. For this, we use a unique dataset containing about 48,000 occupation-specific wage floors, in more than 340 French industries over the period 2006-2014. We find that the NMW has a significant impact on the seasonality and on the timing of the wage bargaining process. Inflation, past sectoral wage increases and real NMW increases are the main drivers of wage floor adjustments; elasticities of wage floors with respect to these macro variables are 0.6, 0.3 and 0.25 respectively. Wage floor elasticities to inflation and to the NMW both decrease along the wage floor distribution but are still positive for all levels of wage floors.
In the years since the Great Recession, many observers have highlighted the slow pace of productivity growth around the world. For the United States and Europe, we highlight that this slow pace began prior to the Great Recession. The timing thus suggests that it is important to consider factors other than just the deep crisis itself or policy changes since the crisis. For the United States, at the frontier of knowledge, there was a burst of innovation and reallocation related to the production and use of information technology in the second half of the 1990s and the early 2000s. That burst ran its course prior to the Great Recession. Continental European economies were falling back relative to that frontier at varying rates since the mid-1990s. We provide VAR and panel-data evidence that changes in real interest rates have influenced productivity dynamics in this period. In particular, the sharp decline in real interest rates that took place in Italy and Spain seem to have triggered unfavorable resource reallocations that were large enough to reduce the level of total factor productivity, consistent with recent theories and firm-level evidence.
This paper applies the DSGE-VAR methodology to assess the size of fiscal multipliers in the data and the relative contributions of two transmission mechanisms of government spending shocks, namely hand-to-mouth consumers and Edgeworth complementarity. Econometric experiments show that a DSGE model with Edgeworth complementarity is a better representation of the transmission mechanism of fiscal policy as it yields dynamic responses close to those obtained with the flexible DSGE-VAR model (i.e. an impact output multiplier larger than one and a crowding-in of private consumption). The estimated share of hand-to-mouth consumers is too small to replicate the positive response of private consumption. Copyright
Recessions are conventionally considered as times when the least productive firms are driven out of the market. How do credit frictions affect this cleansing effect of recessions? We build and calibrate a model of firm dynamics with credit frictions and endogenous entry and exit to investigate this question. We find that there is a cleansing effect of recessions in the presence of credit frictions, despite their effect on the selection of exiting and entering firms. This result holds true regardless of the nature of the recession: average firm-level productivity rises following a negative aggregate productivity shock, as well as following a negative financial shock. The intensity of the cleansing effect of recessions is however lower in the presence of credit frictions, especially when the recession is driven by a financial shock.This article is protected by copyright. All rights reserved.
URL des Documents de travail : http://centredeconomiesorbonne.univ-paris1.fr/documents-de-travail/
The internal cost of default, an important driver of sovereign debt repayment, increases with domestic portfolios' home bias. And so, when using capital controls or other instruments to steer these portfolios, a country faces a trade-off between commitment to repay and diversification. But why does a borrowing country not eschew the internal cost of default through domestic sector bailouts? And why does their sovereign not intermediate the diversification through swaps and other hedging devices? Answering these two questions is key to fathom the nature of internal costs of default. This paper investigates sovereign debt sustainability in a model where domestic and foreign investors optimally select their portfolios and the sovereign optimizes over its debt, default and bailout policies. It derives conditions under which internal bailouts do not preclude sovereign borrowing and establishes when, despite their disciplining benefits, capital controls are undesirable.
This study seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union. I assume that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses should the banks not be able to repurchase the bonds. I argue that regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, whereas regulators in other ‘safe’ countries will impose tighter regulation. As a result, governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank.
We show that financial sector bailouts and sovereign credit risk are intimately linked. A bailout benefits the economy by ameliorating the under-investment problem of the financial sector. However, increasing taxation of the non-financial sector to fund the bailout may be inefficient since it weakens its incentive to invest, decreasing growth. Instead, the sovereign may choose to fund the bailout by diluting existing government bondholders, resulting in a deterioration of the sovereign's creditworthiness. This deterioration feeds back to the financial sector, reducing the value of its guarantees and existing bond holdings as well as increasing its sensitivity to future sovereign shocks. We provide empirical evidence for this two-way feedback between financial and sovereign credit risk using data on the credit default swaps (CDS) of the Eurozone countries and their banks for 2007-11. We show that the announcement of financial sector bailouts was associated with an immediate, unprecedented widening of sovereign CDS spreads and narrowing of bank CDS spreads; however, post-bailouts there emerged a significant co-movement between bank CDS and sovereign CDS, even after controlling for banks' equity performance, the latter being consistent with an effect of the quality of sovereign guarantees on bank credit risk.
The article shows that time-consistent, imperfectly targeted support to distressed institutions makes private leverage choices strategic complements. When everyone engages in maturity mismatch, authorities have little choice but intervening, creating both current and deferred (sowing the seeds of the next crisis) social costs. In turn, it is profitable to adopt a risky balance sheet. These insights have important consequences, from banks choosing to correlate their risk exposures to the need for macro-prudential supervision. (JEL D82, E52, E58, G01, G21, G28)
We build a model where sovereign defaults weaken banks’ balance sheets because banks hold sovereign bonds, causing private credit to decline. Stronger financial institutions boost default costs by amplifying these balance-sheet effects. This yields a novel complementarity between public debt and domestic credit markets, where the latter sustain the former by increasing the costs of default. We document three novel empirical facts that are consistent with our model's predictions: public defaults are followed by large private credit contractions; these contractions are stronger in countries where banks hold more public debt and financial institutions are stronger; in these same countries default is less likely.
We develop a theory of sovereign borrowing where default penalties are not implementable. We show that when debt is held by
both domestic and foreign agents, the median voter might have an interest in serving it. Our theory has important practical
implications regarding (a) the role of financial intermediaries in sovereign lending, (b) the effect of capital flows on price
volatility including the possible overvaluation of debt to the point that the median voter is priced out of the market, and
(c) debt restructuring where creditors are highly dispersed.
Loans are illiquid when a lender needs relationship-specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.
Towards Time-Consistency in Bank Regulation
- C M Kahn
- J A Santos
Kahn, C. M. and J. A. Santos (2015): "Towards Time-Consistency in Bank Regulation,"
unpublished. 6
The impact of sovereign credit risk on bank funding conditions
Committee on the Global Financial System (2011): "The impact of sovereign credit
risk on bank funding conditions," CGFS Papers, 2011. 7
Report on the regulatory treatment of sovereign exposures
European Systemic Risk Board (2015): "Report on the regulatory treatment of
sovereign exposures," March 2015. 7
Efficient Financial Crises
- A Zetlin-Jones
Zetlin-Jones, A. (2014): "Efficient Financial Crises," unpublished. 8, 9