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The Risks of Bank Wholesale Funding

The Risks of Bank Wholesale Funding. Rocco Huang Philadelphia Fed Lev Ratnovski Bank of England. FDIC/Cleveland Fed Conference, April 17, 2008. Asset. Liability. Bank Funding. capital. Deposit. Retail deposits Passive, insured Limited Supply Funded only by deposits?

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The Risks of Bank Wholesale Funding

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  1. The Risks of Bank Wholesale Funding Rocco HuangPhiladelphia Fed Lev RatnovskiBank of England FDIC/Cleveland Fed Conference, April 17, 2008

  2. Asset Liability Bank Funding capital Deposit • Retail deposits • Passive, insured • Limited Supply • Funded only by deposits? • Excess capital / Unused investment opportunities • Short-term wholesale funds • Need to be rolled over in the short-term; effectively more senior • Source: other financial institutions, non-financial corporations, state and local authorities, foreign entities, etc • Instruments: Fed Funds, Repo’s, Large Certificate of Deposits, Commercial Papers, etc. Wholesale

  3. Asset Liability Short-Term Wholesale Funds capital Deposit • Bright side • Fully exploit investment opportunities • Market discipline (Calomiris, 1999) • Reduced liquidity risks (Goodfriend & King, 1998) • Dark side • Aggressive lending + compromised credit quality • Limited market discipline • Sudden stops + inefficient liquidations • How to reconcile? • When is wholesale funding beneficial? • Can banks opportunistically choose risky wholesale funds? Wholesale

  4. Wholesale funds in the past bank failures • What did short-term wholesale funds learn? • Run! • And you (almost always) get your money back in whole and when you want them • Example 1: Continental Illinois Bank • Noticing its energy sector exposure, wholesale depositors kept withdrawing • The Fed kept lending • Wholesale depositors who withdrew escaped unscathed • So they kept running (why not?) • Retail depositors held the bag

  5. Wholesale funds in the past bank failures • Example 2: Northern Rock • Frightened by U.S. crisis, short-term wholesale funds stopped rolling over financing • After sustaining it for a while, NR finally asked for emergency funding from BoE • …which allowed further exit by wholesale funds • THEN retail deposit run finally started • Short-term wholesale investors didn’t lose a cent • They ran faster than ordinary folks! • Message for wholesale funds • Sometimes they wrongfully liquidate the good guys (Northern Rock), but sometimes they hit the bad guys (Continental) • In any case, it was historically costless to run on a bank with insured depositors!!!

  6. How did short-term wholesale funds escape unscathed? • First-come-first-served gives short-term funds effective seniority • until the bank is taken over by the court / government / FDIC / FHLB • Central bank (and FHLB) by providing liquidity to a failing bank also helps finance their exit • and can potentially increase the FDIC loss • Retail depositors and taxpayers hold the bag • Wholesale funds run based on a noisy signal • Why not?

  7. When is wholesale funding a good thing? • Good when they invest in information • Bad when uninformed • Why do they remain uninformed sometimes? • Monitoring costs not fully compensated when passive depositors freeride • Free, noisy signal reduces incentive for monitoring • Effective seniority allows them to shift the burden of liquidation to passive depositors • Making it more attractive to liquidate based on a noisy, negative signal.

  8. The Model Setup • A bank with a long-term investment project • Date 0: Attract funding, and invest • Date 2: Return (per unit of investment) “Good”: X>>1 w.p. P “Bad”: L<1 w.p. (1-p) • Date 1: L<1 (in liquidation) • Wholesale depositors can • incur a cost and get a precise signal on project quality • Screen out bad banks • or rely on a noisy signal that is precise enough (threshold is endogenous) • Example of signals: • market-wide or sector-wide news; e.g. house price seems to contain a lot of information on banks holding a lot of mortgage-backed securities • Energy price on Penn Central, Continental, etc

  9. Bank Depositors only Attractwholesale funds Date 0 Providers of wholesale funds Screen, lend to good banks only Do not screen, lend to all banks Date 1 Upon a noisy negative signal, stay Upon a negative signal, liquidate

  10. What are they thinking? • Wholesale funds: • Get Informed? Depositors free-ride the benefits • Remain Uninformed? Costs of liquidation burdened by the depositors • Incentives distorted by: • Effective seniority over passive depositors • Availability of a free, noisy signal • Banks: • Deposits only? excess capital • Attract wholesale? Can have higher liquidity risk • Incentives distorted by limited liability • Society: • Lending to “bad” projects never optimal [market discipline] • Early liquidation never optimal[liquidity risk]

  11. DSW*** D*** 0 D* D** 1 D Uninformed,but stay upon a negative signal Uninformed,and liquidate upon a negative signal Wholesale financiers Informed Bank Doesnotuse Uses wholesale funds The bank uses wholesale funds, although it is not socially optimal Results from the model

  12. Distorted incentives • Wholesale financiers • Low incentives to screen = Insufficient market disciplineDo not internalize benefits for depositors • High incentives to liquidate = Liquidity risk Withdraw before the depositors, enjoying effective seniority, and thus larger share of a smaller pie • Banks • Over-reliance on risky wholesale fundsLimited Liability; Do not internalize risks of depositors

  13. Is wholesale funding bad? • Less risky if: • Predominantly wholesale • Wholesale not necessarily a problem per se • They seem to be more “reasonable” in financial institutions without much retail deposits • They sat down and bailed LTCM out • They maintained credit lines to Countrywide • Exception: Bear Stearns – people just hated BS for its LTCM role? ? • Predominantly deposits • But: no monitoring; and excess capital • More risky if: • Combination of deposits and wholesale • Use of wholesale funds in depository banks • Insufficient market discipline • Heightened liquidity risks

  14. Model v.2.0. • New model • Endogenous (optimal) arrangement of seniority [0,1] • Endogenous choice of monitoring intensity [0,1] • Optimal seniority arrangement: • Unlike in Calomiris and Kahn (1991), seniority is not always good • Wholesale funds should be made more junior if: • Share of passive retail depositors is higher • The precision of the noisy signal is higher • e.g. For banks holding mainly mortgage-backed securities vs. loans • Liquidation cost is smaller • Inverse U-shaped relationship between monitoring and seniority • Monitoring efforts maximized in the middle • Lower seniority -> incentives not aligned • Higher seniority -> liquidate too often

  15. Thank you!!

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