Imperfect Competition in the InterInterBank Market for Liquidity as a Rationale for Central Banking

Viral V. Acharya
London Business School and CEPR With Denis Gromb and Tanju Yorulmazer
April 17, 2008

Outline
Central Banking has been motivated as a response to market failure arising from asymmetric information, lack of depositor coordination, etc. This paper:
 Motivates Central Banking as a response to market power in inter-bank liquidity transfers
 Surplus banks extract rents from power in these markets  Rent extraction can lead to inefficient allocation of assets

 Central Bank, by being a credible lender at competitive rates, can improve liquidity transfers
 Virtual and virtuous role  Public provision of liquidity improves private provision
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Outline (contd)
Different ways in which banks interact during crises
 Inter-bank lending: Limited due to moral hazard  Asset sales: Inefficient due to specificity of assets  Co-insurance
 Crises may however confer market power on some causing co-insurance arrangements to break down  Ample evidence in support of such breakdowns  Competitive and strategic effects can start playing a role
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Historical motivation
Clearing houses: Before the establishment of Federal Reserve in 1914
 Private arrangements by banks during crises for coinsurance, started in New York in 1853.  Acted as LOLR during crises, suspending convertibility and issued joint claims to protect member banks.  One member bank assigned the central administration role.
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Historical motivation (contd)

In practice, the clearing-house arrangements often failed to organize quickly.
 Anecdotal evidence Timberlake (1984), Goodhart (1988), Park (1991), Goodhart-Schoenmaker (1999), Freixas-Giannini-Hoggarth-Soussa (1999), etc.  Healthier banks may gain deposits, customers, acquire assets at fire-sale prices
Slovin, Sushka and Polonchek (1999), Schumacher (2000)

 Incentives to force a competitor out of business by not providing normal-time loans/assistance in the relationship
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Failure of clearing houses and commercial Central Banks

Episodes from England
 Bank of England orchestrated an insurance fund for Baring Brothers in 1890.  However, BoE was unwilling to support Overend and Gurney in 1866.  Goodhart-Shoenmaker (1999) attribute this to a commercial rivalry between the two banks.

Evidence from France

 Goodhart (1988) reports similar commercial rivalry between Banque de France and Credit Mobilier in 1867

Similar evidence from Australia

 Associated Banks, a co-insurance arrangements, did not support Federal Bank in 1893 due to rivalry (Pope, 1989)
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Panics in the US I
JPMorgan during the 1907 panic (Park, 1991)
 Knickerbocker Trust, Trust Company of America, Lincoln Trust, Moore and Schley were among Trust companies experiencing trouble  NY Clearinghouse, led by Morgan, first offered support only to Mercantile National Bank (the source of the panic through a copper squeeze) and other affiliated banks, but not to trusts (some solvent)  Morgan offered support to Trusts only after two weeks
 During this period, six strongest clearing house banks gained in deposits (Sprague, 1910)
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Panics in the US I (contd)

JPMorgan made a windfall gain in the process (The House of Morgan by Chernow, 1990)
 Morgans favourite creation US Steel acquired Tennessee Coal and Irons assets estimated to be worth $1 billion for $45 million Moore and Schley, one of the assisted brokerage houses held a large stake in Tennessee Coal and Iron The deal would not have been possible under Sherman Anti-trust Act during normal times, but President Roosevelt approved it Grant B. Schley later admitted that they could have been rescued by an outright cash loan rather than the sale of Tennessee Coal

Panics in the US I (contd)

Financial Times Leadership in times of panic The Crisis of 1907 (17 August 2007): The creation of the Fed was a natural response to the realization that control and leadership of the US financial system had effectively been outsourced to one private businessman.

Panics in the US - II
National City Bank during the 1893, 1907 panics (Citibank, by Cleveland and Huertas)
 National City had higher reserve and capital ratios.  During the panics, it gained deposits and loans relative to its competitors.  Grew into Citibank through rapid expansion during these panics  Hoarded liquidity for purchases at fire-sale prices  Not much evidence for its usage in inter-bank markets
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Panics in the US II (contd)

Vanderlip's (Vice President) complaint in early 1907 that National City's low leverage and high reserve ratio was depressing profitability. Stillman (President) to Vanderlip (Vice-president):
I have felt for sometime that the next panic and low interest rates following would straighten out good many things that have of late years crept into banking. What impresses me most important is to go into next Autumn (usually a time of financial stringency) ridiculously strong and liquid, and now is the time to begin and shape for it... If by able and judicious management we have money to help our dealers when trust companies have suspended, we will have all the business we want for many years. 11

Panics in the US III

Potential strategic effects in inter-bank call loan rates (Donaldson, 1992):
 US data for banking panics during 1873-1993 period  Interest rates during panics larger with extremely high volatility during pre-1914 (pre-Fed) panics
Dependence of interest rates in pre-Fed panics on cash reserves of banks before 1914 but not after

 Preliminary evidence that creation of the Federal Reserve had a stabilizing effect on inter-bank lending 12

Panics in the US III (contd)

Donaldson (JFI, 1992)

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Relationship to (some) literature

Goodfriend and King (1988)
  Central Bank should inject liquidity through open-market operations and inter-bank markets will allocate this efficiently Thus, no need for a lender of last resort operation

Frictions can break down Goodfriend-King result

Our paper: No guarantee that liquidity with surplus institutions that have market power will find its way to the needy institutions  Dunn and Spatt (1984) Model of strategic behavior by lenders when the borrower is captive over a part of the loan Our paper: Both inter-bank and asset markets  Carlin, Lobo and Viswanathan (2007) Switch from co-operative to strategic equilibrium in a dynamic model of trading when continuation game is not that valuable
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Relationship to (some) literature

Other frictions may also be of relevance: Flannery (1996)
 Asymmetric information about assets and/or shocks

Bhattacharyya and Gale (1987)

 Asymmetric information about assets and/or shocks  Free-riding by banks on other banks liquidity  Aggregate liquidity shortages may thus result

Repullo (2005)
 Banks may free-ride on (unconditional) injection of liquidity by Central Banks
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Basic structure of the model

Similar to Holmstrom and Tirole (1998) Bank A and B, three dates t= 0, 1, 2, risk-neutrality, no discounting t=0: Bank A owns I units of loans to corporate sector.
 I normalized to one for now

t=2: Loans pay off based on state of the world (R or 0), but probability of R depends on monitoring at t=1
 pH or pL ; p > b, the private benefit from poor monitoring

t=1: Loans need refinancing I with prob. x Bank B has excess liquidity Bank A raises funds by borrowing and/or asset sales
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Borrowing
Limited liability, so borrow against a repayment r in high state Incentive compatibility:

Maximum interest satisfies:

Debt capacity per unit of asset:

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Asset sales
Transfer of ownership at price P. Bank B has less expertise in running As assets:

Asset-specificity thus implies that borrowing is more efficient than asset sales. But, transfer of ownership is better than running assets with moral hazard

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Interaction amongst banks

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Solution
First, solve stage 2 of bargaining when Bank B makes take-it-or-leave-it offer Next, solve stage 1 based on stage 2 offer Stage 2: Bank Bs problem is

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Stage 2 outcomes
Offer:

Bank Bs expected payoff:

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Stage 1
Bank As problem is

Solution:

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Comparative statics
Fraction of Bank As assets sold to Bank B and the associated inefficiency
    

Increase with Bank Bs market power Increase with Bank Bs outside option Increase with Bank Bs opportunity cost of capital Decrease with Bank As outside option Decrease with Bank Bs effectiveness at running Bank As assets
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Determinants of Outside Options

A fraction of Bank As loans are big and rest are small Bank B has an advantage in small loans relative to outsiders, and thereby, also in monitoring Bank A Asset sales: for B as well as outsiders for outsiders Borrowing:

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When bargaining has broken down...

Bank A raises finance from outsiders
 Efficient to sell big loans first  Sell small loans, only if necessary

Bank As outside option XA increases in and decreases in bo In turn, the total fraction of assets liquidated in equilibrium and the associated inefficiency decrease in and increase in bo Generalization: The loan size is distributed F( ), ranked by FOSD
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Generalization
The loan size is distributed F( ) Smaller values of correspond to more specific (or smaller) loans

Fraction of assets sold is above a threshold Bank-A specificity and overall bank-specificity of loans is correlated
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Central Banking
A Central Bank can alleviate the inefficiency if it can improve upon Bank As outside options If it can do so, then it can play a virtual and virtuous role
 CB does not lend in equilibrium

Under what conditions can a Central Bank (or cannot) improve upon the market outcome?
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Different cases of LOLR

No loss-making loans and no supervision:
 CB cannot improve upon the market outcome

Some loss-making loans, but no supervision:

 Akin to lowering collateral quality for lending  CB can reduce Bank Bs market power

Supervision:
 Again, CB can reduce Bank Bs market power  Commitment to the LOLR role, no moral hazard
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Central Banking (contd)

Suppose that the Central Bank can better monitor banks than can outsiders:

As the Central Bank's monitoring advantage over outsiders increases, the equilibrium outcome is more efficient: Bank A borrows more from and sells less assets to Bank B.
 Bank As outside option XA increases
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Supervision as a commitment to lend

Central Banking effective at little cost as in equilibrium Central Bank does not lend to Bank A But, there may be commitment issues The Central Bank must be prepared to lend against collateral that outsiders will not lend against
 Either suffer loss on loans ex post OR Invest in better supervision ex ante

Bank supervision thus naturally coincident with the liquidity provision role of Central Bank
 Provides the commitment to be willing to lend ex post
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Other options
Why dont outsiders improve their monitoring?
 Banks may be unwilling to share information with markets, but be prepared to do so with a Central Bank

Central Bank can set price caps

 But need to set them effectively in all markets for liquidity transfers

Central Bank can auction some of Bank As assets, contingent on lending at competitive rates
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TO DO and Applications
Fuller modeling of Central Bank role, liquidity auctions, Ex-ante markets for liquidity insurance
 Incentives for banks to commit ex ante to providing co-insurance  Optimal ex-ante schemes may, however, lack time consistency  May be renegotiable due to lack of verifiability of private liquidity shocks

Evidence of market power amongst financial institutions during crises

 LTCM (1998) Predators also potential acquirors  Amaranth (2006) JPMorgan, the lender, blocked acquisition and arranged its own bid soon after
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