A Technical Appendix
B Model Parameterization
For illustrative purposes, we decreased α and chose A so as to leave e* unchanged compared to the previous set of figures. The decrease in α raises the bailout threshold ê so that the effect of bailouts on period 0 risk-taking decisions is more pronounced and better visible.
C Data Sources
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We would like to acknowledge helpful comments and discussions with George Akerlof, Robert Bichsel, Olivier Blanchard, Claudio Borio, Maya Eden, Bruce Greenwald, Gita Gopinath, Andy Haldane, Oliver Hart, Jean Helwege, Olivier Jeanne, Bob King, Andrew Levin, Jonathan Ostry, Marco Pagano, Alexandra Peter, Goetz von Peter, Jean-Charles Rochet, Damiano Sandri, Joseph Stiglitz, Elif Ture and Razvan Vlahu, as well as participants at the CEMLA Conference on Macroprudential Policy, the CIGI/INET Conference on False Dichotomies, the 1st CSEF Conference on Finance and Labor, the 13th FDIC Bank Research Conference, the 2013 FIRS Conference, the 2012 JME-SNB-SCG Conference, the 2013 LASA Conference, the 2013 NBER Summer Institute and at seminars at the BIS, the Boston Fed, the IMF and Sveriges Riksbank. Korinek thanks the IMF and BIS Research Fellowship Programs and INET/CIGI for financial support.
An alternative and complementary assumption would be that bank managers are able to extract a significant fraction of the surplus earned by financial institutions in the form of agency rents. The redistributive implications would be the same as in our framework.
Risk-taking in the financial sector generates undesirable externalities on the real economy when losses materialize even if it is driven by traditional banking activities such as loans to Main Street. Therefore it is desirable for the real economy to impose restrictions even on such traditional activities in order to ensure a well-capitalized banking system. We analyze risky lending in more detail in appendix A.2.
For example, Wall Street banks routinely pay out up to half of their revenue as employee compensation in the form of largely performance-dependent bonuses, constituting an implicit equity stake by insiders in their firms. A considerable fraction of remaining explicit bank equity is also held by insiders. Furthermore, only 17.9% of US households hold direct stock investments, and another 33.2% hold equity investments indirectly, e.g. via retirement funds or other mutual funds. And this equity ownership is heavily skewed towards the high end of the income distribution (see Table A2a in Kennickel, 2013).
In a similar vein, it can be argued that risky borrowers (e.g. in the subprime segment) benefitted from greater bank risk-taking because they obtained more and cheaper loans.
If the equilibrium interest rate is sufficiently large that
We should also note that our benchmark model does account for the procyclicality of financial leverage, which is documented e.g. in Brunnermeier and Pedersen (2009). However, this could easily be corrected by making the parameter Φ vary with the state of nature so that Φ (Ã) is an increasing function.
Technically, when financial intermediation is unconstrained at the aggregate level because e > e*, there is a continuum of equilibrium allocations of ki since the lending spread is zero R(e) - 1 = 0 and individual bankers are indifferent between intermediating more or less. In the equation, we are reporting the symmetric level of capital intermediation k* for this case.
Observe that a financial regulator would not find it optimal to change the leverage parameter ϕ in our setup. The parameter cannot be reduced because it stems from an underlying moral hazard problem and banks would default or deviate from their optimal behavior. Similarly, it is not optimal to increase ϕ because this would tighten the constraint on financial intermediation without any corresponding benefit.
By contrast, if bankers interacted in Cournot-style competition in the period 1 market for loans, they would restrict the quantity of loans provided for a given amount of bank equity ei to min
We could further disentangle the first term for workers into a negative term corresponding to the transfers that they make and a larger positive term corresponding to the resulting increase in wages for given x.
In our framework, we assumed that default probabilities are zero in equilibrium. In practice, the interest rate subsidy typically involves not charging for expected default risk.
Since labor supply is constant, a tax on labor would be isomorphic to a lump sum transfer.