Political Favoritism and Industrial Structure in the Banking Sector
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1 Political Favoritism and Industrial Structure in the Banking Sector Thomas Gehrig Finance and Accounting Research Seminar, HU Berlin 18th January 2018
2 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
3 Politics and Banking Doom Loop Systemic risk too-big-to-fail too-interconnected-to-fail too-important-to-fail... Funding source preferential treatment of interest preferential risk weights on sovereign bonds low interest-rate policy...
4 Political Favoritism Asymmetric political interventions national champions large banks systemically important banks... Symmetric policies but potentially asymmetric consequences preferential tax treatment preferential risk weights monetary policy...
5 Research Questions How does political favoritism affect prices: margin squeezes? volume: economic activity and/or employment? industrial structure: is Europe overbanked? horribile dictu: systemic risk?
6 Modelling Requirements Model with asymmetric industrial structure like: Shaked, Sutton (RES, 1982), Gehrig (IJIO, 1996), Dick (JMCB, 2007),... not like: Salop (Bell, 1979), Hauswald, Marquez (RFS 2006), Martinez-Miera, Repullo (RFS, 2017) Vertical product differentiation quality of service probability to repay probability to honor contracts...
7 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
8 Resiliency Measures across European Banks Capital shortfall (million EUR) jan jan jan jan jan jan jan jan jan jan jan jan jan jan jan2016 Average SRISK by SRISK% quantiles low high Gehrig, Iannino, 2017
9 Size Distribution US Janicki, Prescott, 2006
10 Concentration of Deposits US Dick (JMCB, 2007)
11 Exit Entry Dynamics US Janicki, Prescott, 2006
12 Political Challenge How to justify interventions at the top? Top firms are most competitive offer best quality earn highest rents (often) enjoy largest market shares are most profitable
13 Systemic Banks on both Sides of the Atlantic Liikanen Report (2012)
14 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
15 Banking Duopoly with Heterogeneous Banks based on Shaked, Sutton, REStud 1982 Banks: offer different qualities q H > q L (e.g. repayment probabilities) from a range of q [0, q], where q < 1 compete in prices p H, p L funding costs c H, c L Investors: risk neutral heterogeneous wealth, uniformly distributed on y U[y min, ȳ] utility function: u(y, q, p) = q(y p)
16 Interpreting Quality Preferences The quality variable q can be interpreted in various ways promised repayments (investment plus yield) probability of promised repayments being paid out service quality others Generally the quality variable can even be interpreted as a product of several components q = q 1 q 2...q n under the assumption that corr(q i, q j ) > 0 for all i,j.
17 Timeline of Strategic Decisions t=0: banks enter at fixed cost ɛ > 0 t=1: banks select quality q i (at fixed cost C i > 0) t=2: banks compete in prices p i
18 Interpretation as Policy Variables Cost factors: c L : funding cost for low quality (e.g. interest rates) c H : funding cost for high quality (e.g. IRB models ) Supervisory actions: q min > 0: minimum repayment standards (e.g. Basel rules ) q max > q: guarantee (e.g.tbtf)
19 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
20 Price Duopoly Critical Investor: ỹ = q Hp H q L p L q H q L Firm H: max(ȳ ỹ)(p H c H ) Firm L: max(ỹ c L )(p L c L ) Equilibrium prices: ( ) p H p L ( ) p H p L = 1 4q H q L ( 2 ql 1 2q H = 1 4q H q L ) ( ) (qh q L )ȳ + q H c H c L ( ) 2(qH q L )ȳ + 2q H c H + q L c L (q H q L )ȳ + q H c H + 2q H c L
21 Comparative Statics on Prices Minimum standards dq L > 0 increased intensity of competition and margin squeeze increased sensitivity with respect to funding costs Basel regulation intensifies competition (Subsidized) guarantees q H = 1 > q relaxation of competition for H intensified competition for L reduced sensitivity w.r. to funding costs Funding costs dc H = dc L > 0 larger (positive) effect on L relative to H overbanking and monetary poliy: low-interest rate policy has larger impact on margins of L-banks
22 Equilibrium Quantities Critical Investor:ỹ = 2q H q L 4q h q L ȳ + (2q H q L )q H c H q H q L c L (4q H q L )(q H q L ) If dc H = dc L = dc > 0: dỹ dc = q H 4q H q L > 0 dỹ c dc = q L 3q H 4q H q L < 0
23 Equilibrium Profits: H-bank: Π H = 1 (4q H q L ) 2 q H q H q L (2(q H q L )ȳ (2q H q L )c H + q L c L ) 2 dπ H dq H > 0 and dπ H dq L < 0 when c H = c L = 0. L-bank: Π L = 1 (4q H q L ) 2 q H q H q L ((q H q L )ȳ + q H c H (2q H q L )c L ) 2 dπ H dq H > 0 and dπ H dq L < 0 when c H = c L = 0.
24 Quality Competition - Duopoly Result Q-D: Unregulated equilibrium: There is a unique pure strategy equilibrium in qualities with qh = q and 0 < q L < q H = q. (as in Shaked, Sutton, 1982) Equilibrium with TBTF guarantee for largest bank: There is a unique pure strategy equilibrium with q reg H q reg L = ql. = q and
25 Quality Choice - General Result Q-G: Unregulated equilibrium with n > 2 firms needs to be asymmetric In any equilibrium with more than 2 banks selecting same quality, all banks will select identical qualities q 1 = q 2 =... = q n = q and earn zero revenues. In this equilibrium cost of entry cannot be recovered.
26 Industrial Structure: Natural Oligopoly Result NO 1: Let y min > ȳ 4 : in equilibrium at most two banks will acquire positive market shares and earn positive revenues. Result NO 2: The market share of the top bank is bounded below by a strictly positive boundary 1 2.
27 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
28 Too-Big-To-Fail Guarantee Definition: Costless quality enhancement q reg = 1 > q. Implications relaxes competition enhances equilibrium profits of H also enhances equilibrium profits of L invites entry overbanking as consequence of political favoritism?
29 TBTF - Extension to a Network Market Building on bank networks across (isolated) island markets (Gehrig IJIO, 1996) National bail-out guarantees to national top banks prevent integration towards a single market inhibit risk diversification generate excessive entry at the subsidized top generate excessive fiscal burden on tax-payers
30 Basel II - Internal Risk Based Models Definition: Subsidy on c H requires set-up cost C H > 0. Implications price pressure on p H, p L and margin squeeze on p L c L increase H-market share increase H-profits while reducing L-profits increase probability for L-exit increase industry concentration and systemic risk
31 Outline Motivation Empirical Observations Model Unregulated Competition Regulation Conclusions
32 Conclusions Minimum quality regulation (MQR) reduces scope of differentiation and, hence, depresses margins and profitability and induces exit of lower quality banks (i.e. small banks). Hence, MQR increases role of dominant banks. Subsidized guarantees relax competition and induce entry at the bottom. Overbanking results from political favoritism. Favorable risk weights intensify competitiveness and induce exit at lower end. Thus favorable risk weights increase role of dominant banks. Expansionary monetary policy depresses lending rates of lower quality (i.e. small) banks. In short: Political favoritism distorts industrial structure.
33 After Thought For policy makers and supervisors, it [i.e. the priorities on the to-do-list ] means that the political support for the banking sector must finally end - unfortunately, I see only limited signs of this so far. Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank 2016
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