The Risks of Bank Wholesale Funding

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The Risks of Bank Wholesale Funding

• Rocco HuangPhiladelphia Fed
• Lev RatnovskiBank of England

FDIC/Cleveland Fed Conference, April 17, 2008
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Bank Funding
Asset
Liability
capital
Deposit

• Retail deposits
• Passive, insured
• Limited Supply
• Funded only by deposits?
• Excess capital / Unused investment opportunities
• Short-term wholesale funds
• Need to be rolled over in the short-term
  effectively more senior
• Source other financial institutions,
  non-financial corporations, state and local
  authorities, foreign entities, etc
• Instruments Fed Funds, Repos, Large Certificate
  of Deposits, Commercial Papers, etc.

Wholesale
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Short-Term Wholesale Funds
Asset
Liability
capital
Deposit

• Bright side
• Fully exploit investment opportunities
• Market discipline (Calomiris, 1999)
• Reduced liquidity risks (Goodfriend King, 1998)
• Dark side
• Aggressive lending compromised credit quality
• Limited market discipline
• Sudden stops inefficient liquidations
• How to reconcile?
• When is wholesale funding beneficial?
• Can banks opportunistically choose risky
  wholesale funds?

Wholesale
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Wholesale funds in the past bank failures

• What did short-term wholesale funds learn?
• Run!
• And you (almost always) get your money back in
  whole and when you want them
• Example 1 Continental Illinois Bank
• Noticing its energy sector exposure, wholesale
  depositors kept withdrawing
• The Fed kept lending
• Wholesale depositors who withdrew escaped
  unscathed
• So they kept running (why not?)
• Retail depositors held the bag

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Wholesale funds in the past bank failures

• Example 2 Northern Rock
• Frightened by U.S. crisis, short-term wholesale
  funds stopped rolling over financing
• After sustaining it for a while, NR finally asked
  for emergency funding from BoE
• which allowed further exit by wholesale funds
• THEN retail deposit run finally started
• Short-term wholesale investors didnt lose a cent
• They ran faster than ordinary folks!
• Message for wholesale funds
• Sometimes they wrongfully liquidate the good guys
  (Northern Rock), but sometimes they hit the bad
  guys (Continental)
• In any case, it was historically costless to run
  on a bank with insured depositors!!!

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How did short-term wholesale funds escape
unscathed?

• First-come-first-served gives short-term funds
  effective seniority
• until the bank is taken over by the court /
  government / FDIC / FHLB
• Central bank (and FHLB) by providing liquidity to
  a failing bank also helps finance their exit
• and can potentially increase the FDIC loss
• Retail depositors and taxpayers hold the bag
• Wholesale funds run based on a noisy signal
• Why not?

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When is wholesale funding a good thing?

• Good when they invest in information
• Bad when uninformed
• Why do they remain uninformed sometimes?
• Monitoring costs not fully compensated when
  passive depositors freeride
• Free, noisy signal reduces incentive for
  monitoring
• Effective seniority allows them to shift the
  burden of liquidation to passive depositors
• Making it more attractive to liquidate based on a
  noisy, negative signal.

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The Model Setup

• A bank with a long-term investment project
• Date 0 Attract funding, and invest
• Date 2 Return (per unit of investment)
• Good X1 w.p. P
• Bad L
• Date 1 L
• Wholesale depositors can
• incur a cost and get a precise signal on project
  quality
• Screen out bad banks
• or rely on a noisy signal that is precise enough
  (threshold is endogenous)
• Example of signals
• market-wide or sector-wide news e.g. house price
  seems to contain a lot of information on banks
  holding a lot of mortgage-backed securities
• Energy price on Penn Central, Continental, etc

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What are they thinking?

• Wholesale funds
• Get Informed? Depositors free-ride the benefits
• Remain Uninformed? Costs of liquidation burdened
  by the depositors
• Incentives distorted by
• Effective seniority over passive depositors
• Availability of a free, noisy signal
• Banks
• Deposits only? excess capital
• Attract wholesale? Can have higher liquidity risk
• Incentives distorted by limited liability
• Society
• Lending to bad projects never optimal market
  discipline
• Early liquidation never optimal liquidity risk

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Results from the model
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Distorted incentives

• Wholesale financiers
• Low incentives to screen Insufficient market
  discipline Do not internalize benefits for
  depositors
• High incentives to liquidate Liquidity risk
  Withdraw before the depositors, enjoying
  effective seniority, and thus larger share of a
  smaller pie
• Banks
• Over-reliance on risky wholesale fundsLimited
  Liability Do not internalize risks of depositors

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Is wholesale funding bad?

• Less risky if
• Predominantly wholesale
• Wholesale not necessarily a problem per se
• They seem to be more reasonable in financial
  institutions without much retail deposits
• They sat down and bailed LTCM out
• They maintained credit lines to Countrywide
• Exception Bear Stearns people just hated BS
  for its LTCM role? ?
• Predominantly deposits
• But no monitoring and excess capital
• More risky if
• Combination of deposits and wholesale
• Use of wholesale funds in depository banks
• Insufficient market discipline
• Heightened liquidity risks

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Model v.2.0.

• New model
• Endogenous (optimal) arrangement of seniority
  0,1
• Endogenous choice of monitoring intensity 0,1
• Optimal seniority arrangement
• Unlike in Calomiris and Kahn (1991), seniority is
  not always good
• Wholesale funds should be made more junior if
• Share of passive retail depositors is higher
• The precision of the noisy signal is higher
• e.g. For banks holding mainly mortgage-backed
  securities vs. loans
• Liquidation cost is smaller
• Inverse U-shaped relationship between monitoring
  and seniority
• Monitoring efforts maximized in the middle
• Lower seniority - incentives not aligned
• Higher seniority - liquidate too often

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• Thank you!!