Title: Deregulation
1Deregulation
- Deregulation will lead to
- More competition
- More efficiency
- More welfare
- More innovation
- More risk
- Deregulation always requires reregulation of the
new risks
2Crisis in the financial system
3The 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
4The 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
5Economic 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
6Risks of originate and distribute model
7Structured 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
8The 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
9Cashflow waterfall origin
10Cash waterfall destination
11Why 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.
12Why 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
13Disaster myopia(Tverksy and Kahneman)
Subjective probability of disaster
Subjective probability f(time since last crisis)
Real probability
Treshold heuristic
time
Last crisis
14How 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
15Implication
- 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