DiscussionDiscussionResolution Policy and the Cost of Resolution Policy and the Cost of

Bank FailuresBank Failures

Bank Liability Structure, FDIC Bank Liability Structure, FDIC Losses and Time to FailureLosses and Time to Failure

Two general issues addressed in the paperTwo general issues addressed in the paper

– What are the determinants of FDIC losses?What are the determinants of FDIC losses?Are the determinants of the most costly Are the determinants of the most costly

failures different from other failures? Are failures different from other failures? Are there important nonlinearities?there important nonlinearities?

Are resolution costs related to structure of a Are resolution costs related to structure of a failed bank’s liabilities?failed bank’s liabilities?

– What factors impact the time to failure What factors impact the time to failure (conditional on failure)?(conditional on failure)?

Some Conceptual IssuesSome Conceptual Issues How should costly failures be defined? How should costly failures be defined?

– Relative to assets/depositsRelative to assets/deposits– Aggregate costsAggregate costs

What is the purpose?What is the purpose?– Regulatory policyRegulatory policy– Adequacy of aggregate reservesAdequacy of aggregate reserves– Estimate receivership costs. Estimate receivership costs.

How are the FDIC’s costs related to the failed bank’s liability structure?How are the FDIC’s costs related to the failed bank’s liability structure?– Directly by effecting the FDIC’s obligations and relative position among Directly by effecting the FDIC’s obligations and relative position among

creditors (note this has changed over time).creditors (note this has changed over time).FDIC loss= Insured Deposits + Recovery or paid claims of uninsured FDIC loss= Insured Deposits + Recovery or paid claims of uninsured creditors-Estimated Value of assets. creditors-Estimated Value of assets.

– Indirectly through market discipline and its effect on asset quality.Indirectly through market discipline and its effect on asset quality. Techniques to deal with non-linearityTechniques to deal with non-linearity

– Structural: Specify a functional relationshipStructural: Specify a functional relationship– Limit sample/ Create binary measure for the dependant variableLimit sample/ Create binary measure for the dependant variable– Quantile RegressionQuantile Regression

Some Specific Questions/CommentsSome Specific Questions/Comments What is the explanation for a positive relation between losses and fed funds What is the explanation for a positive relation between losses and fed funds

purchased for the most costly transactions?purchased for the most costly transactions?– First Republic and First City cross/guarantees?First Republic and First City cross/guarantees?– Interaction with depositor preference?Interaction with depositor preference?– Pre-FDICIAPre-FDICIA

Interpretation of the coefficients for contemporaneous balance sheet variables: Interpretation of the coefficients for contemporaneous balance sheet variables: Ceteris is not paribus.Ceteris is not paribus.

Nonlinearities or outliers? Nonlinearities or outliers? – How important are nonlinearities/ Any statistical tests for differences?? How important are nonlinearities/ Any statistical tests for differences?? – How would one use quantile regressions as a predictive tool?How would one use quantile regressions as a predictive tool?

Interpreting the time to failure results/ duration analysisInterpreting the time to failure results/ duration analysis– Difficult to use as a predictive tool: Conditioned on failure.Difficult to use as a predictive tool: Conditioned on failure.– Evidence of market discipline? Evidence of market discipline?

Break down liabilities into insured/secured categoriesBreak down liabilities into insured/secured categories How does one explain the same sign on deposits and federal funds?How does one explain the same sign on deposits and federal funds?

Cash in the Market and Optimal Cash in the Market and Optimal Resolution of Bank FailuresResolution of Bank Failures

Model objectives:Model objectives:– Demonstrate that ex post bailouts and provision of liquidity Demonstrate that ex post bailouts and provision of liquidity

to healthy banks are equivalent from a social welfare to healthy banks are equivalent from a social welfare perspective: Both policies prevent inefficient transfers of perspective: Both policies prevent inefficient transfers of assets outside of the banking sector.assets outside of the banking sector.

– Demonstrate the ex ante liquidity provision provides Demonstrate the ex ante liquidity provision provides incentives against herding and thus is superior. Subsidies to incentives against herding and thus is superior. Subsidies to healthy banks increase the rents associated with acquiring healthy banks increase the rents associated with acquiring failed banks. failed banks.

Overview of the ModelOverview of the ModelSome key assumptions: Some key assumptions:

1.1. Two period risk neutral world. Two period risk neutral world. 2.2. Banks invest in risky loans using one period fully insured deposits. Banks invest in risky loans using one period fully insured deposits. 3.3. The banking sector has limited liquidity at t+1. (Both debt and equity is The banking sector has limited liquidity at t+1. (Both debt and equity is

limited) limited) 4.4. Banks are more efficient users of failed bank assets (a la Shleifer and Banks are more efficient users of failed bank assets (a la Shleifer and

Vishny).Vishny).5.5. Government can provide liquidity to the banking sector either through Government can provide liquidity to the banking sector either through

bailouts or through assisting healthy banks acquire failed banks. Purchases bailouts or through assisting healthy banks acquire failed banks. Purchases of failed banks by healthy banks are subsidized. of failed banks by healthy banks are subsidized.

6.6. Government provision of funding for bailouts or liquidity involves fiscal Government provision of funding for bailouts or liquidity involves fiscal costs that are increasing in the size of government expenditures. costs that are increasing in the size of government expenditures.

7.7. The governments objective is to minimize fiscal costs and maximize The governments objective is to minimize fiscal costs and maximize efficient asset use.efficient asset use.

8.8. There are agency costs associated with outside equity (insiders must retain a There are agency costs associated with outside equity (insiders must retain a theta of profits to invest in good projects).theta of profits to invest in good projects).

Results and IntuitionResults and Intuition

At time t + 1, k banks are insolvent. Given limited bank At time t + 1, k banks are insolvent. Given limited bank liquidity the sale price of the assets of will depend on the liquidity the sale price of the assets of will depend on the number of bank failuresnumber of bank failures

For a k > k the government trades efficiency losses For a k > k the government trades efficiency losses associated with the sale of assets to “outsiders” against the associated with the sale of assets to “outsiders” against the fiscal costs associated with bailouts or providing liquidity. fiscal costs associated with bailouts or providing liquidity. Since the both bailouts and liquidity provision have the Since the both bailouts and liquidity provision have the same efficiency gains and fiscal costs (i.e. require p of same efficiency gains and fiscal costs (i.e. require p of funding) they are equally efficient ex post.funding) they are equally efficient ex post.

Ex ante providing liquidity is better because it provides a Ex ante providing liquidity is better because it provides a subsidy for good behavior. subsidy for good behavior.

Some Comments Some Comments Note that for prices p (k) < p surviving banks earn a profit Note that for prices p (k) < p surviving banks earn a profit

on acquiring bank assets. What are the impediments to on acquiring bank assets. What are the impediments to capital flows into the banking sector at time t+1?capital flows into the banking sector at time t+1?– Moral hazard? Moral hazard? – Shouldn’t rents accrue to the Shouldn’t rents accrue to the existingexisting owners and the owners and the

price of outside equity be determined by the risk free price of outside equity be determined by the risk free rate?rate?

– What about additional debt financing?What about additional debt financing? Sector uniqueness is not necessarily equivalent to lost Sector uniqueness is not necessarily equivalent to lost

going concern valuegoing concern value

full price

intermediate pricereservations price

low price

k k

p

p

w/n

=k

n

Prices and Rents Prices and Rents For Failed Bank AssetsFor Failed Bank Assets

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Designing Countercyclical and Risk Designing Countercyclical and Risk Based Aggregate Deposit Based Aggregate Deposit

Insurance PremiaInsurance Premia Objectives: Objectives:

– What does a counter cyclical premium structure What does a counter cyclical premium structure look like?look like?

– How should one think about the appropriate fund How should one think about the appropriate fund size or initial capitalization of the fund?size or initial capitalization of the fund?

– Given historical loss rates, the current asset Given historical loss rates, the current asset distribution of banks what are the trade-offs distribution of banks what are the trade-offs between “countercyclical” rebates, the premium between “countercyclical” rebates, the premium rebates, assessment rates and the default rebates, assessment rates and the default probability of the fundprobability of the fund

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Contributions/Results Contributions/Results Determination of the target fund size involves specifying a fund Determination of the target fund size involves specifying a fund

“default probability” over a given horizon. Given bank failures “default probability” over a given horizon. Given bank failures are not independent, the insurance fund requires an initial are not independent, the insurance fund requires an initial capitalization which in turn implies premiums that are higher than capitalization which in turn implies premiums that are higher than “actuarially fair”.“actuarially fair”.

The default probability under the current system is surprisingly The default probability under the current system is surprisingly high (assuming the loss rate and failure rate assumptions are high (assuming the loss rate and failure rate assumptions are correct).correct).

Trade-offs in the design of countercyclical premium system. Trade-offs in the design of countercyclical premium system. Policy parameters are:Policy parameters are:

1.1. Loss rate rebate Loss rate rebate 2.2. Premium rebate Premium rebate 3.3. Assessment rateAssessment rate4.4. Default probability Default probability

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Some QuestionSome Question While table 5 shows the trade-off, what are reasonable values While table 5 shows the trade-off, what are reasonable values

for countercyclical rebates?for countercyclical rebates?– How are losses on bank failures correlated with the shadow How are losses on bank failures correlated with the shadow

price of capital to the banking system? Should we ignore price of capital to the banking system? Should we ignore market signals? (Acharya and Yorulmazer model)market signals? (Acharya and Yorulmazer model)

– Are historical losses and a Poisson constant arrival rate Are historical losses and a Poisson constant arrival rate reasonable?reasonable?

Politically is this feasible? As failures increase the FDIC Politically is this feasible? As failures increase the FDIC reduces its premiums!! reduces its premiums!! – Requires a lot of faith that there is no regime shift. Requires a lot of faith that there is no regime shift. – Moral hazard incentives are correlated with the shadow Moral hazard incentives are correlated with the shadow

price of capital.price of capital.