Do Banks Take Excessive Risks?

Do Banks Take Excessive Risks? 

Do Banks Take Excessive Risks?

• 1. Banks are essential but risky  Banks provide essential services  Accepting deposits  Making loans  Facilitating payments  But banking is a risky business  Risk from changes in interest rates, exchange rates, or other market prices  Risk that loans will not be repaid  Risk that liquidity will dry up in a crisis Dime Savings Bank of Brooklyn, NY Economic Ideas. 
• 2. How much risk should banks accept?  Banks should not try to avoid risk  They face a trade-off: By accepting more risk, they can earn a higher return  But how much risk should they accept?
• 4. Do banks take excessive risks?  Bank regulators fear that banks, left to their own devices, will take risks that are excessive from the point of view of the economy as a whole  Let’s look at some reasons why banks might take excessive risks:  Contagion effects  Moral hazard  Agency problems.
• 5. Contagion effects Contagion effects arise when the failure of a bank causes harm to other parties  Failure of one bank can cause bank runs as depositors take their money from other banks  Fear of more failures causes banks to stop doing business with one another, causing failures to spread  When banks fail consumers and nonfinancial businesses can’t get the credit they need to operate normally.
• 6. Moral Hazard Moral hazard arises when someone who is protected from loss fails to take measures to avoid excessive risk  The term originated in the insurance business, where people who are insured against loss fail to take measures to minimize risk  For example, people who have flood insurance may build in areas that are known to be at risk of flooding
• 7. Moral Hazard and Deposit Insurance The purpose of deposit insurance  During a bank run every depositor tries to be first in line to withdraw funds  Deposit insurance protects against bank runs by promising to pay depositors even if not first in line. Deposit insurance and moral hazard  Without deposit insurance, depositors would be careful to put their money only in banks that were operated safely  With deposit insurance, this source of discipline disappears—even the riskiest banks can attract deposits Deposit insurance can help prevent bank runs like this one at Northern Rock bank in England
• 8. How to avoid the moral hazard of deposit insurance  Grant insurance only to small depositors—use big depositors to provide market discipline  Rely on bondholders and other uninsured creditors of banks to restrain risk taking  Apply risk based premiums – banks with weak balance sheets must pay more to join the deposit insurance system.  Make sure the deposit system is adequately funded
• 9. Moral Hazard: Too Big to Fail  If a bank is so large that its services are essential to the rest of the economy, the government may be forced to rescue it when it is threatened with failure  If banks know they will be rescued, they may take excessive risks— another example of moral hazard  The implicit guarantee gives the largest banks a competitive advantage over smaller banks  Result: They grow even bigger
• 10. Ideas for limiting the TBTF problem  Establish ―living wills‖ to guide the liquidation of even the largest banks  Make sure managers and shareholders bear their fair share of losses when the bank fails  Expose bondholders and other unsecured creditors to ―haircuts‖ in case of failure, that is, make sure they also bear a share of losses http://commons.wikimedia.org/wiki/File:Fat_Gator.jpg
• 11. Agency Problems: Fiduciary Duties of Managers  As agents of shareholders, financial managers have a fiduciary duty to act in their shareholders’ best interests  They should take prudent risks when there is a good chance of a high return for shareholders. . .  . . . but they should not put their personal gain ahead of shareholder interests, or gamble with shareholders’ money Alice and Jim Walton at 2011 Walmart shareholders meeting
• 12. Gambling with your own money When gambling with their own money, many people think the best games are ones like lotteries that  lose most of the time, but not more than they can afford  don’t win often, but have a huge payoff when they do win  These are called positively skewed risks http://blogs.guardian.co.uk/money/lottery.jpg
• 13. Gambling with other people’s money When gambling with other people’s money, the best games . . .  win some positive amount most of the time  rarely lose, but may have very big losses when they do  Once a big loss comes, the game is over, but the gambler keeps past winnings and someone else bears the cost  These are called negatively skewed risks http://www.stockmarketinvestinginfo.com/images/floorpic.jpg Economic Ideas 111314 from Ed Dolan’s Econ Blog
• 14. Misaligned Incentives  Executive compensation plans are often poorly aligned with fiduciary duties toward shareholders  Bonuses for short-term performance  Lack of ―clawback‖ provisions to recapture past bonuses in case of delayed losses  ―Golden parachutes‖ that give large severance payments to executives even when their bad decisions cause large losses  Such bonus-based compensation plans cause managers to seek strategies with negatively skewed risks “Golden parachutes” may tempt executives to take risks that are not in the interests of shareholders
• 15. Hypothetical Example of misaligned incentives Assume a bonus plan that pays 0.1% of net profit each quarter, with zero bonus in case of loss and no clawback Strategy A  5 quarters of $100 million profit  5 quarters of $10 million loss  10-quarter net for shareholders: profit of $449.5 million  10-quarter result for executive: total bonuses of $500,000 Strategy B  9 quarters of $200 million profit  1 quarter of $2,000 million loss  10-quarter net for shareholders: loss of $201.8 million  10-quarter result for executive: total bonuses of $1.8 million Negatively skewed strategy B has higher payoff for the executive but lower payoff for shareholders
• 16. Not just top managers It is not only top managers who have opportunities to gamble with other people’s money  Individual traders within banks  Creditors of bankrupt firms, when they expect bailouts to shift their losses to taxpayers  Bank depositors, when deposit insurance shifts losses to taxpayers UBS blamed trader Kweku Adoboli for $2.3 billion in losses . His defense was that supervisors encouraged him to ignore trading limits as long as he was winning.
• 17. Why did Shareholders Let it Happen? Why do shareholders condone compensation policies that are not aligned with their interests? Some hypotheses:  There is no misalignment—shareholders are also biased toward excessive risks  Technical error: Risk models do not reveal the negative skew of strategic risks  Bidding for management talent is subject to a ―winner’s curse‖ that leads to overly generous compensation plans  Moral hazard (expectation of bailout)  Corporate governance—shareholders don’t like compensation plans, but can’t do anything about them
• 18. ―Shocked Disbelief‖ . “Those of us who have looked to the selfinterest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief” Alan Greenspan Former Federal Reserve Chairman Testimony before the House Committee on Oversight and Governmental Reform October 23, 2008