22/8/2013: Sovereign Default Risk & Banks in the Euro Area Setting: Harald Uhlig

Harald Uhlig's latest paper "Sovereign Default Risk and Banks in a Monetary Union" (CEPR DP9606, August 2013, http://www.cepr.org/pubs/dps/DP9606) "seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union".

The rationale for the paper is that the "European Monetary Union is in distress. Mechanisms that were meant to safe-guard key institutions and to assure stability have become sources of balance sheet risk for these very institutions. Liquidity provision within
the European Monetary Union rests upon repurchase agreements, by which banks guarantee the repurchase of assets deposited with the ECB. If either the bank fails or the asset fails, but not both, this mechanism safe-guards the repayment to the ECB, since it can either rely on the repurchase by the bank or sell the asset. However, when both fail as well as the bank home country fails, the ECB incurs a loss."

Abstracting away from the (important) debate about the implications of such a 'loss', the theoretical framework described by Uhlig is insightful and interesting. The author assumes "that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses, should the banks not be able to repurchase the bonds."

Furthermore, "In the model, banks pursue their investment strategy voluntarily: it is up to regulators to potentially constrain them. Other explanations are conceivable, of course". This is different from the currently dominant views, as per Reinhart (2012a) as well as Claessens and Kose (2013). Specifically, it is distinct from Reinhart (2012b) argument as to why banks hold bonds of their home country. Reinhart argues that in a “financial repression” setting the regulators "make
[the banks] hold the sovereign bonds, perhaps with strong-arm tactics, perhaps in exchange for “looking the other way” concerning weak portfolios of commercial loans and mortgages, or simply as a “favor” in a long, ongoing relationship. Since the banks could potentially refuse, though at considerable cost, it still must ultimately be preferable to them to hold own-country bonds rather than invest elsewhere or to close: so, in some ways, this paper may also be understood as a model of financial repression." Another view for the system by which the banks end up holding rising exposures to domestic sovereign bonds is a political economy argument: "if sovereign bonds are held by home banks, it makes it politically harder to default on these bonds, as this will hurt domestic banks and savers. If so, then such a portfolio arrangement might serve as a commitment device for the government in trouble."

Uhlig's (2013) paper is not covering the underlying reasons for the holding of the bonds.

Overall, "the issue of sovereign default risk, bank portfolios and the role of the central bank has received considerable attention in the recent literature. Acharya and Steffen (2013) is a careful empirical analysis of the “carry trade” by banks, which fund themselves in the wholesale market and invest in risky sovereign bonds. They document, that “over time, there is an increase in ’home bias’ – greater exposure of domestic banks to its sovereigns bonds – which is partly explained by the ECB funding of these positions"… Relatedly, Corradin and Rodriguez-Moreno (2013) show that USD-denominated sovereign bonds of Euro zone countries became substantially cheaper (i.e., delivering a higher yield) than Euro-denominated bonds during the Euro zone crisis, and ascribe it to the usefulness to banks of Euro-denominated bonds as collateral vis-a-vis the ECB, while USD-denominated bonds do not offer this advantage." In addition, "Drechsler et. al. (2013) document “a strong divergence among banks’ take-up of” Lender-of-Last-Resort assistance “during the financial crisis in the euro area, as banks which borrowed heavily also used increasingly risky collateral”. They test several hypothesis and argue that their “results strongly support the riskshifting explanation”…"

The above supports the Uhlig (2013) model that concludes that:
-- "…Regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, while regulators in other “safe” countries will impose tighter regulation."
-- "…Governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank."
-- "As a result, the monetary union has become a system engineered to deliver underpriced loans from country banks to their sovereigns, and to implicitly shift sovereign default risk onto the balance sheet of the ECB and the rest of the Eurosystem."

The last sentence is the key to it all: the euro system is now "engineered to deliver underpriced" credit "from country banks to their sovereigns", while shifting "sovereign default risk onto… the ECB and the rest of the Eurosystem".

30/8/2012: Does Banking & Financial (De)regulation iImpact Income Inequality?

A new paper, titled "Bank Regulations and Income Inequality: Empirical Evidence", by Manthos D. Delis, Iftekhar Hasan and Pantelis Kazakis (Bank of Finland Research Discussion Paper 18/2012, linked here) studied the effects of financial regulations (deregulation) on income inequality in 91 countries over the period of 1973-2005.

The study yields some very interesting results (emphasis is mine):

• "In general, the liberalization policies from the 1970s through the early 2000s have contributed significantly to containing income inequality."
• "... Abolishing credit controls decreases income inequality substantially, and this effect is long- lasting."
• "Interest-rate controls and tighter banking supervision decrease income inequality; however, these effects fade away in the long term."
• "For banking supervision, the negative effect on inequality [higher supervision leads to lower inequality] is reversed in the long run, a pattern associated with stricter capital requirements that tend to lower the availability of credit". 
• "... Abolishing entry barriers and enhancing privatization laws seem to lower income inequality only in developed countries."
• "... The liberalization of securities markets {expanding securitization] increases income inequality." 

What are the policy implications of these findings?

• "Bank regulations and associated reforms aim at enhancing the creditworthiness of banks and at improving the stability of the financial sector. Several studies over the last decade show that regulations do matter in shaping bank risk (e.g., Laeven and Levine, 2009; Agoraki et al., 2009) or in affecting bank efficiency (Barth et al., 2010) and the probability of banking crises (e.g., Barth et al., 2008)."
• "Yet, what if bank regulations have other real effects on the economy besides those associated with banking stability? And, more important, what if these real effects counteract the intended stabilizing effects?"

Two issues should be considered in answering these questions:

1. "The literature on the relationship between bank regulations and financial stability is inconclusive. In fact, different types of regulation may have opposing effects on financial stability, according to the existing research."
2. "... even if we assume that bank regulations like more stringent market-discipline requirements lower banks' risk-taking appetite and enhance stability (Barth et al., 2008), the empirical findings here suggest that these effects are asymmetric and certain liberalization policies (i.e., liberalization of securities markets) or regulation policies (i.e., higher capital requirements) actually increase income inequality. That is, banks pass the increased costs of higher risks (coming from the liberalization of securities markets) and higher capital requirements on to the relatively lower-income population that lacks good credit and collateral. In other words a trade-off between banking stability and inequality may be present" [Note: this trade-off, I would argue, is most certainly a problem for Ireland today, with future borrowers operating in the environment of reduced family wealth due to property bust and financial assets depletion]. 

"Given the contemporary discussion surrounding (i) the rebirth of Glass-Steagall-type regulatory reforms as they relate to securities trading, and (ii) the discussions under Basel III to increase the risk-adjusted capital base of banks, there may be more to think about before taking those steps."

"On the good side, three clear suggestions emerge from this paper and are also consistent with the findings of Beck et al. (2010)": 

1. "... the liberalization of banking markets, primarily through abolition of credit controls, helps the poor get easier access to credit. This in turn allows them to escape the poverty trap and substantially raise their incomes." 
2. "... appropriate prudential regulation should provide less costly incentives to banks to increase regulatory discipline without hurting the relatively poor. Information technologies that would lower the cost of transparency and more effective onsite supervision that would enhance the trust in the banking system may help achieve this goal."
3. "... economies first need a certain level of economic and institutional development to see any positive effect of the abolishment of entry restrictions and privatizations on equality..."