Economic Brief December 2014, EB14-12

Understanding Market Failure in the 2007–08 Crisis By Borys Grochulski and Wendy Morrison Did market failures cause the 2007–08 fi nancial crisis? While economists have made substantial progress exploring this question, the answer remains unclear. The answer is important because fi nancial regulation that does not address a specifi c market failure risks causing new ineffi ciencies and unintended consequences in the fi nancial system and broader economy. To demonstrate how economic theory can be used to identify market failures and guide policy, this Economic Brief discusses a common market failure called a “pecuniary externality” and demonstrates the pitfalls of applying regulations in situations where the precise sources of market failures are not well-understood.

In the wake of the 2007–08 fi nancial crisis, there Many observers have alleged that much of have been many calls to expand regulatory over- the volatility and external losses experienced sight in the fi nancial sector. Previously, regulation during the 2007–08 crisis resulted from market focused primarily on the health of individual failures. In particular, many fi rms faced a short- fi nancial institutions. Since the crisis, however, fall of liquidity, as demonstrated by a pervasive regulatory reform eff orts, such as the 2010 Dodd- inability to pay or roll over short-term liabilities Frank Act, have focused more on stability in the despite being arguably solvent. The illiquidity fi nancial sector as a whole, a concept known as crisis motivated several extraordinary govern- “macroprudential” or “systemic risk” regulation. ment interventions, such as the Troubled Asset Relief Program and emergency lending facili- Macroprudential regulation hinges on the ties from the Fed that a variety of fi rms, not notion of externalities, or spillovers. If a fi rm’s just commercial banks, could access. In the shareholders and creditors alone face the costs market-failure view, some fundamental market of its failure, the fi rm is likely to fully account for feature provides fi rms with insuffi cient incen- the risks of its operations, leaving no room in tive to maintain adequate liquidity. This view principle for macroprudential regulation. But if has motivated reforms since the crisis, such as fi nancial diffi culties can aff ect other companies, new minimum liquidity requirements for banks individuals, or the real economy in ways that the under section 165 of the Dodd-Frank Act. These fi rm’s stakeholders are not forced to pay for, or are the fi rst such requirements of their kind “internalize,” the fi rm may take excessive risks. for large U.S. banks, and similar measures have Those risks could make the fi nancial system too appeared around the world under the newest fragile and prone to widespread crises like the phase of the international Basel Committee one in 2007 and 2008.1 standards.

EB14-12 - Federal Reserve Bank of Richmond Page 1 Understanding the nature and magnitude of a parties do not imply a market failure. For instance, if market failure is critical to identifying and calibrat- the price of carrots increases, carrot buyers are made ing appropriate regulatory solutions. Regulations worse off as their budgets tighten, but the sellers of that are not directed at specifi c market failures risk carrots benefi t as their budget constraints are relaxed. causing new ineffi ciencies rather than eliminat- This price change, therefore, is not ineffi cient, that is, ing existing ones. This Economic Brief explores how it does not make everyone worse off . Pecuniary exter- theoretical research can be used to guide real- nalities, however, can occur if a change in a price, in world regulation. It considers one type of potential addition to aff ecting buyers’ and sellers’ budget con- market failure known as a “pecuniary externality,” straints, also aff ects the buyers’ or sellers’ incentives to which may be associated with the fi nancial system’s engage in free-riding or other opportunistic behavior. core function of maturity transformation. In a class In these situations, a price change can constitute an of theoretical models, pecuniary externalities are externality and lead to a market failure. the primary catalyst leading to underprovision of liquidity. Whether this market failure characterizes Theoretical research has identifi ed many examples real-world fi nancial markets, however, is an open of pecuniary externalities.2 One particular example question. The resulting discussion demonstrates the is the pecuniary externality that leads to underpro- diffi culties of identifying and evaluating potential vision of liquidity in the banking model developed market failures and points out how macroprudential by economists Douglas Diamond and Philip Dybvig policy designed without insight from theory may (DD).3 Given that widespread illiquidity was a core fail to solve the problem and may risk introducing catalyst of volatility and government intervention additional ineffi ciencies. during the 2007–08 fi nancial crisis, pecuniary exter- nalities have been of particular interest lately. Identifying Market Failures Aside from pursuing social goals of redistribut- In the DD model, banks help depositors attenuate ing wealth, government intervention in markets is the tradeoff between liquidity and return by invest- generally warranted only when there is a market ing the pool of deposits in the appropriate mix of failure—a situation where markets lead to ineffi cient low-return, liquid assets and high-return, illiquid as- allocations. Market failures often are caused by what sets. Despite holding illiquid assets, banks are able to economists call externalities—a situation where an off er depositors on-demand access to their funds, as, economic agent is aff ected by the actions of others typically, not all depositors will want to withdraw at not only through price changes but also directly. One the same time. Thereby, by allowing for a mismatch classic example is an industrial plant that emits pol- in the maturity of their liabilities and assets, banks lution. The plant only charges its customers enough provide depositors with liquidity insurance against to cover its private production costs, ignoring the negative shocks that create a need for immediate costs ‘paid’ by its neighbors who breathe the polluted withdrawal while still allowing them to benefi t from air. This externality will lead the factory to produce the high return produced by the part of the deposit more pollution than is socially optimal. By mandating pool invested in the illiquid assets.4 lower pollution levels or by levying a tax equal to the size of the externality, regulators may force fi rms to A pecuniary externality may arise in the DD frame- internalize the social costs of pollution, resulting in an work if illiquid fi nancial institutions have the ability, in effi cient level of emissions. the face of a shock, to trade with market participants that are more liquid. Liquid participants with no im- A “pecuniary externality” is a special type of external- mediate need for their liquidity would be willing to ity that leads to an ineffi cient market allocation even trade their liquidity because they could reap part of in situations where agents are only aff ected by the the higher returns from the illiquid institution’s port- actions of others through the resulting price changes. folio in addition to the returns from the illiquid assets Ordinarily, price changes that negatively aff ect some they hold directly. Illiquid institutions could then

Page 2 expect to take advantage of the higher returns of They allow for segmented exchanges formed on the an illiquid portfolio while counting on being able to basis of the level of liquid assets held by an institu- purchase liquidity in the market if faced with a shock tion. In order to trade in a given exchange, members while their assets are locked in illiquid investments. would be required to either hold the “right” amount of liquidity or pay a fee proportional to their deviation The possibility of this kind of retrade represents an from it. Such fees force fi nancial institutions to inter- externality because the high return off ered by the nalize the impact of their own liquidity position on illiquid institutions results in insuffi cient liquidity in the price of liquidity within the exchange. As a result, the overall fi nancial market. This is because count- the pecuniary externality vanishes and the exchange ing on market liquidity ex post, not only some but all members’ depositors realize the optimal amount of institutions prefer the illiquid portfolio position ex liquidity insurance. ante. As all actors attempt to free-ride off of market liquidity, initial investment in illiquid assets is too If the assumptions of the Kilenthong and Townsend large in the aggregate—that is, maturity mismatch model refl ect real-world fi nancial markets, then the is excessive—and the resulting resale price of these level of liquid investment provided by the market is assets is too small and the market allocation of the optimal level and government intervention via investment and liquidity is ineffi cient. This mimics minimum liquidity requirements may, at best, simply the observed real-world pattern of overinvestment crowd out market-driven solutions. At worst, liquid- followed by “fi re sales,” in which fi rms that experience ity requirements would distort outcomes and reduce losses are forced to sell assets, reducing asset prices welfare. and hurting the balance sheets of other fi rms hold- ing the same type of assets.5 At the same time, the environment described by Kilenthong and Townsend is highly specialized and Evaluating the Market Failure dependent on specifi c market-access restrictions. In theoretical models, it can be simple to design Whether this is an accurate depiction of real-world fi - regulatory solutions to market failures. For example, nancial markets must be evaluated empirically, which one possible solution to the pecuniary externality is no easy task. Depositors’ preferences for liquidity is to impose minimum liquidity requirements on are hard to measure, making it diffi cult for regulators fi nancial institutions that are perfectly calibrated to to evaluate whether institutions hold too few liquid off set the payoff from engaging in retrade. This idea assets at any given time. Given these diffi culties, and was modeled in a 2009 article by Emmanuel Farhi, others like them, economic research has not yet set- Mikhail Golosov, and Aleh Tysvinski.6 If the potential tled the question of whether pecuniary externalities for using retrading to free-ride on market liquid- are likely to have contributed to the 2007–08 crisis.8 ity leads to underinvestment in liquid assets, then mandating a minimum level of liquidity directly ad- Lessons for Policymakers dresses the externality. It is tempting for policymakers to observe high mar- ket volatility or large fi nancial losses and conclude However, one also must evaluate whether the theo- that a market failure has occurred. The presumption retical model is a good representation of real-world fi - of market failures provides a rationale for policy nancial markets. It is unclear whether this holds in the intervention, allowing policymakers to respond to pecuniary externality case. Recent theoretical work the public’s strong demand for remedy in the face of by Weerachart Kilenthong and Robert Townsend crisis. Indeed, there is a long tradition in the United suggests that market participants may be able to States of major regulatory reforms following crises.9 force insuffi ciently liquid institutions to internalize the costs of their illiquidity.7 In their model, market Although there is a wealth of theoretical research participants are capable of credibly restricting trade on market failures at the level of the individual fi rm, between institutions with diff erent levels of liquidity. there has been relatively little theoretical work on

Page 3 possible market failures that might produce macro- liquidity would be available in a crisis, causing them prudential risk.10 Another example is the aforemen- to underprice credit extended to fi rms engaging in tioned notion of fi re sales. While the possibility of maturity transformation. This is a consequence of the fi re sales may be unproblematic from a micropru- well-known “too big to fail” problem. To be sure, the dential perspective—since each individual fi rm may systemic ineffi ciencies caused by the government be responding rationally to losses—the potential safety net also are not well-explored theoretically.12 for fi re sales seems to present a source of systemic However, there is a wealth of empirical evidence in- risk. Fire sales, however, are not well-understood dicating that creditors underprice the risk of fi rms ex- theoretically, and it is hard to pinpoint the source of pected to benefi t from the government’s safety net.13 market failure and distinguish fi re sales from simply Rather than suggesting a new regulation as a remedy, a downward revision in expectations. Nonetheless, this hypothesis suggests scaling back existing explicit the threat of fi re sales motivated policy intervention and implicit policies that provide excessively risky during the crisis.11 fi rms with liquidity in a crisis. Though some observers argue that the government safety net is necessary for As the discussion of pecuniary externalities shows, fi nancial stability, it also appears to be one important regulations that are not appropriately targeted and cause of instability, leading to eff orts since the crisis calibrated risk crowding out private solutions and to scale back the safety net.14 may lead to unintended consequences. For example, heightened regulation in the traditional banking sec- In actuality, multiple issues—market failures and pol- tor is thought to have contributed to maturity trans- icy failures alike—may be present, and policymakers formation moving into the unregulated “shadow” must decide which problems they have the best hope banking sector over the past several decades. The of solving without causing new problems, which are 2007–08 fi nancial crisis largely took place within this often diffi cult to predict. Theoretical research tested shadow banking sector. against empirical evidence is the best path to crafting macroprudential regulations that may help to pre- To avoid the unintended consequences of misdirect- vent future fi nancial crises. ed regulation, economists’ starting point for regula- tory analysis is to identify whether a market failure Borys Grochulski is a senior economist in the has occurred. Economists generally do this by observ- Research Department at the Federal Reserve Bank of Richmond. Wendy Morrison is a student at the ing a problem—such as a widespread lack of liquid- University of Virginia. This article was written while ity across markets and fi rms in 2008—and trying to Morrison was an intern at the Richmond Fed. replicate that problem inside a theoretical model as a lab for evaluating policy interventions or other Endnotes solutions. Building the lab itself presents challenges, 1 See Hetzel, Robert L., “Should Increased Regulation of Bank though. Even from an economic theorist’s point of Risk-Taking Come from Regulators or from the Market?” Federal view, it is not completely clear under the current state Reserve Bank of Richmond Economic Quarterly, Spring 2009, vol. 95, no. 2, pp. 161–200. of research that pecuniary externalities could be af- 2 See, for example, Kehoe, Timothy J., and David K. Levine, fecting the liquidity of markets. On one hand, one can “Debt-Constrained Asset Markets,” Review of Economic Studies, have pecuniary externalities with private retrade, as October 1993, vol. 60, no. 4, pp. 865–888; Golosov, Mikhail, in the model by Farhi, Golosov, and Tsyvinski. On the and Aleh Tsyvinski, “Optimal Taxation with Endogenous Insur- ance Markets,” Quarterly Journal of Economics, May 2007, vol. other hand, retrade itself may not imply a pecuniary 122, no. 2, pp. 487–534; Lorenzoni, Guido, “Ineffi cient Credit externality, as Kilenthong and Townsend show. Booms,” Review of Economic Studies, July 2008, vol. 75, no. 3, pp. 809–833; Di Tella, Sebastian, “Optimal Financial Regulation This ambiguity about present market failures forces and the Concentration of Aggregate Risk,” Stanford Graduate School of Business Manuscript, July 2014. one to consider other possible causes of mass illiquid- 3 Diamond, Douglas W., and Philip H. Dybvig, “Bank Runs, Deposit ity. A competing hypothesis is that traditional govern- Insurance, and Liquidity,” Journal of Political Economy, June 1983, ment policy led creditors to believe that government vol. 91, no. 3, pp. 401–419.

Page 4 4 The DD model is perhaps most commonly used as a model 13 For example, see “Our Perspective: Too Big to Fail” on the Rich- of bank runs. For a nontechnical summary of that literature, mond Fed’s website, as well as Santos, João, “Evidence from see Ennis, Huberto M., and Todd Keister, “On the Fundamental the Bond Market on Banks’ ‘Too-Big-to-Fail’ Subsidy,” Federal Reasons for Bank Fragility,” Federal Reserve Bank of Richmond Reserve Bank of New York Economic Policy Review, March 2014, Economic Quarterly, First Quarter 2010, vol. 96, no. 1, vol. 20, no. 2. pp. 33–58. 14 For a discussion on those eff orts and how to make them suc- 5 Allen, Franklin, and Douglas Gale, “Limited Market Participa- cessful, see Lacker, Jeff rey M., “Committing to Financial Stabil- tion and Volatility of Asset Prices,” American Economic Review, ity,” Speech at the George Washington University Center for September 1994, vol. 84, no. 4, pp. 933–955. Law, Economics and Finance, Washington, D.C., November 5, 6 Farhi, Emmanuel, Mikhail Golosov, and Aleh Tsyvinski, “A Theory 2014. of Liquidity and Regulation of Financial Intermediation,” Review of Economic Studies, July 2009, vol. 76, no. 3, pp. 973–992. This article may be photocopied or reprinted in its 7 Kilenthong, Weerachart T., and Robert M. Townsend, “Informa- entirety. Please credit the authors, source, and the tion-Constrained Optima with Retrading: An Externality and Its Federal Reserve Bank of Richmond, and include the Market-Based Solution,” Journal of Economic Theory, May 2011, italicized statement below. vol. 146, no. 3, pp. 1042–1077. 8 For a detailed discussion of pecuniary externalities and mass illiquidity, see Grochulski, Borys, “Pecuniary Externalities, Seg- Views expressed in this article are those of the authors regated Exchanges, and Market Liquidity in a Diamond-Dybvig and not necessarily those of the Federal Reserve Bank Economy with Retrade,” Federal Reserve Bank of Richmond Economic Quarterly, Fourth Quarter 2013, vol. 99, no. 4, of Richmond or the Federal Reserve System. pp. 305–340. 9 See, Haltom, Renee, and Jeff rey M. Lacker, “Should the Fed Have a Financial Stability Mandate? Lessons from the Fed’s First 100 Years,” Federal Reserve Bank of Richmond 2013 Annual Report, pp. 4-25. 10 Some economists have argued that theory has played too small a role in the policymaking process. For example, in as- sessing the role of capital requirements as a component of macroprudential regulation, Douglas Gale and Franklin Allen of the University of Pennsylvania argue that “the area of fi nan- cial regulation is somewhat unique in the extent to which the empirical developments have so far outstripped theory.” 11 This point was argued in a speech by Richmond Fed President Jeff rey M. Lacker. See “Economics after the Crisis: Models, Markets, and Implications for Policy,” Speech at the Center for Advanced Study in Economic Effi ciency, Arizona State Univer- sity, Tempe, Ariz., February 21, 2014. 12 There is some theoretical evidence, however. For example, see Farhi, Emmanuel, and Jean Tirole, “Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts,” American Economic Review, February 2012, vol. 102, no. 1, pp. 60–93.

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