The Redistributive Effects of Financial Deregulation1 Anton Korinek

Jonathan Kreamer

Johns Hopkins and NBER

University of Maryland

Presentation at the NBER Summer Institute (EFCE) July 2013, Cambridge, MA 1

Financial support from INET is gratefully acknowledged.

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Introduction

Motivation

Motivation

Trends over the past decades: financial deregulation increasing ‘size’ of financial sector crises with devastating effects on real economy

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Introduction

Motivation

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Korinek and Kreamer (JHU and UMD)

Redistributive Effects of Deregulation

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Introduction

Motivation

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Korinek and Kreamer (JHU and UMD)

Redistributive Effects of Deregulation

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Introduction

Motivation

Motivation Deregulation allows financial sector to: take on greater risk earn higher expected return BUT: financial risk-taking can hurt the real economy: losses in financial sector capital lead to credit crunch steep declines in output, wage earnings, etc. = negative externalities on the real economy → Led to calls from Main Street for tighter regulation → Fiercely opposed by Wall Street

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Introduction

Motivation

Bank equity

Real wage bill 76

5500 75

5000 Pct. Rate

Bil. $

4500 4000 3500 3000

74 73 72

2500 2006Q3

2008Q3

2010Q3

2012Q2

71 2006Q3

Commodity price index (metals)

2008Q3

2010Q3

2012Q2

Spread on risky borrowing 6

240 5

220 Pct. Rate

Index

200 180 160 140

4 3 2

120 2006Q3

2008Q3

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2010Q3

2012Q2

1 2006Q3

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2008Q3

2010Q3

2012Q2

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Introduction

Motivation

Further Motivation

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Introduction

Contribution

Key Questions

Objective of this paper: develop a formal model to analyze: How does risk-taking by banks affect the distribution of surplus in the economy? What are the distributive effects of different financial policies? I I

restrictions on risk-taking bailouts

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Introduction

Contribution

Key Considerations

1

Financial sector is special: I

2

exclusive in its ability to intermediate capital to real economy → at the heart of a modern economy

Financial markets are incomplete: I

banks need to have skin in the game → bank capital matters

I

individuals cannot perfectly share risk → redistributions matter

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Introduction

Contribution

Key Results 1

Risk-taking by the financial sector leads to: I

externalities on the real economy when downside risk materializes (credit crunch, output collapse, ...)

I

financial sector does not internalize these when trading off risk vs. return

→ Wall Street prefers more risk than Main Street

→ distributive conflict 2

Channels that affect equilibrium risk-taking: I I I I

financial deregulation market power in the financial sector bailouts financial innovation

→ shift surplus from Main Street to Wall Street Korinek and Kreamer (JHU and UMD)

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Introduction

Contribution

Key Results 1

Risk-taking by the financial sector leads to: I

externalities on the real economy when downside risk materializes (credit crunch, output collapse, ...)

I

financial sector does not internalize these when trading off risk vs. return

→ Wall Street prefers more risk than Main Street

→ distributive conflict 2

Channels that affect equilibrium risk-taking: I I I I

financial deregulation market power in the financial sector bailouts financial innovation

→ shift surplus from Main Street to Wall Street Korinek and Kreamer (JHU and UMD)

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Introduction

Contribution

Literature Relationship to the Literature on financial regulation: traditional argument: offset moral hazard arising from safety nets e.g. Bagehot (1873), ... on optimal bank capital levels: e.g. Admati et al. (2010), Miles et al. (2012), ... on the macroeconomic effects of losses in the financial sector: e.g. Gertler and Kiyotaki (2010), Gertler and Karadi (2011), ... on incomplete markets and pecuniary externalities: e.g. Lorenzoni (2008), Korinek (2010), ...

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Benchmark Model

Model Setup

Benchmark Model

Benchmark model: two agents: I I

bankers (Wall Street): allocate capital workers (Main Street): provide labor, own firms

linear utility single homogenous good three time periods t = 0, 1, 2

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Benchmark Model

Model Setup

Benchmark Model Bankers: Period 0: I I I

born with 1 unit of capital ˜ with E[A] ˜ >1 invest fraction x ∈ [0, 1] in risky return A remainder 1 − x earns safe return 1

Period 1: I

I I I

˜ determines bank equity: return shock A ˜ + (1 − x) e = Ax raise deposits d at deposit rate r rent out k = d + e at lending rate R financial constraint as e.g. in Holmstrom-Tirole: rd ≤ φRk

Period 2 payoff: Π = Rk − rd

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Benchmark Model

Model Setup

Benchmark Model Workers: Period 1: I I I

born with large endowment of good supply ` = 1 unit of labor at wage w to firms supply d units of capital at deposit rate r to bankers

Period 2: I

receive wage bill w`, return on deposits rd and consume

Firms: collectively owned by workers Period 1: I I

rent capital k from banks at price R hire labor ` from workers at wage w

Period 2: I I

produce output F (k , `) = Ak α `1−α pay banks, workers → zero profits

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Benchmark Model

First-Best

First-Best

Maximize Total Surplus Employment ` = 1 Capital investment k ∗ s.t. Fk (k ∗ , 1) = 1 ˜ >1 Risk-taking x ∗ = 1 since E[A]

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Benchmark Model

Period 1 Equilibrium

Laissez-Faire Equilibrium: Backward Induction Period 1 and 2 Allocations for given bank equity e: First-best level of capital intermediation is feasible iff e ≥ e∗ := (1 − φ)k ∗ If e < e∗ , then k (e) is solution to implicit equation k = e + φkFk (k , 1) In summary, k 0 (e) =



1 1−φαFk

0

> 1 for e < e∗ for e ≥ e∗

→ bank equity matters for real economy when financial constraint is binding Korinek and Kreamer (JHU and UMD)

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Benchmark Model

Period 1 Equilibrium

Marginal Value of Bank Equity

Marginal value of aggregate bank equity for workers:  (1 − α)Fk · k 0 (e) for e < e∗ 0 w (e) = 0 for e ≥ e∗ Marginal value of aggregate bank equity for bankers:  (1 − φ)αFk · k 0 (e) for e < e∗ 0 π (e) = 1 for e ≥ e∗

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Benchmark Model

Period 1 Equilibrium

Marginal Value of Bank Equity Marginal value of bank capital perceived by banker i:     π1 ei , e = 1 + [R(e) − 1] · k1 ei , e =

(1 − φ)Fk 1 − φFk

Compare with bankers collectively: π 0 (e) =

(1 − φ)αFk 1 − φαFk

Note that for e < e∗ , we have: π 0 (e) < π1 (e, e) Korinek and Kreamer (JHU and UMD)

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Benchmark Model

Period 1 Equilibrium

Marginal Value of Bank Equity

π (ei,e)

s(e) w(e) π(e)

1

w’(e) π’(e)

1

0

e*

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e

0

Redistributive Effects of Deregulation

e*

e

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Benchmark Model

Period 0 Equilibrium

Period 0 Problem In period 0, bankers choose x i ∈ [0, 1] to solve:   h  i   ˜ i max Πi x i ; x = E π ei , e s.t. ei = 1 − x i + Ax x i ∈[0,1],ei

Equilibrium x LF satisfies h   i ˜ −1 =0 E π1 e i , e A

Analogous expressions for workers x W and bankers x B collectively

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Benchmark Model

Pareto Frontier

Pareto Frontier Proposition (Pareto Frontier) (i) The preferred risk allocations of workers and bankers satisfy xW < xB   (ii) Over the interval x W , x B , worker welfare W (x) is strictly decreasing in x banker welfare Π (x) is strictly increasing in x (iii) Equilibrium risk-taking satisfies: bankers collectively prefer x B > x LF if e∗ ≤ 1, workers prefer x W < x LF

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Benchmark Model

Pareto Frontier

Pareto Frontier xB

Π

xLF

W

x

W

Figure: Risk-taking by the financial sector has distributive effects Korinek and Kreamer (JHU and UMD)

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Benchmark Model

Pareto Frontier

Intuition for Distributive Conflict Consider two polar cases: 1

Model without financial constraint: I

financial intermediation does not depend on bank capital (capital imposes no pecuniary externalities)

→ no distributive conflict over risk-taking 2

Model of capitalists and workers (no intermediation/storage): I I

capitalists earn profit π = αF (e, 1) workers earn wage w = (1 − α)F (e, 1) (capital imposes symmetric pecuniary externalities on wages)

→ no distributive conflict Our framework: asymmetric externalities on the downside, but not upside occasionally binding constraints lead to redistributive conflict Korinek and Kreamer (JHU and UMD)

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Equilibrium Risk-Taking

Overview

Equilibrium Risk-Taking

Channels that affect equilibrium risk-taking: financial deregulation market power financial innovation bailouts → shift surplus from Main Street to Wall Street

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Equilibrium Risk-Taking

Financial Regulation

Financial Regulation Two simple forms of regulation of risk-taking: quantity intervention x = x¯ or ceiling x ≤ x¯ tax on risk-taking τ x

Corollary (Financial Regulation) (i) A quantity intervention x = x¯ or a tax τ x can implement any risk allocation on the Pareto frontier (ii) A risk ceiling x ≤ x¯ implements any allocation x R ≤ x LF (iii) Lowering x increases worker welfare and reduces banker welfare

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Equilibrium Risk-Taking

Financial Regulation

Pareto-Improving Deregulation? → needs to compensate workers for higher crisis risk uncontingent transfer at t = 0 or 1 doesn’t work: → tightens constraint in low states uncontingent transfer at t = 2: emulates LT debt stake, substitutes for limited pledgeability contingent transfer in good states of t = 1: emulates equity stake, substitutes for missing risk markets → could be implemented as excess profit tax/bonus tax Deregulation can only create Pareto-improvement if we can overcome one of the two financial imperfections

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Equilibrium Risk-Taking

Market Power

Market Power

Suppose there are n banks of mass 1/n −i e = n1 ei + n−1 n e Marginal value of equity is increasing in n: π1i,n (ei , e−i ) =

1 0 n−1 i i · π (e) + · π1 (e , e) n n

Large bankers worry less about credit crunches since they internalize that constraints push up lending rate R(e)

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Equilibrium Risk-Taking

Financial Innovation

Financial Innovation Important dimension of financial innovation: new assets Simplest case: initially only safe asset ˜ then introduce risky asset A I banks choose x > 0 → total surplus increases → workers unambiguously worse off (assuming e∗ ≤ 1) I I

Equivalent to deregulation (raising x¯ from 0) Holds for any innovation that raises riskiness of bank portfolio

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Equilibrium Risk-Taking

Bailouts

Bailouts In credit crunch, workers collectively benefit from bailouts: Wages w(e) increasing in aggregate bank equity ˆ is determined by Bailout threshold e w 0 (e) = F`k (k (e), 1) · k 0 (e) = 1 (marginal increase in wage bill equals marginal cost of bailout) ˆ − e} Optimal bailout transfer t(e) = max{0, e

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Equilibrium Risk-Taking

Bailouts

Bailouts Ex-Post: bailouts substitute for incomplete insurance markets but involve transfer from workers to bankers Ex-Ante: bailouts increase incentive for risk-taking (“moral hazard”) this exacerbates negative externalities on Main Street ex-ante effects often outweigh ex-post effects → bailout guarantees cause redistribution even if no monetary cost

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Equilibrium Risk-Taking

Bailouts

Pareto Frontier xB

xBL ∆ W ∆Π Π

xLF

W

x

W

Figure: Bailouts are akin to “banker-biased” technological progress Korinek and Kreamer (JHU and UMD)

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Conclusions

Conclusions Level of financial risk-taking affects the real economy: I

bank capital has characteristics of a public good

I

low bank capital has negative externalities

→ distributive conflict Financial risk-taking is affected by: 1

financial regulation/deregulation

2

market power

3

government safety nets

4

financial innovation

→ exacerbate distributive conflict

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