Michiel Bijlsma

Competition for traders and risk

The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks’ remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank’s top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labor market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks’ capital requirements does not unambiguously lead to reduced risk-taking by their top traders.

Competition Leverage: How the Demand Side Affects Optimal Risk Adjustment

We study optimal risk adjustment in imperfectly competitive health insurance markets when high-risk consumers are less likely to switch insurer than low-risk consumers. First, we find that insurers still have an incentive to select even if risk adjustment perfectly corrects for cost differences among consumers. Consequently, the outcome is not efficient even if cost differences are fully compensated. To achieve first best, risk adjustment should overcompensate for serving high-risk agents to take into account the difference in mark-ups among the two types. Second, the difference in switching behavior creates a trade off between efficiency and consumer welfare. Reducing the difference in risk adjustment subsidies to high and low types increases consumer welfare by leveraging competition from the elastic low-risk market to the less elastic high-risk market. Finally, mandatory pooling can increase consumer surplus even further, at the cost of efficiency.

The Private Value of Too-Big-To-Fail Guarantees

We estimate the size of the funding advantage for a sample of 151 large European banks for the period 1-1-2008 until 15-6-2012 using rating agencies‟ assessment of banks‟ credit ratings uplift. We find that the size of the funding advantage is large and fluctuates substantially over time. It rises from 0.1% of GDP in the first half of 2008 to more than 1% of GDP mid 2011. The latter value is in line with results from other studies. We find that the marginal effect of total assets relative to GDP on the rating uplift is positive and declines with the size of the bank. In addition, a higher sovereign rating of a bank‟s home country corresponds on average to a higher rating uplift for that bank.

The price of free advice

What factors determine how well consumers make their actual choices with regard to financial products? This article empirically evaluates two different choices consumers make when buying deferred annuities. One choice concerns the type of insurance policy, the other concerns the choice of insurance provider. For both choices, we will analyse what factors explain the quality of the choice made. In particular, we will investigate the role of financial advice in the decision-making process. By combining Dutch consumer survey data and data on quotations by Dutch life insurance companies, we obtain the following results. First, respondents who buy their policy directly from an insurer attain a significantly better match between their risk preferences and the type of policy chosen than respondents who purchase their policy through an insurance broker. Second, respondents who buy their policy through an insurance broker obtain a significantly lower payout than respondents who purchased their policy directly from an insurance company. These results raise doubts about the functioning of both the market for financial advice and the market for life insurances.

Economic Growth and Funded Pension Systems

Growing pension savings lead to deeper capital markets. This can have a positive effect on economic growth by allowing firms that are more dependent on external finance to grow faster. We study this effect using data on 69 industrial sectors in 34 OECD countries for the period 2001-2010 through a difference-in-differences approach that interacts financial development with industry dependence on external finance. We take into account unobserved heterogeneity by including country-time, industry-time and industry-country fixed effects. We find a significant impact of higher level of pension savings on growth in sectors that are more dependent on external financing. The financial crisis does not significantly affect this relation.

Selective Contracting and Foreclosure in Health Care Markets

We analyze exclusive contracts between health care providers and insurers in a model where some consumers choose to stay uninsured. In case of a monopoly insurer, exclusion of a provider changes the distribution of consumers who choose not to insure. Although the foreclosed care provider remains active in the market for the non-insured, we show that exclusion leads to anti-competitive effects on this non-insured market. As a consequence exclusion can raise industry profits, and then occurs in equilibrium. Under competitive insurance markets, the anticompetitive exclusive equilibrium survives. Uninsured consumers, however, are now not better off without exclusion. Competition among insurers raises prices in equilibria without exclusion, as a result of a horizontal analogue to the double marginalization effect. Instead, under competitive insurance markets exclusion is desirable as long as no provider is excluded by all insurers.

Measuring too-big-to-fail funding advantages from small banks’ CDS spreads

Large banks derive a funding advantage from being too-big-to-fail, while small banks do not. To estimate the funding advantage we explain the CDS spreads of small banks in six major European countries during the crisis by market fundamentals and bank-specific characteristics. Next, we extrapolate and predict the CDS spreads of large banks. The difference between the predicted and the observed spread is then interpreted as the funding advantage and amounts to 67 basis points for large banks and 121 for GSIFIs.

Tail Dependence: A Cross-Industry Comparison

Tail dependence is a crucial element in assessing downside risk of industry portfolios. The authors measure tail dependence in the 48 industries by comparing comovements in extreme negative returns within these industries. The industries that score highest are banking, petroleum and natural gas, utilities, financial trading, and insurance. All other industries score significantly lower. The authors identify a large market beta, a large market cap, and low volatility as significant determinants of the tail dependence. In addition, tail dependence in one year is an important indicator for tail dependence in the next year.

Community Rating in Health Insurance: Trade-Off Between Coverage and Selection

We analyze the role of community rating in the optimal design of a risk adjustment scheme in competitive health insurance markets when insurers have better information on their customers’ risk profiles than the sponsor of health insurance. The sponsor offers insurers a menu of risk adjustment schemes to elicit this information. The optimal scheme includes a voluntary reinsurance option. Additionally, the scheme should sometimes be complemented by a community rating requirement. The resulting inefficient coverage of low-cost types lowers the sponsor’s cost of separating different insurer types. This allows the sponsor to redistribute more rents from low-cost to high-cost consumers.

Practical Applications of Tail Dependence: A Cross-Industry Comparison

Systemic risk in the banking industry was quite well recognized after the 2008–2009 financial crisis, as most banks experienced extreme losses across the board. Do negative stress events similarly affect a large number of firms in other industries in terms of very high correlated downside tail risk? What would it mean for portfolio managers interested in tail dependence, or the number of firms that have very large negative returns, given that at least one firm in the group has very large negative returns? ask Sander Muns and Michiel Bijlsma from the CPB Netherlands Bureau for Economic Policy Analysis in The Hague.