Collective Moral Hazard, Maturity M ismatch, and
Systemic Bailouts
Emmanuel Farhi and Jean Tirole
∗
February 17, 2011
Abstract
The paper shows that time-consistent, imperfectly targeted support to distressed
institutions makes private leverage choices strategic complements. When ev eryone
engages in maturity mismatch, authorities have little choice but intervening, creating
both current and deferred (sowing the seeds of the next crisis) social costs. In turn, it is
profitable to adopt a risky balance sheet. These insights have important consequences,
from banks choosing to correlate their risk exposures to the need for macro-prudential
supervision.
Keywords: monetary policy, funding liquidity risk, strategic complementarities,
macro-prudential supervision
JEL numbers: E44, E52, G28.
∗
Farhi: Harvard Universit y, department of Economics, Littauer 318, 1875 Cambridge Street, Cambridge
MA 02138, Tel: 617-496-1835, Fax: 617-495-8570, efarhi@fas.harv ard.edu, and Toulouse School of Economics.
Tirole: Toulouse Sch ool of Economics, Manufacture des Tabacs, 21 allees de Brienne, F-31000 Toulouse,
Phone: (33 5) 61 12 86 42, Fax: (33 5) 61 12 86 37, e-mail: tirole@cict.fr. We thank Fernando Alvarez, Markus
Brunnermeier, Doug Diamond, Luigi Guiso, John Geanak oplos, Bob Hall, Pricila Maziero, Martin Schneider,
Rob Shimer, Jeremy Stein, Nancy Stokey, and Mike Woodford. We also thank seminar participants at the
Bank of France, Bank of Spain, Bocconi, Bonn, Chicago Booth School of Business, IMF, Kellog, LSE,
Maryland, MIT, MIT Sloan School of Business, New York Fed, UCLA Anderson School Management,
University of Houston, Yale and at conferences (2010 AEA Meetings in Atlanta, Banque de France January
2009 conference on liquidity, Banque de France - Bundesbank June 2009 conference, Columbia conference on
Financial Frictions and Macroeconomic modelling, European Symposium on Financial Mark ets in Gersenzee,
SED in Montreal, XIIth Workshop in International Economics and Finance in Rio, XIIth ECB-CFS Network
conference in Rome). Jean Tirole is grateful to Banque de France and Chaire SCOR for financial support
to research at IDEI and TSE. The research leading to these results has received funding from the European
Research Council under the European Community’s Seventh Framework Programme (FP7/2007-2013)
Grant Agreement no. 249429.
Forthcoming, American Economic Review
Forthcoming, American Economic Review
One of the many striking features of the recent financial crisis is the extreme exposure of
economically and politically sensitive actors to liquidity needs and market conditions:
• Subprime borrowers were heavily exposed to interest rate conditions, which affected
their mon thly repayment (for those with adjustable rate mortgages) and conditioned
their ability to refinance (through their impact on housing prices).
• Commercial banks, which traditionally engage in transformation, had increased their
sensitivit y to market conditions. First, and arbitraging loopholes in capital adequacy
regulation, they pledged substantial amounts of off-balance-sheet liquidity support to
the conduits they designed.
1
These conduits had almost no equity on their own and
rolled over commercial paper with an average maturity under one mon th. For many
large banks, the ratio of asset backed commercial paper to the bank’s equity was
substantial (for example, in Jan uary 2007, 77.4% for Citibank and 201.1% for ABN
Amro, the two largest conduit administrators).
2
Second, on the balance sheet, the
share of retail deposits fell from 58% of bank liabilities in 2002 to 52% in 2007.
3
Third,
going forward commercial banks counted on further securitization to provide new cash.
They lost an important source of liquidity when the market dried up.
• Broker-dealers (investment banks) gained market share and became major players in
the financing of the economy. Investment banks rely on repo and commercial paper
funding much more than commercial banks do. An increase in investment banks’
market share mechanically resulted in increased recourse to market financing.
4
Theoverallpictureisoneofawide-scalematuritymismatch. Itisalsooneofsubstan-
tial systematic-risk exposure, as senior CDO tranches, a good share of which was held by
commercial banks, amounted to ”economic catastrophe bonds”.
5
This paper argues that this wide-scale transformation is closely related to the unprece-
dented intervention by central banks and treasuries.
6
Asdescribedmoreindetailwhenwe
map out the interpretation of our model in terms of actual policies, roughly two categories of
1
See e.g. Figure 2.3 (page 95) in Acharya-Ric hardson (2009), documenting the widening gap between
total assets and risk-weighted assets.
2
See Table 2.1 (page 93) in Acharya-Ric h ardson for the numbers for the 10 largest administrators.
3
Source: Federal Reserv e Board’s Flow of Funds Accoun ts.
4
Source: Federal Reserve Board’s Flow of Funds accounts.
5
To use Coval et al (2007)’s expression.
6
Strikingly, by March 2009, the Fed alone had seen its balance sheet triple in size (to $ 2.7 trillion) relativ e
to 2007.
2
interventions were pursued in order to facilitate financial institutions’ access to re financing.
For lack of better words, we term them respectively interest rate and transfer policies. By
interest rate policies, we have in mind various forms of government intervention which effec-
tively lower borrowing costs for banks: lowering the Fed Funds rate to zero, extending debt
guarantees to a wide range of financial institutions, accepting lo w-quality assets as collateral
with low haircuts in loans or repurchasing agreemen ts, purch asing commercial paper in the
primary market etc. By transfer policies, we refer to interventions that primarily boost the
net worth of financial institutions without lowering the ir borrowing cost: recapitalizations,
the purchase of legacy assets at inflated prices etc. The distinction between these two cate-
gories is sometimes blurred in practice. From our perspective, the key distinguishing feature
is whether the in tervention under consideration reduces banks’ borrowing costs or simply
acts to boost their net worth.
In a nutshell, the ce ntral argument of the paper is that private leverage ch oices depend
on the anticipated policy reaction to the overall maturity mismatch. Difficult economic
conditions call for public policy to help financial institutions weather the shock. Policy
instruments however are only imperfectly targeted to the institutions they try to rescue. For
example, the archetypal non-targeted policy, lowering the Fed Funds rate, benefits financial
institutions engaging in maturity mismatch, but its effects apply to the entire economy. An
accommodating interest rate policy involves (a) an invisible subsidy from consumers to banks
(the lower yield on savings transfers resources from consumers to borrowing institutions),
(b) current costs, such as the (subsidized) financing of unworthy projects by unconstrained
entities, and (c) differed costs (the sowing of seeds for the next crisis, both through incentives
for maturity mismatc h, going forward, and the authorities’ loss of credibility).
While the first cost is proportional to the volume of refinancing, the other two are not and
are instead akin to a fixed cost. This generates strategic complementarities in balance-sheet
riskiness choices. It is ill-advised to be in a minority of institutions exposed to the shock, as
policymakers are then reluctant to incur the ”fixed cost” associated with active interest rate
policy. By contrast, when everybody engages in m aturity transformation, the central bank
has little choice but intervening. Refusing to adopt a risky balance sheet then lowers banks’
rate of return. It is unw ise to play safely while everyone else gambles.
7
The same insight applies when some players expose themselves to liquidity risk either
7
As Charles Prince, then CEO of Citigroup, famously stated in the summer of 2007: ”as long as the
music is playing, you have to get up and dance”.
3
because they are unsophisticated
8
or because they engage in regulatory arbitrage.
9
Strategic
complementarities then manifest themselves in the increased willingness of other actors to
take on more liquidity risk due to the presence of unsophisticated players or regulatory arbi-
trageurs. A reinterpretation of our analysis is thus in terms of an amplification mechanism.
The paper’s first objective is to develop a simple framework that is able to capture and
build on these insights. Corporate entities (called ”banks”) choose their level of short-term
debt (or, equivalently, whether to hoard liquid instruments in order to meet potential liquid-
it y needs). In the basic model liquidit y shocks are correlated, and so there is macroeconomic
uncertainty. Maturity transformation is intense in the econom y when numerous institutions
take on substantial short-term debt. The issuance of short-term debt enables banks to in-
crease their leverage and investment, but exposes them to a potential refinancing problem in
case of a shock. When p rivileging leverage and scale, bankers thereby put at risk “banking
stakeholders”, a designation regrouping those agents who would be hurt in case banks have
to delever: bankers themselves, industrial companies that depend on bank loans for their
financing, and employees of those banks and industrial companies.
10
Authorities maximize a weighted average of consumer surplus and banking stakeholders’
welfare. Focusing in a first step on interest rate policy, they can, in case of an aggregate shock,
facilitate troubled institutions’ refinancing by lo wering the effective interest rate at which
banking entrepreneurs borro wing. Howeve r, loose interest rate policy, besides transferring
resources from consumers to banks with refinancing n eeds, might for example facilitate the
financing of unworthy projects (in the basic version) or entails future costs (future illiquidity
of institutions or loss of credibility). This distortion is akin to a fixedcost,whichisworth
incurring only if the size of the troubled sector is large enough. We obtain the follo wing
insights:
• Excessive maturity transformation. The central bank supplies too much liquidity in
the time-consisten t outcome. Our theory therefore brings support to the view that
authorities in the recent crisis had few options when confronted with the fait accompli,
and that the crisis should have been contained ex ante through more careful prudential
policies. While prudential supervision is traditionally concerned with the solvency of
8
Such players may for instance miscalibrate the risk involved in relying on funding liquidity or on secu-
ritization to cover their future needs, and thereby mistakenly engage in maturity mismatch.
9
As was the case with largely underpriced liquidity support to conduits.
10
Note that consumers may have multiple incarnations: As taxpayers/savers, they should oppose an
in tervention, while as employees of these corporate entities, they might welcome it. All these effects are
taken into account in our w elfare analysis.
4
individual institutions, our framework suggests the potential value of a new, macro-
prudential approac h , in whic h prudential regulators consider not only the individual
institutions’ transformation activities, but also the o verall transformation of the strate-
gic institutions.
11,12
• Optimal regulation. In our model, optimal regulation takes the form of a liquidity
requirement or equivalently of a cap on short-term debt. Importantly, breaking down
banks into smaller banks would achieve no benefit in our framework. The basic problem
here is not too big too fail, but rather that the banks as a whole are doing too muc h
maturity m ismatch, and are taking on too mu ch correlated risk.
• Regulatory pecking order. If regulation is costly, our model suggests that regulation
should be confined to a subset of key institutions, the ones that authorities are the
most tempted to bail-out ex post.
13
• Endogenous macroeconomic uncertainty. We relax the correlated-shock assumption
and let banks choose the correlation of their shock with that of other banks. We find
that they actually choose to maximize the correlation of their shocks due to the nature
of the policy response. This result runs counter to conventional wisdom. Financial
theory (CAPM) predicts that, when faced with a choice among activities, a firm will
want to take as much risk as possible in those states of nature in which the economy
is doing well. That is, it will strive to be as negatively correlated as possible with the
market portfolio.
• Sowing the seeds of the next crisis. Loose interest rate policy today increases the likeli-
hood of future crises. First, they signal the central bank’s willingness to accommodate
maturit y mismatch es, and deprive it of future credibility. Second, they stimulate new
11
Although extremely imperfect, liquidity regulation does exist at the micro level (both through stress
tests under Basel II, and through the definition of country-specific liquidity ratios).
12
These questions are at the forefront of the regulatory reform agenda. The Financial Stabilit y Forum
(2009) calls for ”a joint research program to measure funding and liquidity risk attached to maturity transfor-
mation, enabling the pricing of liquidity risk in the financial system” (Recommendation 3.2) and recommends
that ”the BIS and IMF could make available to authorities information on leverage and maturity mismatches
on a system-wide basis” (Recommendation 3.3).
13
These strategic institutions correspond to large retail banks (where size matters indirectly because of the
disruption in the payment and credit systems, or because of the greater coverage in the media), or to other
large financial institutions that are deeply interconnected with them through opaque transactions (as was
the case recently with AIG or the large investment banks). They also include those with close connections
with the central bank; in the latter respect, while starting with Barro-Gordon (1983) the literature on central
bank independence as a response to time-inconsistency has emphasized political independence, our analysis
stresses the need for independence with respect to the financial industry.
5
