PrefBlog

The Boston Fed has released a working paper by Michael Manz, The Optimal Level of Deposit Insurance Coverage, in which a model of depositor behaviour leads to some interesting conclusions:

The model derived in this paper allows for a rigorous analysis of partial deposit insurance. The benefits of insurance involve eliminating inefficient withdrawals and bank runs due to noisy information and coordination failures, whereas the drawbacks consist of suppressing efficient withdrawals and of inducing excessive risk taking. A hitherto hardly noticed conclusion is that a high level of coverage can even be detrimental if bank risk is exogenous, because it undermines the occurrence of efficient bank runs. An extended version of the model shows that systemic risk calls for a higher level of deposit insurance, albeit only for systemically relevant banks from which contagion emanates, and not for the institutions that are potentially affected by contagion.

A vital contribution of the model is to provide comparative statics of the optimal level of coverage. In particular, the results imply that while tightening liquidity requirements is a substitute for deposit insurance, increasing transparency is not. Rather, the optimal coverage increases with the quality of the information available to depositors. Perhaps surprisingly, the degree of deposit insurance should not vary with expectations regarding the development of the real sector. This suggests that countries that in the past turned to increased or even unlimited deposit insurance as a reaction to a crisis, such as Japan, Turkey, or the United States, would do well to pause for thought on whether this is the right measure to strengthen their banking systems. The model also demonstrates why the presence of large creditors with uninsured claims calls for a lower level of insurance and why a high coverage is foremost in the interest of bankers and uninsured lenders. Moreover, it is consistent with small banks being particularly active lobbyists in favor of extending deposit insurance.

Another key advantage of the model is its applicability to various policy issues. In practice, only a small, albeit growing, number of countries maintaining deposit insurance require bank customers to coinsure a proportion of their deposits. According to the model, however, an optimal design of protection should build on coinsurance rather than on setting caps on insured deposits. It further indicates that deposit insurance becomes redundant in combination with full bailouts or optimal lending of last resort. While an unconditional bailout policy is about as inefficient as it can get, an optimal LolR policy combined with perfect public disclosure comes closest to the first best outcome in terms of welfare. Yet such an optimal policy, which requires protection to be contingent on bank solvency, seems far more demanding and hence less realistic in practice than unconditional deposit insurance. If regulators or central banks cannot precisely assess whether a bank is solvent, interventions are likely to be a mixture of the benchmark policies considered. Investigating these cases opens an interesting avenue for future research.

This paper was highlighted in the BIS Annual Report, so I had a look.

The full title of the paper is Why are Most Funds Open-Ended? Competition and the Limits of Arbitrage:

The majority of asset-management intermediaries (e.g., mutual funds, hedge funds) are structured on an open-end basis, even though it appears that the open end form can be a serious impediment to arbitrage. I argue that the equilibrium degree of open-ending in an economy can be excessive from the point of view of investors. When funds compete for investors’ dollars, they may engage in a counterproductive race towards the open-end form, even though this form leaves them ill-suited to undertaking certain types of arbitrage trades. One implication of the analysis is that, even absent short-sales constraints or other frictions, economically large mispricings can coexist with rational, competitive arbitrageurs who earn small excess returns.
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One implication of this is that the connection between arbitrageurs’ profits and overall market efficiency is very tenuous. In Example 1, the ex ante gross return to investors of 1.10 translates into a 2 percent annual alpha for professionally-managed money, assuming a five-year horizon. This looks relatively small, in keeping with the empirical evidence on the performance of fund managers. Yet this small alpha coexists with an infinitely elastic supply of the UC [Uncertain Convergence] asset, which can be thought of as having a price that deviates from fundamental value by a factor of three. Indeed, fund managers barely touch the UC asset, even though eventual convergence to fundamentals is assured, and there are no other frictions, such as trading costs or short-sales constraints. As noted in the introduction, this kind of story would seem to fit well with the unwillingness of hedge funds to bet heavily against the internet bubble of the late 1990s, by, e.g., taking an outright short position on the NASDAQ index—something which would certainly have been feasible to do at low cost from an execution/trading-frictions standpoint.
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Footnote: Brunnermeier and Nagel (2003) give a nice illustration of the risks that hedge funds faced in betting against the internet bubble. They analyze the history of Julian Robertson’s Tiger Fund, which in early1999 eliminated all its investments in technology stocks (though it did not take an outright short position). By October 1999, the fund was forced to increase its redemption period from three to six months in an effort to stem outflows. By March 2000, outflows were so severe that the fund was liquidated—ironically, just as the bubble was about to burst.
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The central point of this paper is easily stated. Asset-management intermediaries such as mutual funds and hedge funds compete for investors’ dollars, and one key dimension on which they compete is the choice of organizational form. In general, there is no reason to believe that this competition results in a form that is especially well-suited to the task of arbitrage. Rather, there is a tendency towards too much open-ending, which leaves funds unable to aggressively attack certain types of mispricing—i.e., those which do not promise to correct themselves quickly and smoothly. This idea may help to shed light on the arbitrage activities of another class of players: non-financial firms. Baker and Wurgler (2000) document that aggregate equity issuance by non-financial firms has predictive power for the stock market as a whole. And Baker, Greenwood and Wurgler (2003) show that such firms are also able to time the maturity of their debt issues so as to take advantage of changes in the shape of the yield curve. At first such findings appear puzzling. After all, even if one grants that managers have some insight into the future of their own companies, and hence can time the market for their own stock, it seems harder to believe that they would have an advantage over professional arbitrageurs in timing the aggregate stock and bond markets. However, there is another possible explanation for these phenomena. Even if managers of non-financial firms are less adept at recognizing aggregate-market mispricings than are professional money managers, they have an important institutional advantage—they conduct their arbitrage inside closed-end entities, with a very different incentive structure. For example, it was much less risky for the manager of an overpriced dot-com firm to place a bet against the internet bubble in 1999 (by undertaking an equity offering) than it was for a hedge-fund manager to make the same sort of bet. In the former case, if the market continued to rise, no visible harm would be done: the dot-com firm could just sit on the cash raised by the equity issue, and there would only be the subtle opportunity cost of not having timed the market even better. There would certainly be no worry about investors liquidating the firm as a result of the temporary failure of prices to converge to fundamentals.

There are some interesting corrollaries to the BIS desire for increased arbitrage:

• Hedge Funds are Good
• Shorting is Good
• Credit Default Swaps are Good

One wonders how much consistency we may see in their views going forward!