CIFRAM: EAGER: Regulating Systemic Risk

University Of Wisconsin-Madison, Madison WI

Investigators

Abstract

This project will develop tools to support financial policymaking. Two types of policymaking will be considered: rules that are imposed on financial intermediaries prior to a financial crisis and an intervention that takes place during a crisis. A number of policies will be evaluated as part of this research project: liquidity requirements, limits on interconnectedness, bailout decisions, restrictions on combining risk-sharing and liquidity-sharing activities within the same banking organization, and FDIC insurance. The intellectual merit of this project comes from modeling interconnected banks as providers of loans and insurance to firms and depositors in the same framework. In the existing literature, financial intermediaries either provide loans or insurance. Overall, the research will advance the understanding of the synergies between different business functions of banks. The research is expected to help regulators with understanding the costs and benefits of different regulatory proposals to limit systemic risk. The project will address a number of policy questions in the Dodd-Frank Financial Reform Act. In particular it will study the costs and benefits of restrictions on large interconnected institutions (Sections 123 and 622) and the effect of liquidity requirements on systemic risk (Sections 115 and 165). The PIs will develop a theoretical framework to provide a microfoundation for banking networks in the presence of private information on the part of borrowers and limited liability. This framework will characterize the conditions under which risk-sharing and liquidity-sharing services should be provided by the same bank. The framework will use a mechanism design approach to solve for optimal allocations that satisfy resource feasibility constraints, incentive compatibility constraints, and participation constraints of three types of economic agents: risk-neutral bankers, risk-neutral firms, and risk-averse depositors. The surplus from liquidity sharing using interbank trade emerges because of differences in funding across banks. The surplus from risk sharing using interbank trade emerges because of imperfect correlation in returns on firms' projects. Bankers use costly state verification when they monitor firms. These costs can be reduced if the same institution provides both loans and insurance to firms. These complementarities between the risk sharing and the liquidity sharing functions of intermediaries are absent from the existing literature in which financial intermediaries either provide loans or insurance, but not both. The comparison between the social planner's solution and the decentralized solution will identify the effect of different organizational designs on the efficiency of the allocation and a role for optimal government policy. Government policies correspond in our framework to constraints on bankers' feasible actions. Liquidity requirements are modeled as a minimum allocation of bankers' funds to a risk-free technology; limits on interconnectedness are modeled as constraints on interbank transfers; and a restriction on commercial banks derivatives trading is modeled as banks' inability to use state-contingent contracts. The costs and benefits of these constraints will be assessed by comparing the decentralized solution under constraints to the planner's solution. The PIs will use the theoretical framework to quantify effects of financial regulation on systemic risk and to derive the optimal financial regulation. The project web site (http://www.regsystemicrisk.net) provides access to further information and research results. The EAGER is funded through a Memorandum of Understanding between the Department of the Treasury, Office of Financial Research and NSF.