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Entangled Financial Systems∗ Adam Zawadowski Boston University email@example.com people.bu.edu/zawa February 21, 2011 Abstract This paper analyzes counterparty risk in entangled financial systems in which banks hedge risks using a network of bilateral over-the-counter contracts. If banks have large exposures to a few coun- terparties, they do not buy insurance against a low probability counterparty default even though it is socially desirable. This is because they do not take into account that their own failure also drags down other banks — a network externality. Given that banks choose short-term financing, the failure of a single large bank prompts a systemic run. Taxing over-the-counter contracts to finance a bailout fund or mandatory counterparty insurance is welfare improving. ∗ This paper is based on the first chapter of my PhD dissertation. I thank Markus Brunnermeier and Wei Xiong for advice, and Ana Babus, Marco Battaglini, Amil Dasgupta, Thomas Eisenbach, Harrison Hong, Paul Glasserman, Mark Flannery, e Zhiguo He, Jakub Jurek, Anil Kashyap, Nobuhiro Kiyotaki, P´ter Kondor, Robert Marquez, Stephen Morris, Tam´s Papp,a e ´ a e e a Ricardo Reis, Jos´ Scheinkman, Felipe Schwartzman, Hyun Shin, David Skeie, Ad´m Szeidl, B´la Szem´ly, Bal´zs Szentes, Pietro Veronesi, Motohiro Yogo, Tanju Yorulmazer (discussant), and conference participants the Western Finance Association 2009 Annual Meeting (San Diego), SIAM 2010 (San Fransisco) and seminar participants at Boston University, Chicago Booth, Central Bank of Hungary, Columbia Business School, Federal Reserve Bank of New York, Federal Reserve Board, Federal Reserve Bank of Boston, Harvard, Imperial College London, LSE, Michigan Ford School, NYU Stern, UCL, and the Princeton University finance, micro and macro workshops for useful discussions and comments on this and earlier versions of the paper. I thank the Federal Reserve Bank of New York and the Central European University for their hospitality while part of this research was undertaken. All remaining errors are mine. 1 Introduction Modern financial institutions are entangled in a network of illiquid bilateral hedging contracts, such as over-the-counter (OTC) derivatives. The fear of these instruments affecting the whole financial system was a major argument brought up to support government intervention in the Financial Crisis of 2008.1 In this paper, I propose a model of the core of the financial system in which large financial institutions (banks from hereon) get endogenously entangled in OTC contracts in order to hedge the risks in their portfolio. However, they expose themselves to counterparty risk through these OTC contracts and the failure of a bank can potentially drag down counterparties. I assess under what conditions the failure of a single large bank could lead to the collapse of the whole system. The main goal of the paper is to understand the conditions under which banks have an incentive to get exposed to counterparty risk without hedging it: I show that the degree of "entanglement" in the system is crucial. The basic question is why do banks not insure against the failure of a counterparty if that could lead to their own failure? I show that banks' individual decisions endogenously lead to a contagious network, even though this is socially suboptimal. The inefficiency comes from a network externality. Banks do not take into account that their own failure can also drag down others: their counterparties, the counterparties of their counterparties, etc. These externalities lead to a market failure: the public good of financial stability is not provided in equilibrium. This inefficient contagious equilibrium exists for relatively rare crisis events. However, if crises are very rare, it is socially optimal not to insure against them. On the other hand, if crises are very likely, then it is even individually optimal for banks to insure against counterparty default. This paper clarifies the effects of "entanglement": it is partially entangled financial systems, those resulting in sparse (not completely connected) networks, that are most likely to be prone to crisis because of an inefficiently low ex ante choice of counterparty insurance. The sparse network structure of OTC contracts is crucial for the externality: it implies that every bank has exposures to only a few counterparties, so banks only care about the potential bankruptcy of their direct counterparties when making decisions. If instead the financial system was dense and each bank had the same exposure to every other bank in the system, the system would be constrained efficient. The interval of crisis probabilities, for which inefficiency prevails, shrinks as the network of hedging contracts becomes denser. The reason is that if every bank is directly linked to the failing bank, they cannot count on other banks' insurance contracts to shield them from the crisis. Since they need to have insurance of their own to survive, free riding is not possible any more. The inefficiency results regarding sparse networks extend to entangled systems where banks hedge with most or all banks in the network but have some disproportionately large exposures. Interestingly, it is exactly the failure of their largest counterparty that banks fail to insure against, since that is the most costly to insure. The limited 1 "Wall Street's crisis", The Economist, March 22, 2008. 2 empirical data on OTC exposures of financial institutions, such as the exposures of AIG, indicate that the financial system indeed exhibits concentrated counterparty exposures: see Table 1 in Section 5. The externality that leads to an inefficient ex ante choice of counterparty insurance can be elim- inated by regulatory intervention. One possibility is to mandate banks to buy default insurance on their counterparties from the other banks in the system or from an outside seller. This could be implemented by pre-funded credit default swaps (CDS). Thus this paper suggests that there are not enough CDS's in the market written on large banks: a counterintuitive conclusion given that CDS contracts also link banks together leading to an entangled system. In my model, banks do not have enough default swaps on other banks that are their counterparties. In essence counterparty insurance makes the network dense and thus eliminates the free riding problem. It is an ex ante mechanism that stabilizes the financial system in case of the idiosyncratic failure of a bank in the core of the system, even if the regulator cannot observe the full network structure. It can be seen as a complement to the recession insurance proposal of Kashyap et al. (2008), which is designed to maintain the stability of the financial system in case of an aggregate shock affecting all banks. If mandatory counterparty insurance is not enforceable, the regulator can simply tax OTC exposures and use the revenues to set up a bailout fund for the counterparties of failing banks. An alternative policy intervention, if implementable, is to mandate the use of a central counterparty (CCP) for hedging risk. The important feature that helps overcome inefficiency in a CCP arrangement is loss mutualization: risks from the failure of a bank are spread evenly all over the system thus it makes all other banks internalize the full social cost of the collapse of another bank in the system, basically again making the network dense. My result that banks fail to insure against counterparty risk gives one potential explanation of why participants in the financial market have resisted the call for setting up a CCP for OTC contracts: it would basically act as an insurer, making trades more expensive. Even if a CCP exists, banks have a strong incentive to opt out and sign bilateral OTC contracts instead. In the second half of the paper, I give a microfoundation to the value of OTC contracts and show how the failure of one bank can lead to a run on another one. While the microfoundation I provide is not the only possible one to get the above mentioned effects, it does give important additional insights. In my microfounded model, banks have to satisfy an endogenous risk-adjusted capital constraints. They hedge their asset risks using OTC contracts, which link banks together. In the event that one of the banks is hit by a large negative shock, it goes bankrupt, leaving its counterparties unhedged. Banks that have lost their hedge may not have enough capital to satisfy their capital constraint and thus could fail. If all banks are linked, the above mechanism can lead to a complete collapse of the financial system. The result that a single default can lead to a systemic crisis only holds for large core banks, the financial system is resilient to the default of smaller periphery banks. Why does the violation of the capital constraint lead to a bank's failure? If banks are financed short-term, they need to hold enough capital to reassure investors of their incentives. In case their risk- adjusted capital is not sufficient, short-term debt is not rolled over. Thus the collapse of the system is 3 induced by a systemic run of short-term lenders due to a crisis of confidence. If capital is costly and borrowing cheap, banks indeed choose to finance their activities by short-term borrowing, keeping as little capital as possible to satisfy incentive constraints. In order to maximize leverage, banks even use their non-pledgable payoff linked to their survival, e.g long-term profits, as "collateral" to overcome the moral hazard problem. If a bank's counterparty fails, it becomes riskier and its probability of default increases, thus decreasing the expected value of non-pledgable payoff. This is what makes the bank's short-term lenders wary of its incentives, withdrawing short-term funds and leading to the liquidation of banks. The above contagion mechanism works beyond the traditional channel through direct credit expo- sure.2 This is important since the ISDA Margin Survey 2008 reports that 65% of total OTC credit exposure is covered by collateral or margin accounts. In this paper, I show that even if there are no direct losses in assets when a counterparty defaults, contagion is possible. Even though in equilibrium there is systemic failure, it is not driven by "domino" losses in assets. The failure comes through the liability side: lenders run on banks whose hedges fail. A crucial assumption is that rehedging is impossible after the failure of the counterparty. This assumption captures the insight that in crisis, as in the aftermath of the Lehman bankruptcy, it is very costly or even impossible to rehedge risks.3 The paper is structured as follows. Section 2 discusses how the paper relates to previous work. Section 3 shows the main inefficiency result in a baseline model with exogenous capital constraints. The full microfounded model is presented in Section 4: it endogenizes the capital constraint and highlights the role of short-term debt. In Section 5, I argue that the proposed contagion mechanism could have contributed to the Financial Crisis of 2008. Section 6 concludes. 2 Related literature The seminal paper of Allen and Gale (2000) shows that while interbank deposits help banks share liquidity risk, they expose banks to asset losses if their counterparty defaults. In their setting, the probability of crisis is arbitrarily small so the crisis is socially optimal. Also, the underlying Diamond and Dybvig (1983) model does not explicitly model equity choice. This contrasts to my model where there is no direct credit exposure and I explicitly allow for anticipated crises, insurance against the default of a counterparty, and for equity choice. Allen and Gale (2000) also show that the system most prone to crisis is the one connected in a sparse network. However, this result is purely mechanical: if a bank has links to more banks in the interbank market, each of its interbank deposits is smaller and thus there is a smaller effect of any failure in the system. In my model, the same result is due to externalities when making ex ante choices. Babus (2009) extends the analysis to allow banks to hold mutual deposits to insure against the failure of a counterparty and finds a mixed equilibrium where some completely insure against failure. In my model, there is no such mixed equilibrium, either 2 See for example Allen and Gale (2000) and Kiyotaki and Moore (1997). 3 "The great untangling", The Economist, November 8, 2008 4 everyone insures or no one. While Dasgupta (2004) allows for positive probability of crisis, he still a solves for a social planner problem. Even though Soram¨ki et al. (2007) and Bech and Atalay (2008) show that interbank lending networks are indeed sparse, empirical evidence on contagion through interbank deposits shows that it is unlikely that large fractions of the banking system could collapse due to the mechanism outlined by Allen and Gale (2000) in advanced countries: see Furfine (2003) for evidence from the US and Upper and Worm (2004) for Germany. The supportive evidence on contagion through interbank deposits comes from developing countries: Iyer and Peydr (2011) finds contagion in India among banks that are smaller on an international scale. Research on networks in finance has uncovered a number of externalities. Kiyotaki and Moore (1997) develop a different model where bilateral credit links result from the specificity of intermediate goods, not from hedging of liquidity risk. They point out an externality due to the chain of credit: entrepreneurs are unwilling to renegotiate loans ex post since they do not internalize the benefits accruing to others in the credit chain. However, they not allow for counterparty insurance, only for insurance against the aggregate event. Lagunoff and Schreft (2001) show that contagion in a financial network cannot only be backward looking through asset losses, but also forward looking: agents break links to reduce their risk exposure. Leitner (2005) extends this analysis to show that links prompt luckier investors to bail-out weaker investors to prevent contagion even without any ex ante commitment, while in my paper bail-out arrangements break down because of externalities in the network and the fact that you have to provision capital for them ex ante. Caballero and Simsek (2009) show that uncertainty about the network structure can lead to inefficient levels of liquidity hoarding. Zawadowski (2010) argues that uncertainty about the availability of funding in a credit network can lead to over-hoarding of liquidity, even in the absence of any defaults in equilibrium. Inefficiencies have been shown in principal-agent problems in non-network setting, e.g. in the literature on "non-exclusive contracts". The key idea about contracting is similar to the one in this paper: in Bisin and Guaitoli (2004), inefficiencies arise because the principal cannot write "exclusive contracts" with the agent, thus the agent might sign other contracts on the side undermining the efficient allocation. Acharya and Bisin (2009) apply a similar approach to selling OTC insurance in opaque markets and show that market participants build up excessive exposures to risks. Bisin et al. (2008) analyze what the optimal contract is if the investor can monitor its portfolio manager's hedging choices but only at a cost. While the underlying friction is similar, this literature does not look at the interaction between inefficiencies due to "non-exclusive contracts" and the network structure of the contracts. Stulz (2009) lists three positive effects of a clearinghouse in OTC markets: netting, monitoring exposures, and spreading losses. I focus on how the third interacts with banks' incentives, while the first two effects have been modeled previously. Duffie and Zhu (2009) show a clearinghouse would help reduce costly margin accounts by netting, Brunnermeier (2009) argues that netting stops worries about the creditworthiness of a single counterparty from leading to a systemic crisis. In the setting of Acharya and Bisin (2009), a clearinghouse monitoring exposures would lead to efficiency. On the other 5 hand, Pirrong (2009) argues that a clearinghouse would reduce the incentives of market participants to monitor each other. My paper also gives an alternative explanation for the breakdown of private coinsurance arrangements between banks, such as those discussed in Calomiris (2000). Acharya et al. (2008) attribute their collapse to the market power of institutions with surplus liquidity, while my paper shows that if banks are connected in a network, coinsurance collapses due to externalities. 3 Baseline model I first introduce a baseline model to show the main source of inefficiency in entangled financial systems. I simply assume that OTC contracts allow for reductions in capital holdings. Section 4 provides one potential microfoundation of the assumptions made in this simple and very general baseline model. 3.1 Setup of the baseline model The model has three time periods: t = 0, 1, 2. I call these the initial, the interim and the final period. There are n banks on a circle indexed by i = 1...n, where n > 3. Each bank is endowed with a real asset, which yields a return of R in the final period. To hold this asset in isolation, the bank needs a capital buffer (capital from hereon) of κ > 0. Bank i can choose to hold capital Ki at t = 0 at an opportunity cost of c per unit. Denote the vector of capital choices by K. However, it is not possible to raise capital at t = 1, except for transferring capital from one bank to another.4 OTC contracts. — Each bank has m potential OTC contracts it can sign with other banks. κ Each of these contracts, if signed, allows both banks to reduce their capital holdings by m. The full microfounded model endogenizes these contracts as bilateral risk-sharing. Note that if a bank signs all OTC contracts available to it, it can reduce its capital to 0. However, if some of these contracts get terminated at t = 1 and the bank does not have enough capital, it goes bankrupt and has to liquidate its real asset for L < R. The potential OTC contracts form a symmetric network, see Figure 1. I m refer to m as the density of the network. If n is low (closer to zero), the network is sparse, if it is high (closer to one), the network is dense. The n · n symmetric matrix of signed contracts is denoted by O, where Oij is 1 if banks i and j signed an OTC contract, and 0 otherwise. OTC contract need mutual consent to be signed,5 but are dissolved without further payments if one of the banks fails. States of nature. — There are two possible states of nature at t = 1. With probability p the state of nature is bad: one of the banks on the circle receives an idiosyncratic shock and goes bankrupt. While the bank hit by the shock cannot self-insure against this shock, other banks can sign insurance contracts conditional on this event.6 The bank hit by the shock is selected with an equal probability, p thus each bank fails with probability n. I refer to the state where there is no idiosyncratic shock, the state realized with probability 1 − p, as the normal state. This idiosyncratic shock in the bad state 4 A similar assumption is made in Shleifer and Vishny (1997): arbitrageurs cannot raise more capital in crisis. 5 That is, I use the pairwise stability concept of Jackson and Wolinsky (1996). 6 In the full model of Section 4, this assumption results from a moral hazard problem. 6 m=2 m=3 m=4 m=5 Figure 1: Varying density networks is the exogenous shock that can potentially drive the financial system into a systemic crisis. Note, however, that the state of nature being bad does not lead to a systemic crisis in general: that depends on the endogenous choices of the banks. Default insurance on counterparties. — Thus in the bad state banks might lose some of their OTC contracts and this might render their capital insufficient and thus cause them to fail. To insure against this counterparty risk, banks can buy default insurance on other banks (but not themselves). An insurance fund facing the same constraints as the bank can sell default insurance to the banks. That is, it faces the same opportunity cost of capital as the banks and cannot raise capital in the interim period.7 The insurance fund has to set aside capital at t = 0 to pay out claimants in the bad state, thus the default insurance is pre-funded. The insurance fund posts spreads sj , which is the price at which default insurance on bank j can be purchased. One unit of default insurance contract on bank j pays out one unit if bank j defaults and zero otherwise. Denote the payment made to bank i as Ci (I). Banks have to pay the premium at t = 0,8 thus the cost for the banks is (1 + c) · sj , since it is like keeping higher capital. Banks simultaneously choose the quantity of insurance based on the posted prices: they cannot make it conditional on others' insurance choice.9 The n · n matrix of insurance coverage is denoted by I, where Iij is the default insurance bought by bank i on bank j. Since banks have an incentive to buy default insurance on their counterparties only, I use the term counterparty insurance from now on. I call a bank "insured" if it has enough default insurance on its counterparties to survive their collapse. Payoffs and equilibrium. — Denote the endogenous probability of bank i going bankrupt by qi which depends on the capital K, OTC contract O, and default insurance I choices of all banks. The 7 This insurance fund could consist of many competing entities selling insurance. Furthermore, banks could sell this default insurance to each other as well, which would make the analysis slightly more complicated but leaving the main results unchanged. 8 This is not an important assumption, the effective cost of insurance comes from it having to be pre-funded. 9 The crucial assumption is not exactly how the insurance is traded and priced but that a bank's insurance choice cannot be made conditional on other banks' insurance choice. Given that in practice it is very easy to undo insurance, e.g. by selling a CDS, this assumption seems reasonable. 7 payoff of bank i can be written as: [1 − qi (K, O, I)] · R + qi (K, O, I) · L − c · Ki + Ci (I) − (1 + c) · sj · Iij (1) j=i where the last term is the total amount spent on default insurance. The equilibrium can be defined as a the triplet (K, O, I) and insurance prices (spreads) sj , in which banks maximize expected payoff (no bank wants to deviate) and the insurance fund breaks even. Given the symmetric setup of the model I restrict my attention to symmetric equilibria. I refer to financial networks, in which the collapse of a single bank leads to the collapse of the whole system, as contagious. If in the bad state all banks fail, I call that a systemic crisis. In this subsection, I show that for some intermediate values of the probability p of the bad state, none of the banks hold enough capital or counterparty insurance to survive, even if the network is contagious. Equilibrium without counterparty insurance. — At first let us abstract from counterparty insurance. In order to prove that holding zero capital in a contagious system is an equilibrium, we have to analyze the potential deviation of one bank. Note that if the system is contagious, then the only deviation that can save the bank from liquidation is to completely self-insure by holding capital κ in order to survive even if all other banks, including its counterparties, fail. In this case, the bank only fails if it p is hit directly by the exogenous shock, with probability n. However, it has to maintain a higher level of capital. This deviation to autarchy is profitable in a contagious system if and only if: p p (1 − p) · R + p · L − 0 · c < 1 − ·R+ ·L−κ·c (2) n n Thus a bank chooses to self-insure by holding substantial capital10 if and only if: n κ p > pa (m) = ·c· (3) n−1 R−L Note that if p < pa (m) the contagious system is an equilibrium even if counterparty insurance were available. The reason is that in the contagious system no bank contributes to the insurance fund, thus the deviating bank has to self-insure. Equilibrium with counterparty insurance. — Now let us assume that default insurance on counter- parties is available. Banks either fully insure against counterparty failure or do not insure at all, since partial insurance is not enough to survive. In the full insurance equilibrium each bank buys insurance κ coverage of m on each of its m counterparties from the insurance fund. Thus the overall capital held by the insurance fund to back (pre-fund) the counterparty insurance contracts is κ, exactly enough to stabilize the counterparties of the failing bank. The insurance is fairly priced such that the insurance fund breaks even. If all banks fully insure κ against the failure of their counterparties buying insurance of m on each, the insurance fund breaks 10 Whether the bank signs the OTC contracts is irrelevant, if it has enough capital it does not need them in the first place. 8 even if s is determined by: κ κ n·m· · s − p · κ − c · (κ − n · m · · s) = 0 m m where the first term is the total insurance premium collected from all n banks, the second is the expected payout and the third is the opportunity cost of holding capital beyond that raised from the selling the insurance. This yields: 1 p c s= · + 1+c n n p where the first term is the actuarially fair price: each bank fails with probability n ). The second 1 term is the cost of setting aside capital: the term n is due to the fact that the insurance seller can use the same unit of capital to back up insurance sold on all n banks, since the failure of these banks 1 are disjunct events if all banks are insured. The multiplier 1+c is due to banks having to pay the insurance premium ex ante at t = 0 and disappears once s is multiplied by the cost for the bank 1 + c. Given the risk neutrality of the banks, the actuarially fair component cancels out in cost-benefit p calculations, since the expected insurance receivables are n for every unit of insurance. The net costs c of counterparty insurance end up being n per unit of insurance purchased. Such an insurance scheme is sustainable if no bank chooses to opt out. Let us analyze the possible deviation of a single bank. If a bank opts out from buying insurance, the probability that the bank p (m+1)·p goes bankrupt and thus has to liquidate its assets increases from n to n , since given that it is uninsured, it also collapses if either of its counterparties collapses. The private benefit from not buying insurance is clear: the bank does not have to pay for the default insurance contracts. Note that the insurance fund will lose on insurance once someone opts out. Also, if the bank is insured against counterparty default, it does not need any additional capital. Thus a bank stays in the insurance scheme if and only if: p p c κ 3p 3p 1− ·R+ ·L+ ·m· > 1− ·R+ ·L (4) n n n m n n where the left hand side is the expected payoff from staying in the insurance scheme; the right hand side is the expected payoff if the bank chooses to opt out from buying insurance. This deviation undermines the equilibrium with insurance, furthermore there are no mixed strategy insurance equilibrium either. To see this, consider the following example: when m = 2 (banks on a circle), if every other bank buys insurance this is not an equilibrium either. Although the probability of being hit by the crisis doubles due to every other bank being uninsured, so does the price of insurance since only every other bank contributes to the cost of setting aside capital. Thus the insurance scheme is sustainable if and only if: c κ p > pi (m) = out · (5) m R−L Since pi (m) < pa (m), there is a range with multiple equilibria: both the systemic crisis and the out stable system with insurance are equilibria. 9 Social optimum. — On the other hand, the insurance is socially optimal if the total welfare of the system with counterparty insurance is higher than that without it: (n − p) · R + p · L − c · κ > (n − n · p) · R + n · p · L − c · 0 (6) where the left hand side is the payoff of all n banks in a stable system with counterparty insurance and the right hand side is that without insurance, in a contagious system. Thus counterparty insurance is socially optimal if and only if: c κ p > ps (m) = · (7) n−1 R−L insurance socially optimal 0 ps pi pa p optimal inefficiency multiple no systemic crisis equilibria crisis Figure 2: Equilibria as a function of the probability p of the bad state Note that as p → 0, the financial system completely collapses in crisis and crisis is socially optimal, as in the analysis of Allen and Gale (2000). However, in an intermediate region of probabilities of the bad state p ∈ (ps , pi ), counterparty insurance is not sustainable in equilibrium, even though it out is socially optimal: I call this the inefficiency region. Figure 2 shows the different equilibria as the probability of the bad state increases. Figure 3 shows the regions of different equilibria for varying m. The interval of the probabilities of the bad state for which inefficiency prevails is the largest for sparse networks of OTC contracts. The figure shows that the network can even be considered sparse, and thus likely to be inefficient, when each bank connects to a quarter or half of all banks in the system. On the other hand, for an almost completely dense networks with m = n − 1, where all banks are connected to all other banks, there is no inefficiency. Note that multiple equilibria are still present even if all banks are linked to all others, since ps (n − 1) < pa (n − 1). Why does the inefficiency region shrink as the network becomes denser? The intuition is that in sparse networks banks can free-ride on the counterparty insurance of others, while in dense networks they cannot. Assume for example that bank A is linked to bank B, and bank B is linked to bank C, however, A is not directly linked to C. If B insures against the failure of C, A can enjoy the benefits from being shielded from the failure of C without having to contribute and without buying insurance against the failure of B. However, if bank A is also directly linked to bank C, then it has to buy counterparty insurance itself on bank C, it cannot simply free-ride on the insurance of bank B. Note that in a completely dense network where all banks are connected to all other banks, every bank has to buy counterparty insurance on all the other banks. All banks face the same decision 10 p 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 m 0 2 4 6 8 10 12 14 Figure 3: Inefficiency region in networks of different densities p denotes the probability of the bad state, while m the number of OTC counterparties. In the darkly shaded region, the socially optimal equilibrium with counterparty insurance cannot be supported. In the lightly shaded region, there are multiple equilibria: both the socially efficient equilibrium with counterparty insurance and the inefficient one without insurance are equilibria. The parameters used in the figure are: c·κ = 0.04, R = 1.01, L = 0.7, n = 15. For a discussion of plausible parameter values see the numerical example in Subsection 4.2. and in equilibrium no bank can free-ride on another bank's counterparty insurance: the externality disappears. 3.2 Inefficiency and the missing market What is the missing market that makes the privately optimal choice socially inefficient? In the model, inefficiency is simply due to the assumption that OTC contracts cannot be made conditional on the counterparty's decision about counterparty default insurance. This is exactly the sense in which OTC contracts in the model are "non-exclusive": counterparties cannot control all other contract choices of banks, see Section 2. However, allowing for banks to contract on their counterparties' insurance choice would not lead to an efficient outcome, nor would "due diligence" contracts. If others cannot verify whether such a covenant is indeed implemented, efficiency is not restored. This is due to the fact that it would still only incorporate the private benefits to the two counterparties, but not to the system as a whole. Counterparties could still decide to drop the clause demanding them to insure and thus increase their own expected payoffs. Thus the missing market is a more complicate contract: one that would allow all banks to write contracts conditional on all other banks' insurance choice. The critical point here is whether other banks can price their counterparty insurance conditional on mandatory insurance clauses being implemented. Given that in practice counterparty insurance can easily be undone by selling CDS's, it seems unreasonable that banks can price counterparty 11 insurance conditional on others' counterparty insurance, e.g. CDS holdings. For example if cheap counterparty insurance has been sold on a reference entity because it held counterparty insurance on its counterparties, the sellers of the counterparty insurance would have to able to stop this bank from undoing its counterparty insurance or would have to able to reprice the counterparty insurance by increasing the price the protection buyer has to pay. Given the liquidity, high volumes, long maturities, and fixed insurance premia in CDS contracts. it seems unreasonable that protection sellers can make sure the reference entity does not unload its counterparty insurance. If default insurance is priced correctly, it could potentially reveal whether a bank holds counterparty insurance or not. Thus contracting on e.g. the CDS price of a bank could in principal make holding counterparty insurance contractible. As discussed above, if banks can contract on the counterparty insurance of everyone else, efficiency is indeed restored. However, this argument rests on two crucial assumptions. First, that nothing else influences CDS prices, only the choice of counterparty insurance. In practice, many other factors can obfuscate the price signal such that it does not reveal the holding of counterparty insurance. Second, it has to be enforceable that banks that are reference entities in counterparty insurance contracts cannot undo their own counterparty insurance, an assumption that seems unreasonable in practice since all default insurance contracts would have to be conditional on all other banks' CDS prices. 3.3 Possible policy responses In case of inefficiency, mandatory counterparty insurance would be welfare improving. However, if the default contracts (swaps) are not well diversified or not properly pre-funded, then that could result in another layer of counterparty risk on top of the existing one. For example, if banks want to game the regulation, they could easily set up a firm that issues very cheap default insurance for all agents to cover the needs from regulation but then fails to pay in crisis. However, this can be overcome by mandating that default insurance be properly pre-funded, thus capital set aside ex ante to pay in case of default events. I argued that banks are not able to force their counterparties to hold counterparty insurance. A similar constraint might apply to the social planner or government. However, the government can implement the same transfer scheme as the counterparty insurance without having to verify who holds default insurance on whom. All the government has to do is collect taxes (the price of counterparty insurance) and in case of a default give a capital injection to all the counterparties of the failing bank. The information the government needs is simply a registry of OTC contracts from which it can compute the overall amount of OTC contracts of each bank and tax accordingly. Not only is such a scheme easy to implement but it also compensates the government for its commitment of capital. The government can even use the taxes to set up a bailout fund. As discussed in Section 3.2, it is not necessary that the regulator implement mandatory counter- party insurance, it is enough if it continuously verifies whether banks have counterparty insurance and ensures that banks can sign contracts that are contingent on others' counterparty insurance. While 12 banks could hypothetically set up a self-regulatory framework to verify counterparty insurance, it seems unlikely that such an entity would be able to verify insurance without the powers of a sys- temic regulator. Furthermore, mandating counterparty insurance or taxation might be superior, since then banks do not have to sign complicated contracts that demand counterparty insurance for their counterparties, the counterparties of their counterparties, etc. Another possible policy not discussed until now is mandating the use of a central counterparty (CCP from hereon) with loss mutualization. This would ensure that the losses (or capital needs) after the default of a bank are spread out to all other banks, similar to that in case of mandatory coun- terparty insurance. However, this approach relies on the critical assumption that the OTC contracts can be standardized and the CCP can manage a contract even if the bank that was the original coun- terparty went bankrupt. The fact that while default insurance on large banks is easily standardized, while other risks are not, leads to a potential hybrid setup. This would standardize default swaps on large banks as reference entities and make them available through the CCP, basically resulting in an insurance fund. All other OTC contracts that can be standardized can be traded through the CCP as well. For all other products that are not standardized or traded through the CCP and thus remain OTC, counterparty insurance would be mandatory. To ensure that counterparty insurance does not add another layer of entanglement to the system, they would have to be purchased from the CCP. The notional amount of insurance that would have to be bought for each OTC instrument would be determined by the amount of extra capital that would be required if the bank held it on its own balance sheet. Note that this is much more efficient than making all banks keep enough capital to survive a crisis, which in the model means forcing all banks into autarchy. The reason is that in case a bank defaults, the insurance scheme surgically injects the capital into the counterparties of the failing bank and thus stabilizes the system. 3.4 Simple extensions of baseline model Heterogenous link sizes — While the assumption that banks have large OTC exposures to some banks while no exposure to others captures some aspect of the financial system, it is very simplistic. See for a the example the exposures of AIG in Table 1 or the network of interbank lending in Soram¨ki et al. (2007). In general, banks seem to have some disproportionately large exposures within the core of the financial system, while they have smaller but not zero exposure to others. In this section, I show that the main results of the paper carry through to such a case. That banks have OTC contracts with all other banks does not mean that the network is dense and thus efficient. Instead of all OTC contracts allowing for the same capital reduction, I assume each bank has two strong links (large exposures) to two counterparties, such as in the baseline model with m = 2. The strong links are arranged in a circle as before. Banks are also exposed to all other banks through weak links (small exposures): see Figure 4. All banks are the same size, thus they are ex ante symmetric. Strong links allow for capital reduction of κs , while weak links κw , where κs > κw and the total 13 amount of capital reduction due to OTC contracts is the same as before: κ = 2 · κs + (n − 3) · κw . The setup of the model is otherwise unchanged. Figure 4: Heterogenous link sizes Thin lines represent OTC contracts that allow for capital reduction of κw while thick lines represent contracts that allow for capital reduction of κs . Banks now have several possible ways of opting out of the insurance: they can stop buying insurance on strong links, weak links, or both. The main insight is that, in case of full insurance, opting out from insurance on any counterparty exposes the bank to the same probability of default by assumption. This is because each counterparty, irrespective of the strength of the link, has the same probability p n of exogenous default. Thus a deviating bank will first choose to quit buying default insurance (e.g. CDS's) on its strong links, since these are more costly than insuring weak links. The reason is that a bank needs to buy more default insurance on its strong links, since it needs a larger increase in capital when such a link fails. The condition for deviation is the same as in case of the circle (m = 2). Simply replace κ with κs in Equation 5 with m = 2. In the special case where κw = 0 we arrive at Equation 5 with m = 2, which is the expression for the baseline model with the circle. On the other hand if κw = κs we arrive at 5 with m = n − 1 describing the completely dense network. Note that once banks give up their insurance on strong links, the system is contagious and all banks fail in the bad state. This implies that insuring weak links is useless, thus once the insurance on strong ones is dropped, so are the ones on weak links. Thus there still is an interval of the probabilities of the bad state in which the equilibrium is inefficient; this interval shrinks as the weak links become closer in size to the strong links. The intuition is simply that if the weak links are small compared to the large links, the system in essence still looks like a circle and the externalities lead to a breakdown of the insurance scheme. However, as the weak links approach the size of strong links, the network in essence becomes one like the completely dense network which is efficient. Beyond the core of the financial system — All networks considered up to now showed that the failure of a single counterparty is enough to drive the whole system into a systemic default. In a more general setting with banks of heterogenous size, some large banks in the core of the system might 14 hold enough capital to survive the default of small counterparties. This does not contradict the basic insight that core banks do not insure against the failure of other core banks. From a more macro perspective (and beyond the model), the failure of a large core bank is more likely in case of bad macro outcomes, in which banks' capital buffer has already been "used up" by the failure of small counterparties (or in general defaults on loans). Network formation — A natural question that arises is that if more dense networks are more efficient, do banks have incentives to form such dense networks ex ante? Clearly if there is no cost of choosing a dense network ex-ante, a dense network would be the equilibrium. While I do not formally model network formation, one can easily show that if there is a cost for adding counterparties, sparse networks arise in equilibrium. There is a trade-off: while having more counterparties might allow for larger savings on capital (not modeled in this paper) and a more efficient system, there is a private cost of adding more counterparties (such as establishing trading relationships, setting up trading desks, learning about new other types of risks). The main insight of the model goes through in this case too: while the costs are private, the benefits of increased stability are public, thus the density of the network in general will be sparse. Furthermore, if banks hold counterparty insurance, making the network dense might even be wasteful from a social point of view, due to the costs of setting up new OTC relationships. 4 Full microfounded model This section provides a microfounded model for the financial system. While it is not the only potential microfoundation and interpretation of the baseline model, it still generates important insights. It endogenizes the contracts between the banks as risk sharing contracts and highlights the importance of short-term debt. The basic intuition is the following. Banks become more risky if their counterparty fails because they lose an OTC hedging contract. This means they are more likely to go bankrupt thus their non-pledgable payoff decreases, because this payoff is conditional on survival. Therefore the bank cannot convince its short-term lenders that it has the proper incentives to exert effort. This leads to a crisis of confidence and short-term lenders do not roll over the bank's debt. The section also shows that banks endogenously choose short-term financing. The results in this section are presented in the form of Lemmas and Propositions, the proofs involve relatively straightforward algebra and are relegated to the Appendix. 4.1 Model setup Participants and markets. — The model has three time periods: t = 0, 1, 2. There are n markets on a circle indexed by i = 1...n, where n > 3. There are two types of market participants: n entrepreneurs and a continuum of investors, both of them assumed to be risk-neutral. Only entrepreneurs can invest in risky real assets, investors can only invest in bank debt. 15 Entrepreneur i can set up a bank in market i, and no bank can operate in multiple markets. By establishing a bank, the entrepreneur becomes both manager and equityholder of the corresponding bank, i.e. there are no agency issues between the owners and the management of the bank. As equityholders, entrepreneurs have limited liability. The equity provided by the entrepreneur is the capital of the baseline model. Entrepreneurs have an outside option to invest in an asset with expected return of Re in the long run (from t = 0 to 2), which they cannot liquidate in the interim period. The other type of participant is a continuum of investors, who cannot invest in bank equity, only debt issued by the bank. Investors can be interpreted as uninformed life-cycle savers.11 Thus bank i is financed by equity (stock) Ki ≥ 0 provided by entrepreneurs and debt Di ≥ 0 provided by investors. Denote the vectors of stock and debt by K and D, respectively. Both market participants are risk neutral, have abundant capital at t = 0, and value payoff only in the long run. Neither of them gets additional endowment at t = 1. All participants in the market have full understanding of the model of the economy, know the network structure,12 and act rationally. Investments. — In market i, bank i can use its expertise to invest a unit in a long-term real asset which yields a return of Ri = R + i − i+1 − δi in the long run, where R is a constant and i ∼ N (0, σ) are normally distributed independent random variables with variance σ. Note that risks in neighboring markets exactly offset each other: see Figure 5. δi is an idiosyncratic shock to the bank's asset value, the realization of which depends on bank i's effort as I discuss later. If the investment is liquidated early at t = 1, it only yields L < R: I rule out partial liquidation due to the specificity of the real asset.13 I assume that all the liquidation value accrues to the bondholders and cannot be reinvested in the real asset. Investors can invest in an outside liquid asset as well that has a return of Rf,0 = 1 in the short run (from 0 to 1) and Rf,1 from t = 1 to 2.14 I assume Re > R > Rf,1 .15 This can be interpreted as the talent of entrepreneurs (e.g. financial sophistication) being scarce. To achieve this desired higher return, they borrow from investors using debt contracts. However, entrepreneurs do not have any superior investment possibility in the interim period. Projects also have a non-pledgable payoff of X beyond Ri : if a bank survives the last period in the model, i.e. can settle all its contractual obligations, it gets this additional payoff. It can be thought of as franchise value, expertise of the bankers, growth opportunities, certain types of intangible capital, etc. It cannot be seized by the creditor in case of default since it is only valuable within the bank, if the bank survives. Even though banks cannot directly borrow against it, it still has an important 11 I take it as given that they prefer simple debt securities. For a model of how debt is informationally insensitive and preferred by uninformed investors, see Gorton and Pennacchi (1990). 12 This assumption can be relaxed: it is enough if agents know that all banks are connected and each lender knows the counterparties of the bank it is lending to. 13 In general it would be enough to give an upper bound on liquidation value: if liquidation is too costly, it not only reduces the balance sheet but also destroys equity. 14 Letting entrepreneurs invest in this asset would not change the results since they would never invest in it in equilibrium. 15 The required return on equity is taken as exogenous here but could be endogenized using scalable investments and limited entrepreneurial capital. 16 i-1 i+1 hedge εi hedge εi+1 i Ri-1=R+εi-1-εi-δi-1 Ri+1=R+εi+1-εi+2 -δi+1 Ri=R+εi-εi+1 -δi Figure 5: Market and risk structure around market i The figure depicts the risk structure of the model in Section 4. Ri is the return on the real project i and R is a constant. The shocks are offsetting between neighbors and thus can be completely hedged. δi is an idiosyncratic shock to the bank's asset value which depends on the bank's effort role in the decision of the banks in the interim period. The idea of using the threat of termination to induce effort is similar to that of Bolton and Scharfstein (1990). Idiosyncratic shocks and moral hazard. — Banks are subject to moral hazard: the idiosyncratic component δi of the long-term project of bank i depends both on the state of nature and the bank's un- observable effort choice ei,0 ∈ {0, 1} at t = 0 and ei,1 ∈ {0, 1} at t = 1. There are two states of nature: with probability p the unobservable state of nature is "bad": one bank on the circle gets the worst possi- ble idiosyncratic shock, δi = d, irrespective of its effort. Formally, δi = max [d(1 − ei,0 ), d(1 − ei,1 ), µi ] for all i = 1...n. The shock δi is stochastic since it depends on µi which depends on the state of nature: with probability 1−p: ∀i : µi = 0 µ ∼ with probability p: ∀j = i : µj = 0 (8) for i = j : µi = d p where, in the bad state, bank j is selected with an equal probability n from {1, 2...n}. Following the model of Holmstr¨m and Tirole (1997), banks get private benefit Bi = B0 ∗ (1 − o ei,0 )+B1 ∗(1−ei,1 ) depending on their efforts. That is, if they exert full effort in both periods, they get 0, while if they shirk in both periods, they get B0 + B1 . Since the shareholders and the management of the bank are the same, this can be both thought of as direct payoffs to the equityholders or higher wages and perks to the management: for a detailed discussion see Section 4.3. If a bank goes bankrupt at t = 1, I assume ei,1 = 1, thus there is only private benefit based on the effort at t = 0. Thus the idiosyncratic shock can take on a bad value for three reasons: shirking in the initial period, shirking in the interim period or simply bad luck. In the good state, δi = 0 if bank i exerts full effort, and δi = d if it shirks in either period. However, in the bad state, one of the banks receives 17 δi = d irrespective of its effort, while the other banks get the idiosyncratic shock according to their efforts. This large shock to one bank can be thought of as a risk outside the standard model used by market participants or simply a mistake: something that cannot be hedged by the affected bank itself, but still market participants know there is some small probability of it happening. Even though market participants do not directly observe efforts, they do get a signal about the expected realization of δi at t = 1: si = max [d(1 − ei,0 ), µi ]. That is they get a bad signal about a bank if it either shirked in the initial period or if it was hit by the shock µ. Since the effort choices are only observable by bank i, outsiders cannot tell apart bad luck from shirking. In equilibrium, bad realizations of si are due to bad luck but any insurance leads to a moral hazard problem, making these idiosyncratic risks non-insurable for the bank hit by it directly but insurable for others: see Lemma 6. Given that in the equilibrium of this model the banks choose full effort, the idiosyncratic shock driving the results of the model and leading to a potentially systemic crisis is the shock unrelated to effort hitting a single market in the bad state. Contracts. — Banks can choose between long-term and short-term debt financing. Short-term debt has to be rolled over at t = 1, thus debtholders have an option to withdraw funding and force the bank to liquidate the real project. They can also reset the interest rates in the interim period based on the observed behavior of the bank, even if writing such a state contingent contract is hard ex ante in the initial period. The benefit of short-term debt is that it has a lower interest rate since it can be withdrawn in a state-contingent way and thus can help overcome the moral hazard and risk shifting problem at t = 0. I do not allow long-term debt to be explicitly state-contingent on bank actions, since in practice a bank's risk management is hard to verify. This is in line with the assumption discussed below that counterparty insurance, another form of risk management, is non-verifiable. The benefit of long-term debt, on the other hand, is that it is a safe financing source even in the bad state. I do not allow for the renegotiation of debt contracts, a reasonable assumption given that large financial institutions usually issue bonds and commercial papers. Banks can unload the risks of their real investments using hedging contracts (OTC contracts of the baseline model). To establish an contract between two banks, both banks have to agree in the initial period to enter into the contract. I rule out the Nash equilibrium of no hedging contracts if there is also an equilibrium where the contract is established: in essence I use the pairwise stability concept of Jackson and Wolinsky (1996). Why do banks choose to hedge at all, since debt contracts induce risk-shifting? The reason is that in equilibrium the banks choose short-term debt, and the riskier the bank, the more equity it has to keep in order to roll over its debt. Note that the setup is symmetric, so assuming equal bargaining power, the banks do not pay each other for the hedging contract, it has price zero at t = 0. Since no information is revealed about 's in the interim period, the price remains zero at t = 1. The n · n symmetric matrix of signed contracts is denoted by O, where Oij is 1 if banks i and j signed an OTC contract, and 0 otherwise. I also allow banks to buy default insurance on their counterparties. Like in the baseline model, the insurance is provided by an insurance fund (or a continuum of competitive ones) which face the 18 same cost of capital as banks: it has an outside option yielding Re . The insurance fund is invested in the risk-free asset. Banks have to pay the insurance premium ex ante and the default insurances have to be fully funded: insurance sellers have to be able to pay out all claimants in the bad state. The insurance fund posts prices (spreads) sj : the price at which default insurance on bank j can be purchased. One unit of default insurance contract on bank j pays out one unit if bank j defaults and zero otherwise. Banks simultaneously choose the quantity of insurance based on the posted prices. The n · n matrix of insurance coverage is denoted by I, where Iij is the default insurance bought by bank i on bank j. I assume that the existence of counterparty insurance is non-verifiable, thus the price of hedging contracts cannot be made conditional on the counterparty having default insurance on its own counterparties. In practice it is indeed hard to verify counterparty insurance, since it can easily be undone by offsetting contracts. Bondholders have seniority to equityholders and get an equal share of the proceeds from liquidating the bank. Furthermore, if the bank defaults in the interim period, all its state contingent hedging and insurance contracts are canceled without payment. Given that the expected value of every is zero at t = 1, this is their fair value. However, if banks survive until the final period once risks are realized, then they first have to settle their hedging contracts before paying back debt. These assumptions are a reasonable approximation of the practical features of U.S. bankruptcy laws regarding derivatives (Bliss and Kaufman 2006), see further discussion in Section 4.3. Timeline of events and information sets. — The timeline of events is the following. At t = 0, the initial period, bank i, using its own resources, decides on whether to invest one unit in real asset i. Then it can decide whether to leverage up using either long-term or short-term debt: one way to do this is through share repurchases. It then chooses effort level ei,0 ∈ {0, 1} and whether to sign OTC contracts to hedge their risks. At t = 1, the interim period, all market participants get the signals si for all i's. They can also observe all the hedging contracts outstanding in the market.16 If investors hold short-term debt they can decide whether to roll over the debt or collect proceeds and invest in the outside liquid asset instead. If the bank goes bankrupt because its short-term financing is not being rolled over, it has to liquidate its real project. If bank i receives continued financing, it then chooses effort ei,1 ∈ {0, 1}. At t = 2, the final period, 's are realized, real investment i yields payoff of Ri , hedging contracts are settled. Banks pay back their debt and all banks that could fulfill all their obligations, i.e. survive, get an extra non-pledgable payoff of X. Finally, all participants consume their payoffs. Entrepreneur's choice. — The entrepreneur's problem is to choose the maximum expected payout, given some constraints. The first choice is between long and short-term debt. This decision is made given the schedule of rates posted by investors. Given that in equilibrium long-term debt financing is not offered by investors due to the commitment problems in the model (see Subsection 4.2 for the proof), here I only present the choice in case of short-term debt. In case of short-term debt financing, 16 The assumption about the observability of is not necessary, it is made for simplicity. The key is that it is non-contractible. If there was an upper bound on σ, lenders would be sure that the bank has the incentives to hedge. 19 entrepreneur i's problem is to choose debt (bond) Di , equity (stock) Ki , effort levels, and OTC and default insurance contracts to maximize: (1 − π1 ) · Et=0 [max(0, Ri − Rl,1 Rl,0 Di + Ci )|A] + (9) (1 − π1 ) · (1 − π2|1 ) · X − Re · Ki − Re · j=i sj · Iij where the event A is survival at t = 1. The maximization is subject to the following constraints: (1 − π1 ) · Et=0 [max(0, Ri − Rl,1 Rl,0 Di + Ci )|A] + (10) (1 − π1 ) · (1 − π2|1 ) · X − Re · Ki − Re · j=i sj · Iij ≥ 0 1 = K i + Di (11) Et=1 [max(0, Ri − Rl,1 Rl,0 Di + Ci )] + (1 − π2|1 ) · X ≥ B1 (12) The first constraint is the participation constraint of the entrepreneur, the second one is the accounting identity that assets equal liabilities. The third constraint ensures that the bank exerts effort at t = 1 conditional on surviving. Ci is the net payoff from hedging and insurance contracts that bank i has signed. π1 is the endogenous probability that the bank goes bankrupt at t = 1. π2|1 is the probability that the bank fails at t = 2, conditional on surviving at t = 1. Rl,0 is the endogenously determined interest rate paid by the entrepreneur on its short-term debt from t = 0 to 1, while Rl,1 is that from t = 1 to 2. To receive the final payoff, both pledgable and non-pledgable, the bank has to survive both periods t = 1 and t = 2 without ending up bankrupt, this occurs with probability (1 − π1 ) · (1 − π2|1 ). The max operator makes sure that payoff at t = 2 is only taken into account if the bank can repay all its obligations. It is assumed that in case of bankruptcy, shareholders are wiped out completely, an assumption that is proved in Lemma 2. The incentive compatibility constraint at t = 0 is not spelled out: Lemma 4 shows that it is satisfied in equilibrium. Debtholder's choice. — Interest rates are determined endogenously such that investors break even. Investors anticipate the banks' equity and investment choices in equilibrium. The expected return on bank debt has to be the same as the return on the outside liquid asset with corresponding maturity. If the bank does not go bankrupt, creditors are repaid in full. In case there is a shortfall of proceeds compared to debt obligations, all creditors share equally. This means that there is no strategic interaction between them, thus liquidation only happens when it is optimal for all bondholders of that bank, i.e. there is no front-running. In general, even if the model has a good equilibrium there is a bank-run equilibrium. Following Allen and Gale (2000), I rule out the bank-run equilibrium in case there is a non bank-run equilibrium as well. I assume that debt does not carry any covenants, thus the amount of debt and the interest rate on it cannot be contingent on any given level of equity, thus the bank takes interest rates as given. However, ex post the decision whether to roll over debt can depend on the amount of equity held by the bank. This is an important simplifying assumption, since equityholders can take interest rates as 20 given when making decisions. Also, this assumption rules out long-term borrowing, since with long- term debt there is no interim decision that can be made conditional on a bank's level of equity and risk exposure. This assumption is by no means central to the results: see the discussion in Subsection 4.3. Parameter restrictions and assumptions. — The following parameter restrictions are needed in order to make the problem relevant to modeling counterparty risk in a contagious network: L>R−d>0 (13) d > B 0 + B1 (14) B1 ≥ (R − Rf,1 ) + X (15) R − B1 > Rf,1 L (16) The restriction of Equation 13 ensures that it is rational for debtholders to liquidate a project when the bank does not exert effort. This is crucial, since otherwise one would need some kind of bank-run framework to ensure contagion. While I do believe this is a possible channel, the main goal of the paper is to show that systemic crisis is possible in an entangled financial system, even without coordination issues between investors. Restriction 14 means that it is socially optimal to exert effort. Equation 15 ensures that banks have to keep at least some equity to overcome moral hazard and banks cannot operate with negative equity. Restriction 16 implies that a bank goes bankrupt if its debt is not rolled over in the interim period. To ensure that short-term borrowing is feasible, even though long-term borrowing is not, one has to place an upper limit on B0 , the private benefit from shirking in the initial period. Furthermore, to make sure that the entrepreneur's participation condition is satisfied ex ante, one has to place an upper bound on the return on the outside option to entrepreneurs. The following, not too intuitive, Assumption 1 does both. Note that the coefficient of Re is positive (by restriction 15), making Assumption 1 an upper bound on Re . Assumption 1. R + X − B1 (1 − p) · B1 > B0 + Re · 1 − (1 − p) · Rf,1 The following technical Assumption 2 is made to facilitate the solution of the model and is by no means necessary. It ensures that banks only hold the minimal amount of equity in order to roll over their debt. Assumption 2. √ 2 p·X σ≥√ · Re p π Rf,1 1 − nL − 1 Definition of equilibrium. — The equilibrium is defined as a subgame perfect Nash equilibrium of (K, D) financing decisions and effort choices (e0 , e1 ) for all banks, pairwise stable contracting choices 21 (I, O), interest rates (Rl,0 , Rl,1 ) and default insurance prices s for all banks, such that: entrepreneurs maximize expected payoff and the insurance fund and lenders break even. 4.2 Systemic run and crisis in equilibrium Equilibrium with contagion. — First, let us abstract from counterparty insurance, it is added later. Given the above parameter restrictions, I prove the existence of the following subgame perfect Nash equilibrium for an intermediate range of probabilities of the bad state. Banks choose to finance their operations using short-term debt, which is used as an incentive device to ensure prudent behavior at t = 0. Since equity is costly, banks hold equity that is just enough to make the incentive constraint satisfied to exert effort in the good state at t = 1. This means there is no slack equity to use in the bad state. When one of the banks defaults, all banks default. The defaults are driven by all short-term debtholders denying to roll over debt. Debtholders run since they know that if the neighboring bank collapses and they do not run, then the bank they lent to becomes risky because it lost one of its hedges. This increases the probability that it ends up bankrupt at t = 2 and in turn reduces the expected value of the non-pledgable payoff as of t = 1. Since the non-pledgable payoff is used as reputational collateral in the incentive constraint, the incentive constraint is now violated. Thus it is optimal for the debtholders to withdraw their funding and liquidate the project instead of letting it mature while the bank shirks. The run on the neighbors of the failing bank makes the lenders to the second neighbors weary of the incentives of their own banks and along a similar logic they also run, etc. Thus in equilibrium once the initial bank failure is known, lenders to all banks linked together rationally run: a systemic freeze in lending to banks. In the following I show, step by step, that the proposed equilibrium exists: this yields a potential microfoundation for the baseline model of Section 3. First, we conjecture that banks use short-term debt and hedge their risks. Lemma 1 calculates how much is the minimal equity needed to ensure that debt is rolled over in the interim stage given the level of riskiness of the bank's assets. Lemmas 2 and 3 prove that the contagion mechanism indeed leads to the collapse of all connected banks. Then, in Lemmas 4 and 5, I verify that short-term debt financing is chosen over long-term debt and that hedging of risks is optimal for banks. Finally, Proposition 1 shows that if the probability of the bad state is small, then banks endogenously choose to hold only the minimum amount of equity and thus the system is contagious and completely collapses in the bad state. Minimal equity needed for rolling over debt. — I conjecture that the banks use short-term debt and that they hedge their risks. I verify this in Lemmas 4 and 5. It is also assumed that in case of bankruptcy, shareholders are wiped out completely, a conjecture that is proved in Lemma 2. For notational simplicity I drop the subscript i since entrepreneurs are ex ante symmetric. Define as K(Rl,0 , σ1 ) the minimal amount of equity that needs to be held by the bank to make sure the incentive constraint is satisfied in the interim period if it holds risks of standard deviation 22 σ1 at t = 1 and borrows at the rate Rl,0 . Banks need to hold equity since creditors are worried that banks could misbehave in the interim period and collect private benefits B1 . Lemma 1. If a bank has a final payoff with expected value R and normally distributed risk σ1 as of t = 1 and is financed by short-term debt, then the minimum amount of equity to be held by this bank to avoid a withdrawal of debt financing at t = 1 is given by the following implicit equation: B1 − (R − Rf,1 Rl,0 ) − [1 − π 2|1 (Rl,0 , σ1 )] · X K(Rl,0 , σ1 ) = (17) Rf,1 Rl,0 where the endogenous probability of default at t = 2 is: Rl,1 Rl,0 [1 − K(Rl,0 , σ1 )] − R π 2|1 (Rl,0 , σ1 ) = Φ (18) σ1 and Φ denotes the cumulative density function of the standard normal distribution. The short-term ∂K rate Rl,1 charged to the bank at t = 1 is determined endogenously. Also, K(Rl,0 , σ1 ) ≥ 0 and ∂σ1 > 0. This lemma provides a microfoundation for the value of bilateral contracts in reducing equity, since K(Rl,0 , σ1 ) > 0 for σ1 > 0 and holding capital is costly. Thus if a bank looses an OTC hedging contract and has to hold its risk on its own, it needs more capital. Also note that the minimal amount of equity K is decreasing in the bank's expected non-pledgable payoff 1 − π2|1 · X. This is important since it highlights that non-pledgable payoff is crucial: it is used as "collateral" to overcome the moral hazard problem. Thus if the expected value of non-pledgable payoff decreases because of an increase in the probability of bankruptcy π2|1 , more equity is needed to ensure high effort. In fact the increase in the required amount of equity in the bad state is the main mechanism that leads to withdrawal of short-term financing. Minimal equity is not enough in the bad state. — Let us denote K h (Rl,0 ) = K(Rl,0 , 0) the amount of equity needed if the bank is fully "hedged" and analyze the case in which all bank hold equity of only K h (Rl,0 ), as if they were riskless. To show that in this case all banks collapse in the bad state, two steps are needed. First, in Lemma 2, I show that the bank, the market of which is hit in the bad state by the µ shock (bad luck), fails. As a next step, in Lemma 3, I show that if bank i collapses and leaves its counterparty, bank i + 1, unhedged, that counterparty will also suffer a run of creditors, i.e. its debt will not be rolled over and thus it too will fail. Since all banks are linked, lenders of all banks will rationally run. Lemma 2. If a bank only holds equity of K h (Rl,0 ), it goes bankrupt if its debt financing is not rolled over at t = 1. If for bank i, the signal about final payoff at t = 1 is bad (si = d), then its creditors do not roll over its debt and thus the bank has to be liquidated because it is bankrupt. The interpretation is straightforward. Consider the bank, the long-term project of which is guar- anteed to have a bad payoff, either because of the shock µ or because of an unhedged risk. It is optimal for its creditors to demand the project be abandoned and liquidated, since that is still better than 23 letting this bad project run. In fact, this is exactly the rational for short-term debt: creditors want to have the right to terminate a project if it is surely going to have a very low return e.g. when the bank did not exert sufficient effort in the initial period. Note that at this point ruling out renegotiation is important: see Subsection 4.3 for a discussion. The next step, formalized in Lemma 3, is at the heart of the contagion mechanism. If all banks hold only an equity of K h (Rl,0 ), the failure of a bank's OTC counterparty leads to a violation of its incentive constraint, since it now holds too much risk for its capital. Since it would choose to shirk, its creditors run and it is preemptively liquidated. Lemma 3. In case a bank holds equity of K h (Rl,0 ), it exerts full effort at t = 1 if both of its coun- terparties survive. However, it chooses to shirk if one or both of its counterparties defaults leaving it unhedged: its debt is not rolled over at t = 1, it goes bankrupt and its real project is liquidated. Lemma 3 highlights the main mechanism of contagion through the loss of hedging contracts. The intuition is as follows: if a bank collapses and leaves its counterparty unhedged, that bank will become more risky. Becoming more risky means that there is a larger probability of it going bankrupt at the final date of t = 2. This in turn reduces the expected value of non-pledgable payoff beyond the long run. However, non-pledgable payoff was used as collateral in the incentive problem: basically it is used by banks to be able to commit to high effort even with relatively low levels of equity. This mechanism, to my best knowledge, has not been proposed previously as a potential cause for a cascade of bank runs induced by wholesale creditors or bondholders. Choice of debt maturity and hedging. — Now I show in Lemmas 4 and 5 that -hedging and short- term borrowing is indeed the optimal choice for banks. Given the assumption that banks cannot commit to a capital structure at t = 0, long-term borrowing is not feasible. Lemma 4 below formalizes this intuition. Lemma 4. Since banks cannot commit to a given equity level at t = 0, long-term borrowing is not offered by the investors, thus entrepreneurs use short-term debt. Furthermore, they are willing to participate in the market. Long-term lending is impossible under these assumptions since if the investor has no mechanism to enforce that the bank has some level of equity and contracts at the interim period, there is no way the bank can commit to exerting effort. Once the bank has raised long-term debt it is always worthwhile to shirk and collect private benefits. Thus in this model, the short-term debt is an optimal outcome like in Calomiris and Kahn (1991) and Diamond and Rajan (2001). In practice it might be the case that using short-term debt is an inefficient outcome like in Brunnermeier and Oehmke (2009). Since I focus on the inefficiencies due to the network of hedging contracts, I choose to model short-term debt as an efficient choice. Lemma 5. For any i ∈ {1...n}, bank i completely hedges risk i with bank i + 1, and risk i−1 with bank i − 1 in case debt is short maturity. 24 The basic insight is that with short-term debt, banks are punished by higher borrowing rates, or even withdrawal of funds in the interim period, if they do not hedge their risks. Thus even though the entrepreneur's payoff is a convex function of the pledgable payoffs of the bank's operations, the entrepreneur cannot gain from shifting risk to debtholders. Furthermore, not hedging also decreases the expected value of their non-pledgable payoff, through the increased probability of bankruptcy, so all in all they lose by not hedging their risks. The Lemma also highlights the strong incentive to get entangled in these OTC hedging contracts: hedging decreases the amount of equity that has to be held in order to satisfy incentive constraints, since a hedged bank is less risky. It also makes clear that banks do not simply engage in hedging to lower the capital requirement set by the regulator: there is an underlying moral hazard issue that is the "raison d'etre" of these contracts. Contagious system in equilibrium. — Similarly as in the baseline model, a potential deviation from the proposed contagious Nash-equilibrium is that a bank chooses to hold a higher amount of equity, √ to make sure it survives the bad state. An autarchic bank holds total risk of 2σ, so the amount √ of equity it needs is: K a (Rl,0 ) = K(Rl,0 , 2σ), where "a" stands for "autarchy". Intuitively, if the probability of a systemic crisis is high, it is worth to self-insure, while if it is low, given the high costs of holding equity, no bank chooses to self-insure. Proposition 1 formalizes this intuition and gives a cut-off value in the probability of the bad state p. Proposition 1. There exists a pa > 0, such that if p < pa , then there is an equilibrium where all ˆ ˆ banks hold equity of only K h (Rl,0 ) and the system completely collapses if a single bank fails, i.e. if the h financial network is contagious. The implicit equation for pa is: ˆ a Re [K a (Rl,0 ) − K h (Rl,0 )] − π2|1 X h h ˜ ˆ p = n−1 (19) n B1 − π2|1 X ˜ The equation is implicit for the cutoff value of pa since both K a (Rl,0 ) and K h (Rl,0 ) depend on pa ˆ h h ˆ h ˜ through Rl,0 . π2|1 is the endogenous probability of bankruptcy. In the specific case where the system is contagious and all banks fail in the bad state, the endogenous short-term interest rate at 0 is: h 1 Rl,0 = Rf,1 L (20) 1−p 1− R+X−B1 Furthermore, the entrepreneurs' participation constraint holds in this equilibrium. Suboptimal counterparty insurance. — Since the shock µ in the bad state is so devastating to the system, it might be worthwhile to insure against it. However, due to the moral hazard problem, such an insurance is not possible. This also means that any policy which saves failed banks to prevent systemic crisis creates a moral hazard problem, thus relying on ex-post bailouts is not a reasonable policy in this model. Also, the initial shock is too big for banks to self-insure. 25 Lemma 6. It is not feasible to have an insurance scheme that aims at saving the bank hit directly by the shock µ (bad luck) in the bad state. Furthermore, banks do not hold enough equity on their own to survive being directly hit by the shock µ. However, insuring against the default of another bank is feasible, since it does not entail the same moral hazard problem. Under such a scheme, the banks neighboring the one that failed get a state contingent transfer to raise their equity and allow them to roll over debt. Let us denote the capital needed by a bank if it loses one of its hedges as K u (Rl,0 ) = K(Rl,0 , σ), where "u" stands for "unhedged". Since the counterparty insurance contracts in place have to be fully funded ex ante, the amount of capital set aside has to add up to 2 · [K u (Rl,0 ) − K h (Rl,0 )]. Proposition 2 contains the main results of the paper: in an intermediate range of the bad state probabilities p, counterparty insurance cannot exist in equilibrium even though it is socially optimal. Thus the inefficiency result of the simple baseline model of Section 3 carries over for the full microfounded model.17 Proposition 2. There exist thresholds pi and ps , st. pi > ps > 0 and ˆ ˆ ˆ ˆ (i) if p < ps , it is not socially optimal to insure against counterparty risk ˆ (ii) if ps ≤ p < pi , counterparty insurance is socially optimal but it cannot be sustained in equilibrium ˆ ˆ (iii) if p ≥ pi , the stable equilibrium with voluntary counterparty insurance is sustainable ˆ The implicit equations for ps and pi are: ˆ ˆ 2 Re − Rf,1 ˆ π2|1 X ps : ˆ p= · · 2 (21) ˆ n − 1 Rf,1 Rl,0 R + X − Rf,1 L − ˆ n−1 π2|1 X n − 1 Re − Rf,1 ˆ π2|1 X pi : ˆ p= · · (22) n ˆ Rf,1 Rl,0 B1 − π2|1 X ˆ ˆ ˆ the equations are implicit since Rl,0 , the endogenous interest rate at t = 0, depends on p. π2|1 is the endogenous probability that a bank goes bankrupt at t = 2 if it is the counterparty of a failed bank and got ample capital infusion through the insurance scheme to roll over its debt. A numerical example. — For illustrational purposes I give a numerical example for which all the parameter restrictions and assumptions are satisfied and the unique equilibrium is the one with systemic crisis. I use R = 1.01, Rf,1 = 1 to model that the assets of banks are not much more profitable than their liabilities. I set n = 15 to model the core of the global financial system. The non-pledgable payoff is set to X = 0.15 reflecting that the stock market value of large banks is small compared to their balance sheets. The return to early liquidation is set to L = 0.7, loss from shirking is set to d = 0.5, private benefit in the initial period to B0 = 0.05, in the interim period to B1 = 0.2. The standard deviation of risks is set to σ = 0.1. The entrepreneurs demand returns of Re = 1.25. This value might seem high but it is a long-term return over more than a year and the average annual 17 Proving pi < pa is tedious and does not provide any additional insights so it is not included in this theorem. ˆ ˆ 26 return on common equity for investment banks was 16% before the crisis.18 The probability of the bad state is chosen to be p = 0.05, corresponding to the bad state (crisis) few times a century. The resulting minimal equity share of a bank in the contagious equilibrium is K h = 0.053, which means the banks in the model work with leverage of about 20, which was not unusual for banks just before the Financial Crisis of 2007-2008. 4.3 Discussion of model assumptions and robustness In this section, I discuss some of the key assumptions of the microfounded model and also argue that the main results would still hold if some of the assumptions were relaxed. OTC contracts in bankruptcy. — A central assumption implicit in the structure of the model is that banks cannot rehedge with other banks if their counterparty fails. Even though this assumption is extreme, it captures the fact that rehedging is very costly in crisis and note that the qualitative results of my analysis would hold if rehedging were possible but costly. Evidence from the aftermath of the Lehman default suggests that even if counterparties could rehedge, they incurred huge losses,19 since they had to rehedge in a very volatile market with counterparties who were less willing to hedge away their risks. Also, many risks are specialized and thus illiquid, even more so in crisis, making them even harder to replace (Stulz 2009). Regarding the legal background of OTC contracts: Bliss and Kaufman (2006) argue that while margin accounts are not subject to automatic stay in bankruptcy, replacement costs have to be liti- gated. Counterparties can close-out contracts with a failing bank and demand the replacement value. However, if the replacement value is not covered by collateral the counterparty becomes a general creditor and is subject to the automatic stay provision in bankruptcy. Thus unless the liquidation value is high, counterparties suffer substantial losses or have to take back the risk on their balance sheets. This means that OTC counterparties basically become general creditors of the failing firm. One can take the analysis in this paper as an indication of what happens if OTC counterparties are not completely shielded from losses. If they were completely shielded and would promptly (and without any uncertainty) receive the full replacement value of their OTC contracts, crisis would not spread. This ideal world of no losses on OTC contracts does not seem to correspond to reality (there would be no need for margins otherwise), furthermore exemptions for OTC contracts are under attack from a legal perspective, see for example Edwards and Morrison (2005) and Roe (2011). Rehedging. — Why is rehedging costly from a theoretical perspective? Notice that in the equilib- rium of the model, banks do not hold excess capital. Thus if the neighbors of the failing bank wanted to reinsure their risks with other banks, these other banks would also need to have capital to sign these new -hedging contracts since they do not hold an exactly offsetting risk. Depending on how convex the function K(Rl,0 , σ1 ) is in σ1 the amount of capital needed might be similar or less than the amount of capital needed by the two banks unhedged neighbors to hold the risk on their own balance 18 "Capital spenders" in "A special report on international banking", The Economist, May 19th, 2007. 19 "Citadel Files Claim to Recover $470.5 Million", The Wall Street Journal, August 25, 2009. 27 sheet in the first place. Thus even neglecting fixed costs of establishing new hedges, rehedging is costly and banks might as well choose to keep the unhedged risks on their own balance sheets. While this result might be specific to the model, it captures the main insight that excess capital in the system is needed to be able to rehedge, making it very costly, especially when capital is scarce. From a practical perspective, it is unlikely to have excess capital in the system in bad states of the world, e.g. because this coincides with a bad macro outcome and losses on assets already deplete bank capital in the first place. Nature of OTC contracts. — A theoretical question is why only two banks can contract on each risk and how these contracts are enforced. Here I propose one way to rationalize these assumptions. Assume that the realization of is observable and thus enforceable by the court. Ex ante each bank has several types of risks which are indistinguishable from the risk for any outside bank. However, not all risks have a normal distribution like the risk , they might be skewed such that if the bank can sell this risk for price zero to another bank, it makes substantial profits. Thus except for banks i and i + 1 which can distinguish risk i risk from other risks, no other bank will be willing to buy risk i, since it is afraid of "being taken for a ride". This kind of market breakdown due to asymmetric information is akin to the lemon's problem of Akerlof (1970). Fire sales. — Another important question is whether some entrepreneurs would want to sit on the sideline to buy real assets as banks fail. However, this is not the case since entrepreneurs have a large opportunity cost and crises are relatively infrequent. Thus they would have to buy assets at huge discounts (low liquidation value) to make up for the large opportunity cost of sitting on liquid assets: liquidation in a real sense is still better. Private benefit. — The choice of using a private benefit framework instead of risk-shifting is due to two reasons. First, debt contracts are in general not optimal for a settings with risk-shifting (Biais et al. 2007), while they are optimal in case of unobservable effort that results in a shift in the distribution of the returns (Innes 1990). Second, if one looks at recent years, there is evidence for banks engaging in activities that can be modeled by private benefits: such as accounting profits being pumped out of a company in the form of dividends, equity repurchases and high bonuses before the long-term projects mature. For example, Acharya et al. (2009) show that some banks kept on paying out substantial dividends during the Financial Crisis of 2007-2008, irrespective of large losses and dwindling capital. Debt covenants. — In the model, debt does not have any covenants, thus debtholders cannot ex ante force the bank to hold a given level of equity or to sign a given contract. This assumption is used for two reasons. First, bondholders indeed have limited influence on the financing and investment choices of a large financial institution: such complete contracts are very hard to write. Second, to maintain the simplicity of the analysis: one can then ignore the effect of the firm's decisions on the interest rate it is charged by debtholders in the initial period. Even in the presence of covenants on equity choice, if the temptation to misbehave in the initial period B0 is high enough, banks still choose short-term financing and the system is contagious. 28 Runs. — The model assumes a rational run of lenders in order to emphasize that the results do not hinge on inefficient runs. Clearly the results would still hold if we allowed for inefficient runs. One possibility would be to use the dynamic model of He and Xiong (2009) where investors holding the shortest term debt run if the fundamental of a bank deteriorates or it becomes too risky, even if the bank itself is solvent. Contingent debt. — An important assumption is that in crisis short-term bondholders get the value of the liquidated real project and are not liable towards the counterparties of the failed bank. A potential alternative setup would be one in which bondholders of the failed institution are forced to pay their counterparties some compensation for the broken contract out of the liquidation value L. Since bondholders anticipate the lower payout in crisis, they would increase interest rates, leading to slightly more capital being held in the system. However, this capital is only to offset expected losses from this insurance scheme, thus it is not as costly as holding enough capital in the system to replenish balance sheets. It is less costly, since bondholders "store" the equity and then provide it in a state-contingent fashion. However, such a setup is not realistic for several reasons. First, it is not in line with current U.S. bankruptcy laws (Bliss and Kaufman 2006). Second, problems with implementing such a debt contract are similar to that in the case of renegotiation: the main benefit of a debt contract is its simplicity. Third, in a more general setting, such debt contracts give incentives to banks to contract with weak counterparties and leads to reduced market monitoring (Bergman et al. 2003). 5 Discussion and the Financial Crisis of 2008 There are three questions to answer in order to assess whether the mechanism shown in this paper is realistic in a modern financial system, in particular whether it could have contributed to the credit market freeze during the Financial Crisis of 2008. First, I consider whether each bank has only a few large counterparties. Second, I analyze whether the failure of a financial institution could lead to a run on its major counterparties. Third, I give anecdotal evidence that financial institutions do not necessarily insure against the loss of a counterparty. The results of the model show that the crucial question when deciding whether the financial system is likely to be inefficient is the density of the hedging network. Thus the regulator should collect information on the size of OTC hedging exposure of banks to assess the stability of the financial system. Unfortunately, the data on OTC hedging contracts of banks is not public. However, in early 2009, under public pressure because of the immense taxpayer funds it received, AIG did disclose the payments it made to counterparties on some OTC hedging contracts. The payments to counterparties are a good proxy of the size of OTC exposures. While the model of the paper is not about AIG, this data gives us an idea about the network structure. Table 1 shows that these payments were heavily concentrated towards a few banks, while some other major banks has almost no direct exposure to 29 AIG. The concentration of payments is strong: the top three counterparties account for about half of the payments, hinting at a sparse network. Payments (billions) cumulative counterparty CDS coll. Maiden III total total ee e e Soci´t´ G´n´ral 4.1 6.9 11.0 Goldman Sachs 2.5 5.6 8.1 Deutsche Bank 2.6 2.8 5.4 49.5% Merrill Lynch 1.8 3.1 4.9 59.4% UBS 0.8 2.5 3.3 66.1% Calyon 1.1 1.2 2.3 70.7% Barclays 0.9 0.6 1.5 73.7% total 22.4 27.1 49.5 100.0% Table 1: Payments of AIG to top counterparties: September 16 to December 31, 2008. The first column are the margin payments for credit default swaps, the second payments through the limited liability company Maiden III, in billions of US dollars. Only counter- parties receiving over 1 billion are included in the table. The last column is the cumulative payments to top counterparties and their proportion as of all payments. Payments due to securities shorting are not included. 20 There is also indirect evidence that OTC exposures could lead to contagion due to the loss of hedg- ing contracts. First, Moody's has claimed that replacement costs incurred by Lehman counterparties was a strong indirect contagion channel around the Lehman bankruptcy.21 Second, according to Table 1, some exposures to AIG were large enough to potentially prompt a run of wholesale creditors on its counterparties. For example, Goldman received payments of 11 billion by the end of the year 2008 from AIG for OTC hedges after AIG was saved by the US government and the Federal Reserve Bank on September 16, 2008. The amount of its total stockholder equity on November 30, 2007 was 42.8 billion. Thus had AIG failed and had Goldman been unable to replace these contracts, it would have incurred substantial equity losses. While Goldman claimed after the crisis that it had ample insurance against the default of AIG,22 this claim could not be verified by investors and it is disputed whether it would have covered the losses.23 My model shows that it was reasonable for investors to believe that Goldman might not have had the proper incentives to hedge. According to the data from the Depository Trust & Clearing Corporation (DTCC),24 the amount of single name CDS contracts outstanding on large institutions is relatively small.25 For example on August 28, 2009 the net notional amount of CDS outstanding on Goldman Sachs was only 5.4 billion, 21 "Credit Default Swaps and Counterparty Risk", European Central Bank, August 2009 22 "Goldman Confirms $6 Billion AIG Bets", The Wall Street Journal, March 21, 2009 23 "Goldman's Price of Protection", The Wall Street Journal, March 18, 2009 24 DTCC claims: "Trade Reporting Repository that operates and maintains the centralized global electronic database for virtually all CDS contracts outstanding in the marketplace." 25 See: www.dtcc.com/products/derivserv/suite/ps index.php, last accessed April 6, 2010. 30 only about 1% of its debt (excluding deposits and accounts payable).26 The numbers are similar for AIG, Bank of America, etc. While it is beyond the scope of this paper to do a statistical analysis of this data, in the light of these numbers, it seems unlikely that OTC counterparties of major banks were insured against their failure in 2008. The events around the default of Lehman Brothers also yields some evidence that counterparties did not have enough insurance ex ante against the default of the banks they did business with. The spike in CDS prices of major OTC counterparties can be at least partially attributed to counterparties trying to hedge their exposure and thus driving up spreads.27 6 Concluding remarks This paper develops a model of an entangled financial system where banks use OTC contracts to hedge their asset risks. In such a system, the failure of a single bank can lead to the complete collapse of the financial system as creditors run on all banks simultaneously. I show that even though banks use OTC contracts to hedge risks and thereby expose themselves to counterparty risk, they are unwilling to insure against counterparty default. The reason is a market failure: the externalities of bankruptcy inflicted on others through derivative contracts is not internalized by the banks. The paper also takes a step in clarifying the effect of entanglement: while both no entanglement and full entanglement lead to safe systems, it is partially entangled systems that are most prone to crisis and inefficiency. Based on limited data and anecdotal evidence, I draw the conclusion that the conditions for such a contagious equilibrium are realistic. Thus the results of the paper can be used to guide the regulator and further empirical research on what kind of data to gather, and to test whether the underlying assumption are indeed met in the financial system. Beyond the financial sector, the insight regarding the low ex ante choice of counterparty insurance can be extended to modeling industrial networks and trade. 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The non-pledgable payoff is conditional on not being bankrupt at t = 2 if the bank survived at t = 1: [1 − π2|1 (Rl,0 , Rl,1 , D)] · X. The left hand side of the incentive constraint, the expected total payoff to entrepreneur if he exerts effort at t = 1 is the sum of these two terms. The bank chooses K = 1 − D, s.t. the incentive constraint binds: this yields implicit equation 17 for the equity. Restriction 15 implies that K(Rl,0 , σ1 ) > 0 holds always, since Rl,0 ≥ 1. Denote the risk held by the bank at t = 1 by η ∼ N (0, σ1 ). The bank defaults in t = 2 if and only if: R + η < Rl,1 Rl,0 D. Given the normal distribution of η, the probability of default at t = 2 is as stated in the lemma. Rl,1 is determined by investors breaking even on the loan of size Rl,0 D = Rl,0 (1 − K) at t = 1: Rl,1 Rl,0 D 1 x−R Rf,1 Rl,0 D = Rl,1 Rl,0 D − (Rl,1 Rl,0 D − x) φ dx (24) −∞ σ1 σ1 where the expression on the right hand side is the nominal debt payment minus the expected shortfall due to bankruptcy. This simplifies to the following implicit expression for Rl,1 (Rl,0 , σ1 ): Rl,1 Rl,0 D − R Rl,1 Rl,0 D − R (Rl,1 − Rf,1 )Rl,0 D = σ1 · φ − (R − Rl,1 Rl,0 D) · Φ (25) σ1 σ1 34 Taking the derivatives of the three equations determining the equilibrium, one can solve for the partial derivative of interest: ∂K X Φ(x) · (R − Rl,0 Rl,1 (1 − K)) + φ(x)σ = · >0 (26) ∂σ1 Rl,0 Rf,1 σ 2 Φ(x) + σX φ(x) where (R − Rl,0 Rl,1 (1 − K)) > 0 since the pledgable income has to be larger than the total repayment on debt. This means that both the denominator and the nominator are positive, thus the partial derivative is positive. Proof of Lemma 2 A bank goes bankrupt at t = 1 if the liquidation value of the project is not enough to cover debt obligations, i.e. Rl,0 D > L. If the minimum level of equity is held, implying debt level of Dh (Rl,0 ) = 1 − K h (Rl,0 ), the condition for bankruptcy is R − B1 + X > Rf,1 L, which in turn is satisfied by restriction 16. For banks hit directly by the shock µ (bad luck), i.e. si = d, the long-term return on the real project is R − d irrespective of the bank's effort at t = 1. Bankruptcy follows from restriction 13, i.e. that R − d < L, and the investors optimally liquidate the real investment. Proof of Lemma 3 If neither of the counterparties default, exerting effort is optimal, since the incentive constraint is sat- isfied with equity K h (Rl,0 ). If one or two of the counterparties defaults, the risk of payoff (measured ∂K as of t = 1) σ1 increases. By Lemma 1 ∂σ1 > 0, so a higher level of equity would be needed to roll over debt. Debt financing is thus not rolled over and the bank goes bankrupt. Also, the change in the interest rate Rl,1 simply offsets the effects of risk shifting, thus the interest rate charged at t = 1 does not change the expected pledgable payoff of the entrepreneur at t = 1 either: the incentive constraint is only effected by the change in the expected value of non-pledgable payoff. Proof of Lemma 4 If the bank takes long-term debt without any covenants, it can simply keep no equity and exert low effort in both periods to receive private benefits of B0 + B1 . This is a lower bound on the payoff it can get from shirking. On the other hand one can derive an upper bound on payoffs if it behaves. Since equity is costly, K = 0 gives an upper bound on equity. The lower bound on interest rates from t = 0 to t = 2 is the riskless rate Rf,1 . Thus the upper bound on payoffs with behavior and long-term debt is (R − Rf,1 ) + X, which by restriction 15 is lower than B0 + B1 . Thus the bank has no incentive to exert effort with long-term debt, short-term debt is used in equilibrium. We also have to check whether short-term debt is feasible. Choosing short-term debt the bank can still choose to hold K = 0, misbehave and then go bankrupt at t = 0. The payoff from this behavior is B0 . Assuming the complete collapse of the network in the bad state, which basically gives a lower 35 bound on profits with short-term debt and exerting effort, the expected profit is: B1 − R − X E[P ] = (1 − p) · [R + X − Rf,1 Rl,0 Dh (Rl,0 )] − Re K h (Rl,0 ) = (1 − p)B1 − Re · h +1 (27) Rf,1 Rl,0 Substitute Dh (Rl,0 ) and notice that since at least some of the debt is recovered even in crisis: Rl,0 < h 1 1−p . The condition for exerting effort at t = 0 when holding short-term debt is: B1 − R − X (1 − p) · B1 − Re (1 − p) · +1 > B0 (28) Rf,1 which is satisfied by Assumption 1. Proof of Lemma 5 The first potential gain from not hedging risks is that equityholders can shift risk to debtholders. Since contracts are observable at t = 1, if the bank does not hedge, in order to shift risk to debthold- ers, it will face higher borrowing costs at t = 1 when the short-term debt is renewed, which exactly offsets the gains from risk-shifting. The second possible gain from not hedging risks that the bank avoids contagion in the bad state. When the bank's counterparty defaults on its hedging contract, there are no direct losses, contagion spreads through losing the contract itself and becoming risky. However, even when banks hold hedging contracts, they could just as well hold the same amount of equity they would have as a risky autarkic bank without hedges and be resilient to contagion. All in all, there cannot be any gain from not hedging risks, furthermore not hedging risk increases the probability of bankruptcy at t = 2, thus decreasing the expected value of non-pledgable payoff, implying that banks are not simply indifferent between hedging and not, they strictly prefer to hedge. Proof of Proposition 1 If no one holds slack equity, no single bank has the private incentive to deviate and hold equity that is just enough to survive the collapse of the rest of the system if and only if: (1 − p) · [R − Rf,1 Rl,0 Dh (Rl,0 ) + X] − Re K h (Rl,0 ) ≥ (1 − p) · [R − Rf,1 Rl,0 Da (Rl,0 ) + X]+ h h h h h n−1 n p · [R − Rf,1 Rl,0 Da (Rl,0 ) + (1 − π2|1 )X] − Re K a (Rl,0 ) h h ˜ h (29) where ˜ Rl,1 Rl,0 Da (Rl,0 ) − R h h π2|1 = Φ ˜ √ (30) 2σ The left hand side of the inequality is the expected payoff the contagious system, and the right hand side is that when the bank holds enough equity K a (Rl,0 ) to survive the bad state. Note that since h investors cannot make the ex ante interest rate conditional on equity choice, they charge the same initial interest rate to the bank that chooses to deviate and hold higher equity. A bank with equity 36 K a (Rl,0 ) only goes bankrupt if it is directly hit by the shock µ at t = 1 or in case it falls short of h paying back debts at t = 2 in case of a systemic crisis. In a systemic crisis the deviating bank is risky, ˜ even though it can roll over its debt, so the interest rate on its loan will jump to Rl,1 > Rf,1 , which is set s.t. the investors break even. Rearranging and using that the incentive constraint at t = 1 is binding yields: h h h h Re [K a (Rl,0 ) − K h (Rl,0 )] + (1 − p) · Rf,1 [Rl,0 Da (Rl,0 ) − Rl,0 Dh (Rl,0 )] h h (31) −˜2|1 X π n−1 a h ≥ n p · [R − Rf,1 Rl,0 D (Rl,0 ) + (1 − π2|1 )X] ˜ B1 rearranging we arrive at the implicit Equation 19 for pa . However, the bank could choose to hold even more equity than that needed to simply roll over its debt if it is worth to increase the probability of survival. I take the partial derivatives of Equations ∂π2|1 ˜ ∂ Rl,1 30 and 25. This gives a system of two equations with two unknowns: ∂K and ∂K . We solve for ∂π2|1 ∂K : the first equation is the marginal increase in survival probability at t = 2, in case more equity is held ex ante. The second is the expected payoff given equity K: ˜ h R−Rl,1 Rl,0 (1−K) φ σ1 ∂π2|1 1 h ∂K = − σ1 · R−Rl,1 Rh (1−K) ˜ · Rf,1 Rl,0 (32) l,0 1−Φ σ1 h E[P ] = (1 − p) · [R − Rf,1 Rl,0 · (1 − K) + X]+ (33) n−1 h n p · [R − Rf,1 Rl,0 · (1 − K) + (1 − π2|1 (K)) · X] − Re K where the second term in Equation 34 is the payoff in case the whole financial system collapses except for the one holding surplus equity. The change in E[P ] if the bank increases K over the minimum level needed for rollover: ∂E[P ] p h n−1 ∂π2|1 = 1− · Rf,1 Rl,0 − pX · − Re (34) ∂K h K=K a (Rl,0 ) n n ∂K h note that Rl,0 does not change if the bank chooses higher equity, since at t = 0 it cannot commit to higher equity. Given the costs of holding more equity, the bank will choose not to overinsure if and only if: n−1 ∂π2|1 p h h pX · − ≤ Rf,1 Rl,0 + (Re − Rf,1 Rl,0 ) (35) n ∂K n 37 ∂π2|1 Substituting ∂K , it is sufficient to show that: ˜ h R−Rl,1 Rl,0 (1−K) φ σ1 1 Re p pX · · ˜ ≤ 1− L −1 (36) σ1 h R−Rl,1 Rl,0 (1−K) Rf,1 n 1−Φ σ1 φ(x) 2 √ Given that 1−Φ(x) ≤ π for any x, and σ1 = 2σ, this holds by Assumption 2. Thus the bank does not choose to hold reserves beyond that needed to roll over debt. We now pin down the interest rate on the bond from t = 0 to 1. In the short run, investors demand expected return of 1. Given that all banks are liquidated in the bad state, the indifference condition is: 1 · Dh (Rl,0 ) = (1 − p) · Rl,0 Dh (Rl,0 ) + p · L (37) R+X−B1 Substituting Dh (Rl,0 ) = Rf,1 Rl,0 the above expression yields the interest rate stated in the lemma. Now we turn to showing that the participation constraint of the entrepreneur E[P ] > 0 is satisfied if all banks hold this minimal equity using hedging and short-term debt. The complete collapse of the network in the bad state gives a lower bound on profits. Given that the incentive constraint is binding, the expected profit is: B1 − R − X h h h E[P ] ≥ (1 − p)[R + X − Rf,1 Rl,0 Dh (Rl,0 )] − Re K h (Rl,0 ) = (1 − p)B1 − Re · h +1 (38) Rf,1 Rl,0 h 1 Since at least some of the debt is recovered even in the bad state: Rl,0 < 1−p , the condition for participation simplifies to R + X − B1 (1 − p)B1 − Re 1 − (1 − p) >0 (39) Rf,1 which is satisfied by Assumption 1, given that B0 ≥ 0. Thus entrepreneurs choose to participate. Proof of Lemma 6 Assume there is an insurance scheme in place that guarantees bank i to continue at least until t = 2 if the signal about its idiosyncratic shock was bad, i.e. si = d. Note that the insurance scheme cannot be made contingent on effort, only on this signal, which may either be due to bad luck or low effort at t = 0. Thus if a bank chooses low effort at t = 0, it is guaranteed to continue to t = 2, thus it can choose low effort again. Thus by low effort and an initial choice of equity K = K h (Rl,0 ) it can achieve payoff of B0 + B1 − Re · K h (Rl,0 ). On the other hand if it chooses high effort, the upper bound on its profits is: R − Rf,1 + X − Re · K h (Rl,0 ) where we assumed it could borrow all fund for the investment at the riskless late, and that the investment succeed with probability one. Clearly, by restriction 15, it is a profitable deviation to shirk since B0 > 0. Thus insuring against si = d is not feasible. 38 Now I show that self-insurance against the shock µ (bad luck) is never optimal for a bank. In order to survive the shock µ, the bank would have to hold surplus equity of d. Ignoring the opportunity cost of capital we get a necessary condition for self-insuring. In case of being hit by the shock, the loss from losing equity of d must be offset by the gain of surviving, i.e. the payoff to the bank after repaying debt: d < R + X − Rf,1 Rl,0 Dh (Rl,0 ) h h (40) R+X−B1 substituting Dh (Rl,0 ) = Rf,1 Rl,0 we arrive at the necessary condition d < B1 which can never hold since it contradicts the parameter restriction d > B0 + B1 (Equation 14) given that B0 > 0. Proof of Proposition 2 First, I simply assume that the counterparties of the failing bank get only enough equity to roll over debt: I show that this is indeed the case at the end of this proof. The argument follows the proof of the baseline model, so I just highlight the differences. The net opportunity cost of insurance for the ˆ ˆ bank if it fully insures is 2 · K u (Rl,0 ) − K h (Rl,0 ) · (Re − Rf,1 ). The private incentive of a single n bank to deviate from counterparty insurance, thus become uninsured in a system where the rest of the network is insured and thus stable, is: p ˆ ˆ ˆ p ˆ ˆ 1 − 3 n · R − Rf,1 Rl,0 Dh (Rl,0 ) + X − Re · K h (Rl,0 ) ≥ 1 − n · R − Rf,1 Rl,0 Dh (Rl,0 ) + X − ˆ p ˆ ˆ Re · K h (Rl,0 ) − 2 · n · π2|1 · X − ˆ 2 n · K u (Rl,0 ) − K h (Rl,0 ) · (Re − Rf,1 ) (41) where the probability of failure at t = 2 in case a bank's counterparty fails and it gets capital infusion from the insurance is: ˆ ˆ Rl,1 · Rl,0 · Du − R ˆ π2|1 = Φ (42) σ ˆ ˆ and Rl,0 is the endogenous short-term rate if all banks choose to insure and Rl,1 is the interest rate charged to the two banks that get capital injection through the default insurance contracts in the bad state at t = 1. If the bank is uninsured but all the others are insured, it goes bankrupt if either it or 3p its two counterparties are hit by the shock µ (bad luck) in the bad state, thus with probability n. By Lemma 2, if financing is withdrawn at t = 1, then the equity holder does not get anything. In case of p choosing to be insured, the term −2 · n · π2|1 · X has to be added, since even if a bank's counterparty ˆ u ˆ failed and it has K (Rl,0 ), i.e. can survive at t = 1, it may still fail at t = 2 and lose the non-pledgable payoff. Note that since the investors cannot make the interest rate they charge at t = 0 conditional on the bank insuring against counterparty default, they do not charge higher interest rates to the deviating bank. Clearly the lenders can anticipate what the bank does in equilibrium, so they charge an interest rate to break even. 39 We arrive at an implicit equation for pi , which yields Equation 22: ˆ ˆ ˆ K u (Rl,0 ) − K h (Rl,0 ) · (Re − Rf,1 ) i π2|1 · X · (Re − Rf,1 ) ˆ ˆ p : p= = (43) ˆ ˆ R − Rf,1 · Rl,0 · Dh (Rl,0 ) + X − π2|1 · X ˆ ˆ Rf,1 · Rl,0 · (B1 − π2|1 · X) ˆ Now I calculate social welfare. The expected payoff of debtholders is the same irrespective of the equilibrium, since they set interest rate to ensure they get the risk-free return in expectation. Thus we only have to look at the expected payoff of the entrepreneurs. The welfare per entrepreneur is: W = (1 − π1 ) · [R + X − Rf,1 Rl,0 D] − π2|1 X − Re K (44) where we used that creditors receive an expected return of Rf,1 at t = 1 on their investment of Rl,0 D but if the bank fails with probability π2|1 , it loses the non-pledgable payoff. Using that Rl,0 is set such that creditors break even in expectation at t = 0: D = (1 − π1 )Rl,0 D + π1 L. Substituting D = 1 − K on the left hand side and rearranging this yields: (1 − π1 )Rf,1 Rl,0 D = Rf,1 − Rf,1 K − π1 Rf,1 L (45) which we now substitute into the welfare W : W = (1 − π1 ) · (R + X) − π2|1 X + π1 Rf,1 L − Rf,1 − (Re − Rf,1 )K (46) In the insured equilibrium the probability of going bankrupt at t = 1 is that of being hit directly p by the idiosyncratic shock, π1 = n. The probability of going bankrupt at t = 2 is that of being the counterparty of the failed bank, times the conditional probability of going bankrupt with equity K u (Rl,0 ), thus π2|1 = 2 p π2|1 . The social benefits outweigh the social costs of the counterparty ˆ ˆ n insurance for the system as a whole if and only if: n · (1 − p) · [R + X] + n · p · Rf,1 · L ≤ (47) ˆ u ˆ h (n − p) · [R + X] + p · Rf,1 · L − 2 · p · π2|1 · X − 2 · K (Rl,0 ) − K (Rl,0 ) · (Re − Rf,1 ) ˆ ˆ where we simplified by nK h (Rl,0 )·(Re −Rf,1 ). The left hand side is the total welfare without insurance, while the right hand with insurance. Thus counterparty insurance is socially optimal if p > ps , where ˆ the implicit equation for ps is: ˆ ˆ ˆ K u (Rl,0 ) − K h (Rl,0 ) · (Re − Rf,1 ) s 2 p : ˆ p= · 2 (48) n−1 R + X − Rf,1 · L − n−1 · π2|1 · X ˆ ˆ ˆ π2|1 ·X ˆ where substituting K u (Rl,0 ) − K h (Rl,0 ) = ˆ yields Equation 21. Rf,1 ·Rl,0 40 Mixed strategy equilibria can be ruled out like in the baseline model. A subtle point is that if not all banks insure, then in the bad state a given portion of the network collapses. Since investors break even on debt and anticipate the equilibrium, the initial nominal interest rate Rl,0 is higher in a mixed equilibrium than in the full insurance equilibrium. This means more equity has to be held since the probability of default, ceteris paribus, increases in Rl,0 . Thus the conclusion of no mixed strategy equilibria still holds. Up to now I assumed that banks choose to buy exactly enough insurance to roll over their debt at t = 1 if their counterparty fails. Here I show that banks do not over-insure beyond this level. The expected payoff for an individual bank under the insurance scheme is: p ˆ ˆ ˆ E[P ] = 1 − n · R − Rf,1 · Rl,0 · Dh (Rl,0 ) + X − Re · K h (Rl,0 )+ (49) 2 ˆ ˆ p (Re − Rf,1 ) · n · K u (Rl,0 ) − K h (Rl,0 ) − 2 · n · π2|1 · X ˆ ˆ In the symmetric case, increasing insurance coverage for all banks is like increasing K u (Rl,0 ) in the above equation and has the following marginal effect on expected payoff: ∂E[P ] 2 2p ˆ ∂ π2|1 u = − · (Re − Rf,1 ) − ·X · (50) ∂K n n ∂K u Following the similar derivation in Proposition 1, we arrive at a sufficient (but not necessary) condition for the banks not to choose to increase the amount of insurance they buy and thus the amount of capital set aside for insurance payments: 1 2 Re p p·X · · ≤ −1 · 1− ·L (51) σ π Rf,1 n which is fulfilled by Assumption 2. 41
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