discussion of 'bank interconnectivity and leverage' by ... · discussion of "bank...
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Summary Comments Conclusions
Discussion of ”Bank Interconnectivity andLeverage” by Alessandro Barattieri, Laura
Moretti and Vincenco Quadrini.
Martin Summer
Oesterreichische Nationalbank
Third BIS Research Network meeting: Global FinancialInterconnectedness , Basel October 1st and 2nd 2015
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Summary Comments Conclusions
Summary
• The paper starts from the observation that the ratio of assetsover equity in the US banking sector - a measure of leverage -shows a strong co-movement with the ratio of non-coreliabilities over total assets - a measure of interconnectedness -in the data.
• Suggests an explanation for this co-movement based onoptimal portfolio choice.
• Presents an empirical analysis of hypothesis resulting from theportfolio choice model for various levels of aggregation ofbanks.
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Summary Comments Conclusions
The key mechanism in the model.
• An infinitely lived owner-managed bank faces aportfolio-choice problem under risk with three alternativeinvestments: Issuing liabilities to the non-financial sector,making loans to the non-financial sector and buy and sellshares of the loans to the non-financial sector from and toother banks. Diversification is costly.
• Diversification of idiosyncratic risks from lending induce banksto issue more liabilities to the non-financial sector and investmore in the non-financial sector.
• Diversification costs and the return spread between loans andliabilities vis a vis the non-financial sector are then the maindrivers of leverage and interconnectivity.
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Summary Comments Conclusions
What have we observed in terms of interconnectedness?
A short intermediation chain. See Shin 2010.
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Summary Comments Conclusions
What have we observed in terms of interconnectedness?
A long intermediation chain. See Shin 2010.
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Summary Comments Conclusions
Does the measure used in the paper captureinterconnectedness?
The ratio of non-core deposits to total assets is only a very indirectmeasure of interconnectedness. The measure would for instancenot distinguish whether non-core deposits are held in either of thefollowing three situations:
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Summary Comments Conclusions
Does the measure used in the paper captureinterconnectedness?
• If for a given structure of interconnectedness banks wouldsubstitute non-core deposits for core deposits or equity, themeasure would indicate that interconnectedness hasdecreased, while it is the same in both situations.
• Core deposits over total assets is a ratio so weakly related towhat we normally think of as interconnectedness, that it isalmost a misleading term.
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Summary Comments Conclusions
Is the mechanism plausible?
• The paper tells the story of co-movements of bank leverageand interconnectedness as a story of diversification of a loanportfolio within the banking sector.
• What we have observed before and after the crisis is howeversomething that looks quite different.
• Banks have issued more and more liabilities against more andmore asset classes of increasingly deteriorating quality andheld these liabilities within the financial sector.
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Summary Comments Conclusions
An alternative mechanism. Geanakoplos 2009
• The tranching and repackaging of financial claims allows toprofit from the heterogeneity of different investors in theirmarginal valuation of income across time and states.
• This engineering of new collateral pushes the collateral valueof different asset classes and creates space in the balancesheet of different investors for yet even more debt and moreleverage.
• This process is self stabilizing in the system as a whole for anextended period, because in this process collateral becomesconcentrated in the hands of like minded investors, decreasingvolatility and reassuring lenders that lending is safe.
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Summary Comments Conclusions
Another way of looking at the problem: Shin 2010
From Shin 2010, Risk and Liquidity we learn that the aggregatebalance sheet of the financial sector can be viewed as the followingidentity:
Total lending to ultimate borrowers = total debt liabilities tonon-banks + total equity of intermediaries
Manipulating the basic accounting identities appropriately, Shinshows that total debt liabilities to non-banks can equivalently bewritten as the sum accross intermediaries of
product of equity of intermediary x proportion of outside funding x(leverage - 1)
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Summary Comments Conclusions
The balance sheet mechanics of a boom
When leverage increases, for total liabilities to non-banks beingconstant
• There must be a decline in outside funding.
• Banks must therefore lend more to each other
• The closely interconnected balance sheets of intermediaries isa necessary byproduct of a boom because lending andborrowing from each other is the only way intermediaries canincrease their balance sheets and grow.
This is an implication of overall accounting.
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Summary Comments Conclusions
The empirical results
The empirical results basically find a strong and positivecorrelation between the leverage and the interconnection measureat all levels of aggregation. It confirms also the theoreticalhypothesis about the dependence of the interconnectednessmeasure on the return differential
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Summary Comments Conclusions
A basic question on the empirical part
The strong positive correlation between the interconnectednessmeasure and the leverage measure seems to be built inmechanically by the definition of the measures.
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Summary Comments Conclusions
A functional dependence
Denote total assets TA, equity E, core deposits D, total liabilities L
Leverage =TA
EQ(1)
Interconnectedness =TA− EQ − D
TA(2)
= 1− EQ
TA− D
TA(3)
So by construction leverage is an increasing function ofinterconnectedness.
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Summary Comments Conclusions
Other comments
• The role of diversification costs are unclear. It seems they arejust needed to get a solution out of the first order conditions.
• It is unclear what ft actually is.
• It is unclear how lt and ft are pinned down. As theoptimization problem is written there seems to be no limit toincreasing lt and ft .
• Conceptually it seems quite inadequate to think of therelation between leverage and interconnectedness from theperspective of a single person decision problem against anexogenous environment which will absorb any sales and supplyany purchases at the given prices. This seems to me anobviously inadequate perspective.
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Summary Comments Conclusions
Conclusions
• The issue discussed in this paper is interesting and important.There is a literature which has analyzed how leverage andinterconnectedness is related offering competing explanationsand mechanisms with which this analysis should be comparedand confronted.
• In the current form the paper has in my view someshortcomings with respect to
• The measure of interconnectedness.• The theoretical model underlying the empirical analysis.• Empirics: Conceptual problems in the measures lead to
conceptual problems in the empirical analysis.