Dimitrios P. Tsomocos

Procyclicality and the new Basel Accord - banks’ choice of loan rating system

Summary.The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committee’s latest proposals, in October 2002.

Equilibrium Analysis, Banking, Contagion and Financial Fragility

This paper contains a general equilibrium model of an economy with incomplete markets (GEI) with money and default. The model is a simplified version of the real world consisting of a non-bank private sector, banks, a central bank, a government and a regulator. The model is used to analyse actions by policy-makers and to identify policy relevant empirical work. Key analytical results are: a financially fragile system need not collapse; efficiency can be improved with policy intervention; and a system with heterogeneous banks is more stable than one with homogeneous ones. Existence of monetary equilibria allows for positive default levels in equilibrium. It also characterises contagion and financial fragility as an equilibrium phenomenon. A definition of financial fragility is proposed. Financial fragility occurs when aggregate profitability of the banking sector declines and defaults in the non-bank and banking private sectors increase. Thus, equilibria with financial fragility require financial vulnerability in the banking sector and liquidity shortages in the non-bank private sector. The model will be used as a basis to carry out empirical work on the costs of financial instability, to quantify the effectiveness of particular regulatory tools such as capital requirements, and to identify trade-offs between increasing stability through action by authorities and the efficiency of the financial system.

Financial Regulation in General Equilibrium

This paper explores how different types of financial regulation could combat many of the phenomena that were observed in the financial crisis of 2007 to 2009. The primary contribution is the introduction of a model that includes both a banking system and a “shadow banking system” that each help households finance their expenditures. Households sometimes choose to default on their loans, and when they do this triggers forced selling by the shadow banks. Because the forced selling comes when net worth of potential buyers is low, the ensuing price dynamics can be described as a fire sale. The proposed framework can assess five different policy options that officials have advocated for combating defaults, credit crunches and fire sales, namely: limits on loan to value ratios, capital requirements for banks, liquidity coverage ratios for banks, dynamic loan loss provisioning for banks, and margin requirements on repurchase agreements used by shadow banks. The paper aims to develop some general intuition about the interactions between the tools and to determine whether they act as complements and substitutes.

A strategic market game with a mutual bank with fractional reserves and redemption in gold

We utilize the strategic market game approach to analyze the role and function of a mutual bank with variable fractional reserves, redemption in gold, and endogenous interest rate formation. We specify the conditions of enough money and its distribution. Using the continuum of traders model, we show existence and optimality for the case ofno bankruptcy as well as for the case in which there exists the potentiality of bankruptcy. Finally, we analyze the relationship of the gearing ratio and the bankruptcy penalty with respect to the resulting equilibrium allocations.

How Does Macroprudential Regulation Change Bank Credit Supply

In the paper we have assumed that the probability of a bank-run, q, is a decreasing function of q LIQ1+x I D R (1+r D ) . The purpose of the online appendix is to present the microfoundations that justify our assumption. We follow the of Goldstein and Pauzner (2005) who apply the global game techniques of Carlsson and van Damme (1993) and Morris and Shin (1998) in bank-run models. Section 1 derives q, while section 2 discusses existence and uniqueness. We show how our framework satisfies the assumptions underlying the existence and uniqueness of a threshold equilibrium, and refer the reader to the aforementioned papers for details.

Debt deflation effects of monetary policy

We assess the role that monetary policy plays in the decision to default using a General Equilibrium model with collateralized loans, trade in fiat money and production. The monetary authority extends long-term credit against risky collateral along with its traditional monetary operations. The value of collateral depends on traditional monetary policy and agents can optimally choose to default depending on the relative value of the collateral to the face value of the loan. Default results in foreclosure, higher borrowing costs, inefficient investment and a decrease in total output. We show that pre-crisis contractionary monetary policy interacts with Fisherian debt-deflation dynamics and can increase the probability that a crisis occurs.

A Strategic Market Game with Seigniorage Costs of Fiat Money

A model that includes the cost of producing money is presented and the nature of the inefficient equilibria in the model are examined. It is suggested that if one acknowledges that transactions are a form of production, which requires the consumption of resources, then the concept of Pareto optimality is inappropriate for assessing efficiency. Instead it becomes necessary to provide an appropriate comparative analysis of alternative transactions mechanisms in the appropriate context.

Macro-Modelling, Default and Money

Mainstream macro-models have assumed away financial frictions, in particular default. The minimum addition in order to introduce financial intermediaries, money and liquidity into such models is the possibility of default. This, in turn, requires that institutions and price formation mechanisms become a modelled part of the process, a ‘playable game’. Financial systems are not static, nor necessarily reverting to an equilibrium, but evolving processes, subject to institutional control mechanisms themselves subject to socio/political development. Process-oriented models of strategic market games can be translated into consistent stochastic models incorporating default and boundary constraints.

Option Values and Endogenous Uncertainty in ESOPS, MBOS and Asset-Backed Loans

We consider contracts to purchase assets by means of streams of payments over time, with the asset as security. These give the purchaser an option not present if all payment is made up front, the option of stopping payments and delivering the asset in satisfaction of the remaining debt. We argue that the value inherent in such options explains the attractions of asset-backed loans, employee stock option plans and MBOs.

Principles for Macroprudential Regulation

The drafting of macroprudential regulation is largely being driven by the need by policy makers to meet timetables that have been agreed. The legislative drive is taking place without any clear theoretical framework to organise the objectives. In this article we propose two principles that any satisfactory framework ought to respect and then describe one specific model that embodies these principles. We explain the insights from this approach for regulatory design.