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Deregulation

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Deregulation Deregulation will lead to More competition More efficiency More welfare More innovation More risk Deregulation always requires reregulation of the new risks – PowerPoint PPT presentation

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Title: 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
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