Understanding financial fragility: the roles of opacity, fire sales, and sovereign debt

• Main Author: Izumi, Ryuichiro
• Format: Text
• Language: unknown
• Published: No Publisher Supplied 2019
• Subjects: Iceland
• Online Access: https://dx.doi.org/10.7282/t3-7m8s-d831; https://rucore.libraries.rutgers.edu/rutgers-lib/61768/

This dissertation studies fragility-enhancing economic mechanisms and how government policy can promote - or may inadvertently undermine - the stability of the financial system. It is composed of three separate essays that investigate this question in the context of particular aspects of the recent global financial crisis: the opacity of assets, fire sales, and the link between banking and sovereign debt crises. Each of these chapters aims to inform an ongoing policy debate about appropriate changes to financial policy and regulation.In Chapter 1, I study how the opacity, or complexity, of banks' assets affects financial stability and asks when the level of opacity should be regulated. An important feature of the global financial crisis was widespread "runs" in which depositors and other creditors withdrew funds from a variety of shadow banking arrangements that invested in complex assets that were difficult to value, especially once financial markets became stressed. Some policy makers have argued that this type of opacity makes runs more likely and should be prohibited by regulation. Others have argued that opacity plays a useful role by making the value of a bank's liabilities less sensitive to information and therefore more liquid. This chapter asks: What is the optimal degree of opacity in the financial system? To answer this question, I analyze a version of the cite{Diamond1983} model of financial intermediation with financial markets and fundamental uncertainty as in cite{Allen1998}. I add the ability of a bank to make its assets {it opaque} in the sense that it will take time to discern the true value of the assets. Until the true state is known, the bank's assets will trade in financial markets based on their expected payoff. By choosing the level of opacity, the bank determines how many of its depositors will be paid while its assets remain information insensitive in this sense. In other words, opacity of the bank's assets offers an insurance benefit in the spirit of the classic cite{Hirshleifer1971} effect. However, I show that this type of opacity also has a cost in terms of financial stability. In particular, a higher level of opacity makes the bank more fragile in the sense that it introduces equilibria in which a self-fulfilling bank run is more likely to occur. In choosing the level of opacity for its assets, I show that a bank faces a trade-off between providing insurance to more of its depositors and increasing its susceptibility to a self-fulfilling run. If depositors can accurately observe the bank's opacity choice before depositing their funds, competition will drive banks to choose the optimal level. If, however, depositors are unable to observe this choice, banks will have an incentive to become overly opaque and regulation to limit opacity would improve welfare.In Chapter 2, which is a joint work with Yang Li, we study whether policies that aim to mitigate "fire-sales", in which assets are sold at prices well below their fundamental value, actually promote financial stability. Fire-sales were an important contributing factor in the global financial crisis. After the crisis, policy makers aimed to prevent future fire-sales by requiring banks to hold sufficient liquid assets to survive distressed periods without selling illiquid assets. However, forcing banks to hold larger amounts of liquid assets entails an opportunity cost in terms of lost opportunities of illiquid and profitable investments. We study whether the opportunity costs associated with liquidity regulation worsens financial fragility and derive the optimal level of liquidity regulation. We construct a model in which banks choose a portfolio of liquid and illiquid assets, anticipating that a bank run may occur and force the bank to sell illiquid assets. When banks have to sell more illiquid assets, the price will fall further (a {it fire-sale}). We show that banks choose to hold a larger amount of illiquid assets than is socially optimal. Liquidity regulation can correct this fire-sale externality. However, we find a striking result: in some cases, liquidity regulation worsens financial fragility in the sense that it introduces equilibria in which a self-fulfilling bank run is more likely to occur. The reason is that when banks are allowed to hold fewer high-return, illiquid assets, they tend to offer a lower repayment to depositors who remain invested which, in turn, can increase the incentive for depositors to withdraw early. As a result, policy makers must balance the desire to correct the fire-sale externality against the increased fragility that liquidity regulation may bring.In Chapter 3, I study whether government guarantees or liquidity regulation are a more effective way to prevent financial crises when these policies interact with the government's fiscal position. A government guarantee is a popular policy to mitigate banking panics. However, there was a lot of criticism about the taxpayer money used to bail out the banks in the global financial crisis. Recent reforms in the U.S. and Europe move in the direction of restricting the ability of the public sector to provide guarantees in a future crisis and to instead introduce tighter financial regulations. I contribute to this discussion by considering the negative feedback loop between the fiscal position of the government and the health of the banking sector. The fiscal cost of guarantees may hurt sovereign debt sustainability, and an unsustainable debt undermines the effectiveness of guarantees, as occurred in Greece, Iceland, Ireland and Italy in the recent crisis. This chapter asks: Are government guarantees or financial regulation a more effective way to prevent banking crises in the presence of the negative feedback loop? To answer this question, I construct a version of cite{Diamond1983} model of financial intermediation in which the government issues, and may default on, debt. Banks hold some of this debt, which ties their health to that of the government. The government's tax revenue, in turn, depends on the quantity of investment that banks are able to finance. Without any policy, this economy is fragile in the sense that a self-fulfilling bank run occurs in an equilibrium. I compare government guarantees, liquidity regulation, and a combination of these policies to find the best way to eliminate this equilibrium. This comparison given the negative feedback loop is novel in the literature. I show that each policy adversely affects the government's fiscal position through revenue and/or expenditure, which in turn determines the effectiveness of each policy. I show that the guarantee tends to be effective in preventing banking crises when the return on long-term investment is high and when the government's initial debt is small. In some cases, the combination of guarantees and liquidity regulation is needed to prevent crises. In other cases, liquidity regulation alone is effective and adding guarantees would make the financial system fragile.