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Why Are Banks Not Recapitalized During Crises?

Matteo CrosignaniNYU Stern

24 October 2014

Bocconi CarefinStructural Changes in the Banking Sector

Outline

1 INTRODUCTION

2 MODEL

3 EMPIRICAL EVIDENCE

INTRODUCTION MODEL EMPIRICAL EVIDENCE

FACT 1: RELIANCE ON DOMESTIC BANKSLevels Non-GIIPS

INTRODUCTION MODEL EMPIRICAL EVIDENCE

FACT 2: PRIVATE AND PUBLIC LENDINGNon-GIIPS

INTRODUCTION MODEL EMPIRICAL EVIDENCE

FACT 3: RELUCTANCE TO RECAPITALIZE EU BANKS

◮ EBA (Oct11): banks need $146 bn to meet new capitalrequirements

◮ Acharya, Engle, Pierret (2014): EBA underestimates capitalshortfall → reliance on risk-weight

◮ Asset Quality Review

◮ Basel III: delays in implementing CRD IV (Dec12 → Jan14)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

THIS PAPER

◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds

◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues

→ LL binds in bad state

EAD

INTRODUCTION MODEL EMPIRICAL EVIDENCE

THIS PAPER

◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds

◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues

→ LL binds in bad state

◮ Fact 2. Govt bonds become more attractive relative tolending to private sector → crowding-out

EAD

INTRODUCTION MODEL EMPIRICAL EVIDENCE

THIS PAPER

◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds

◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues

→ LL binds in bad state

◮ Fact 2. Govt bonds become more attractive relative tolending to private sector → crowding-out

◮ Fact 3. Govt faces a trade-off when setting capitalrequirements

◮ ↓ private lending → ↓ tax collection◮ ↑ demand for dom bonds → ↑ debt capacity, ↓ govt yields

EAD

INTRODUCTION MODEL EMPIRICAL EVIDENCE

LITERATURE REVIEW

Theory: Acharya, Rajan (2013); Gennaioli, Martin, Rossi (2014);Acharya, Drechsler, Schnabl (2014); Bolton, Jeanne (2011);Broner, Erce, Martin, Ventura (2013); Broner, Martin, Ventura(2010).

Empirical: Acharya, Steffen (2013); Becker and Ivashina (2014);Arslanalp, Tsuda (2012); Brutti, Saure (2013); Acharya, Engle,Pierret (2013); Drechsel, Drechsler, Marques-Ibanez, Schnabl(2013).

INTRODUCTION MODEL EMPIRICAL EVIDENCE

WELL CAPITALIZED BANKS

Italy Spain

IT Firms Unicredit Santander ES Firms

INTRODUCTION MODEL EMPIRICAL EVIDENCE

F1: HOME BIAS AND CROWDING-OUT

Italy Spain

IT Firms Unicredit Santander ES Firms

INTRODUCTION MODEL EMPIRICAL EVIDENCE

F2: BANKS NOT RECAPITALIZED DURING CRISES

Italy Spain

IT Firms Unicredit Santander ES Firms

INTRODUCTION MODEL EMPIRICAL EVIDENCE

F3: RACE TO THE BOTTOM

Italy Spain

IT Firms Unicredit Santander ES Firms

Outline

1 INTRODUCTION

2 MODEL

3 EMPIRICAL EVIDENCE

INTRODUCTION MODEL EMPIRICAL EVIDENCE

ENVIRONMENT

◮ Two-periods

◮ No discounting

◮ Risk neutrality

◮ Two countries with a banking sector and a government

◮ Countries only differ in domestic banks’ initial capital

◮ Shock hits w.p. 1 − θ ∈ (0, 1) at t = 1.5

INTRODUCTION MODEL EMPIRICAL EVIDENCE

INVESTMENT OPPORTUNITY SET

Italy Spain

IT Firms BankI(1−

α)(1−

k)

α(1

−k)

k

◮ Invest k in lending

◮ → α home bias in govt bond market

INTRODUCTION MODEL EMPIRICAL EVIDENCE

PRIVATE LENDING

◮ Invest k at t = 0. Revenues f (k) at t = 1 and t = 2◮ Shock destroys t = 2 revenues◮ Govt levies tax τ in both periods

t=0 t=1 t=2

θ

1 − θ

−k (1 − τ)f (k)

0

(1 − τ)f (k)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

DOMESTIC GOVERNMENT BONDS

◮ Banks invest qD = α(1 − k) in domestic govt bonds◮ Govt repays debt with proceeds from tax collection

→ default in bad state

t=0 t=1 t=2

θ

1 − θ

−qD

0

qD(1 + r)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

FOREIGN GOVERNMENT BONDS

◮ qF = (1 − α)(1 − k) invested in foreign govt bonds

◮ Foreign govt defaults w.p. 1 − θ

t=0 t=1 t=2

θ

1 − θ

−qF

θqF(1 + r∗)

θqF(1 + r∗)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT DEBT CAPACITY

◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT DEBT CAPACITY

◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0

◮ Govt defaults if not able and/or not willing to pay◮ Not able if τf (k) < D(1+ r) (AP)◮ Not willing if C(α, k) < D (WP)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT DEBT CAPACITY

◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0

◮ Govt defaults if not able and/or not willing to pay◮ Not able if τf (k) < D(1+ r) (AP)◮ Not willing if C(α, k) < D (WP)

⇒ investors are willing to buy govt bonds if

D ≤ min

{

C(α, k),τθf (k)

1 + r

}

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT SPENDING

τf (k∗) + τβθf (k∗)︸ ︷︷ ︸

tax collection

+D − βθ(1 + r)D︸ ︷︷ ︸

govt debt

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT SPENDING

τf (k∗) + τβθf (k∗)︸ ︷︷ ︸

tax collection

+D − βθ(1 + r)D︸ ︷︷ ︸

govt debt

where

D = min

{

C(α, k),τθf (k)

1 + r

}

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

2(1 − τ)f (k)

(1 − τ)f (k)

Good state: lending (t = 1, 2)Bad state: lending (t = 1)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

2(1 − τ)f (k) +qD(1 + r)

(1 − τ)f (k)

Good state: lending (t = 1, 2) + dom. bondsBad state: lending (t = 1)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗)

(1 − τ)f (k) +qFθ(1 + r∗)

Good state: lending (t = 1, 2) + dom. bonds + for. bondsBad state: lending (t = 1) + for. bonds

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

[ 2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L ]+

[ (1 − τ)f (k) +qFθ(1 + r∗) −L ]+

Good state: lending (t = 1, 2) + dom. bonds + for. bonds - debtBad state: lending (t = 1) + for. bonds - debt

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L

(1 − τ)f (k) +qFθ(1 + r∗) −L

Suppose L is “low enough” (W)

◮ LL does not bind

◮ Invest in domestic bonds iff θ(1 + r) ≥ θ(1 + r∗)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ PROBLEM

t=1

θ

1 − θ

2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L

0

Suppose L is “high enough” (U)

◮ LL binds in the bad state of the world

◮ Invest in domestic bonds iff (1 + r) ≥ θ(1 + r∗)

EAD

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BENCHMARK CASE: WELL CAPITALIZED BANKS

◮ Assume both banks are “well capitalized”

→ identical: k∗, D∗, r∗

α(z)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BENCHMARK CASE: WELL CAPITALIZED BANKS

◮ Assume both banks are “well capitalized”

→ identical: k∗, D∗, r∗

Italy Spain

BankI BankS

α(z)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

HOME BIAS AND CROWDING-OUT

◮ Assume Italian banks are W and Spanish banks are U

INTRODUCTION MODEL EMPIRICAL EVIDENCE

HOME BIAS AND CROWDING-OUT

◮ Assume Italian banks are W and Spanish banks are U

◮ Assume f (k) = ǫ√

k and C(α, k) = z − (1 − α)(1 − k)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

HOME BIAS AND CROWDING-OUT

◮ Assume Italian banks are W and Spanish banks are U

◮ Assume f (k) = ǫ√

k and C(α, k) = z − (1 − α)(1 − k)◮ Crowding out in Spain: kS < kI◮ → Home Bias in Spain → rS < rI◮ → Home bias in Italy: αI = αS = 1◮ Higher debt capacity DS > DI

Italy Spain

BankI BankS

α(z)

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ CAPITALIZATION AND MULTIPLE EQM

In eqm, in the bad state of the world, banks’ revenues are

[ǫ(1 − τ)√

k − L]+

LI LI0

W

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ CAPITALIZATION AND MULTIPLE EQM

In eqm, in the bad state of the world, banks’ revenues are

[ǫ(1 − τ)√

k − L]+

LILI LI0

W U

INTRODUCTION MODEL EMPIRICAL EVIDENCE

BANKS’ CAPITALIZATION AND MULTIPLE EQM

In eqm, in the bad state of the world, banks’ revenues are

[ǫ(1 − τ)√

k − L]+

LS

LS

LS

LILI LI0

Multiple Equilibria

WW

WU

UW

UU

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GOVERNMENT CAPITALIZATION CHOICE

Government re-capitalizes domestic banks iff

τǫ(1 + θ)(√

kW −√

kU)︸ ︷︷ ︸

increased taxcollection

≥ (DU − DW)︸ ︷︷ ︸

lower debtissuance

+ θ((1+ rW)DW − (1+ rU)DU)︸ ︷︷ ︸

higher payments tobondholders

INTRODUCTION MODEL EMPIRICAL EVIDENCE

WELFARE

Recapitalization is always efficient

((1− kW)(1+ rW)− (1 − kU)(1+ rU))︸ ︷︷ ︸

higher profits fromholding govt bonds

+ ǫ(1 − τ)((1+ θ)√

kW − 2θ√

kU)︸ ︷︷ ︸

no crowding-out

≥ 0

INTRODUCTION MODEL EMPIRICAL EVIDENCE

WELFARE

Recapitalization is always efficient

((1− kW)(1+ rW)− (1 − kU)(1+ rU))︸ ︷︷ ︸

higher profits fromholding govt bonds

+ ǫ(1 − τ)((1+ θ)√

kW − 2θ√

kU)︸ ︷︷ ︸

no crowding-out

≥ 0

...but high levered banks want to recapitalize iff

((1− kW)(1+ rW)− (1 − kU)(1 + rU))︸ ︷︷ ︸

higher profits fromholding govt bonds

+ ǫ(1− τ)((1+ θ)√

kW − 2θ√

kU)︸ ︷︷ ︸

no crowding-out

≥ L(1 − θ)

Outline

1 INTRODUCTION

2 MODEL

3 EMPIRICAL EVIDENCE

INTRODUCTION MODEL EMPIRICAL EVIDENCE

SUPPORTING EMPIRICAL EVIDENCE

Model prediction: highly levered and “local” banks drive thepurchases of domestic bonds in crisis

INTRODUCTION MODEL EMPIRICAL EVIDENCE

SUPPORTING EMPIRICAL EVIDENCE

Model prediction: highly levered and “local” banks drive thepurchases of domestic bonds in crisis

Data: EBA stress tests and Bankscope

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GIIPS HIGH VS. LOW LEVERAGE BANKS

INTRODUCTION MODEL EMPIRICAL EVIDENCE

GIIPS LOCAL VS. INTERNATIONAL BANKS

Core Banks

INTRODUCTION MODEL EMPIRICAL EVIDENCE

ALTERNATIVE CHANNELS

◮ Moral suasion◮ Consistent as long as what we observe is an equilibrium

outcome

◮ Regulatory arbitrage◮ Inconsistent with lower holdings of GIIPS non-domestic

bonds

◮ Information advantage◮ Capitalization should not matter

INTRODUCTION MODEL EMPIRICAL EVIDENCE

CONCLUSION

◮ Shown that during crises◮ govts rely on domestic bond buyers◮ banks increase holdings of domestic govt bonds◮ policy makers are reluctant to recapitalize domestic banks

◮ Developed a tractable GE model that rationalizes thesefacts and yields additional empirical implications

◮ Shown that stress test data support the proposed channel

Outline

4 Appendix

Appendix

FACT 1: INCREASING HOME BIAS (LEVELS)Back

Appendix

FACT 1: HOME BIAS (NON-GIIPS)Back

Appendix

FACT 1: HOME BIAS (NON-GIIPS)Back

Appendix

FACT 2: PRIVATE AND PUBLIC LENDING

(NON-GIIPS) Back

Appendix

FACT 2: PRIVATE AND PUBLIC LENDING

(NON-GIIPS) Back

Appendix

GIIPS LOCAL & HIGH LEV. VS. INTERN. & LOW LEV.Back

Appendix

CORE HIGH VS. LOW LEVERAGE BANKSBack

Appendix

EXPOSURES AT DEFAULT Introduction

Banks’ Problem

Bank Country GIIPS Bank Name Exposure to EAD (em) EAD/E

GR EFG Eurobank Ergasias GR 53,005 47.0GR Alpha Bank GR 46,171 18.1IT Banca Monte Paschi Siena IT 205,347 15.6ES Banco Popular Espanol ES 120,981 11.2IT Banco Popolare IT 122,583 10.0ES Caixa ES 259,731 8.7IE Irish Life and Permanent IE 36,487 8.0ES BBVA ES 378,707 7.3IT Intesa Sanpaolo IT 418,126 6.8IT Unicredit IT 382,176 5.4IE Bank of Ireland IE 68,883 5.2GR EFG Eurobank Ergasias PL 5,707 5.1IE Bank of Ireland GB 64,743 4.9IE Allied Irish Banks IE 85,923 4.6GR EFG Eurobank Ergasias RO 4,552 4.0ES Banco Santander ES 355,523 3.3GR EFG Eurobank Ergasias BG 3,607 3.2ES Banco Santander GB 292,735 2.7GR EFG Eurobank Ergasias DE 2,801 2.5IT Unicredit DE 151,948 2.1GR Alpha Bank CY 4,848 1.9IE Irish Life and Permanent GB 8,466 1.9IE Allied Irish Banks GB 32,117 1.7GR Alpha Bank RO 4,261 1.7GR Alpha Bank GB 3,059 1.2IT Unicredit AT 74,355 1.0

Appendix

HHB AND LHB REGIONSBack

α

z z

1

0

LHB

HHB

α