Contributions published at Banking (Jean-Charles Rochet)

Traditional models of sovereign debt assume that governments seek to maximize the long terminterests of their countries.We assume instead that governments borrow and default according to their own political interests. In particular they often have limited horizons and are reluctant to default strategically. This allows us to define a maximum sustainable debt to GDP ratio, and compute it as a function of the countrys fundamentals. We find that maximum sustainable debt varies a lot across countries, consistent with the notion of country specific debt (in)tolerance. Actual debt ratios are below their maximum sustainable levels, as governments seeking further terms in office fear debt-induced default that may jeopardize their prospects for reelection. The difference between actual and maximum sustainable debt ratios creates a "margin of safety" that allows governments to increase debt if necessary with little corresponding increase in default risk. The probability of default climbs precipitously once the margin of safety has been exhausted.

In this paper the decisions of a firm's manager, in terms of exposure to a profitable but risky technology, distribution of dividends and (costly) re-injection of cash to ward off bankruptcy are studied. The analysis of the manager's optimal choices is done via a value function whose state variable is the firm's current level of reserves. Contingent on whether proportional or fixed costs of reinvestment are considered, singular stochastic control or stochastic impulse control techniques are used.

In this paper the optimal consumption strategy of an investor who owns a fixed sized risky project is studied. The cash flows generated by the risky project follow an arithmetic Brownian motion, and the investor earns interest on cash reserves. The short-rate may be stochastic, and the time horizon may be finite. This results in a family of Hamilton-Jacobi-Bellman variational inequalities that include PDEs whose solutions must be approximated numerically. To do so an finite element approximation and a time marching scheme are employed.

This article examines how firms facing volatile input prices and holding some degree of market power in their product market link their risk management with their production or pricing strategies. This issue is relevant in many industries ranging from manufacturing to energy retailing, where risk averse firms decide on their hedging strategies before their product market strategies. We find that hedging modifies the pricing and production strategies of firms. This strategic effect is channelled through the risk-adjusted expected cost, i.e., the expected marginal cost under the measure induced by shareholdersrisk aversion. It has diametrically opposed impacts depending on the nature of product market competition: hedging toughens quantity competition while it softens price competition. Finally, committing to a hedging strategy is always a best response to non committing, and is a dominant strategy if firms compete à la Hotelling.

The problem of optimal investment with CRRA (constant, relative risk aversion) preferences, subject to dynamic risk constraints on trading strategies, is the main focus of this paper. Several works in the literature, which deal either with optimal trading under static risk constraints or with VaR-based dynamic risk constraints, are extended. The market model considered is continuous in time and incomplete, and the prices of financial assets are modeled by Ito processes. The dynamic risk constraints, which are time and state dependent, are generated by a general class of risk measures. Optimal trading strategies are characterized by a quadratic BSDE. Within the class of time consistent distortion risk measures, a three-fund separation result is established. Numerical results emphasize the effects of imposing risk constraints on trading.

The problem of optimal investment with CRRA (constant, relative risk aversion) preferences, subject to dynamic risk constraints on trading strategies, is the main focus of this paper. Several works in the literature, which deal either with optimal trading under static risk constraints or with VaR{based dynamic risk constraints, are extended. The market model considered is continuous in time and incomplete, and the prices of financial assets are modeled by It^o processes. The dynamic risk constraints, which are time and state dependent, are generated by a general class of risk measures. Optimal trading strategies are characterized by a quadratic BSDE. Within the class of time consistent distortion risk measures, a three{fund separation result is established. Numerical results emphasize the effects of imposing risk constraints on trading.

The majority of academic economists share the view that a corporation should serve the exclusive interests of its shareholders (shareholder value maximization). This view is fi rmly grounded on the extension, by Arrow (1953) and Debreu (1959) of the two welfare theorems to production economies with uncertainty and complete markets. This paper considers a variant of the Arrow-Debreu model where uncertainty is endogenous: probabilities of productive outcomes depend on decisions made by fi rms. In that case, a competitive equilibrium with shareholder value maximizing fi rms (capitalist equilibrium) is never Pareto optimal. This is because endogenous uncertainty implies that firms exert externalities on their consumers and their employees. When rms are stakeholder oriented, in that their managers are instructed to maximize a weighted sum of their shareholder value and of their contributions to consumer and employee welfares, the new competitive equilibrium (stakeholder equilibrium) improves upon the capitalist equilibrium.

We model a Systemically Important Financial Institution (SIFI) that is too big (or too interconnected) to fail. Without credible regulation and strong supervision, the shareholders of this institution might deliberately let its managers take excessive risk. We propose a solution to this problem, showing how insurance against systemic shocks can be provided without generating moral hazard. The solution involves levying a systemic tax needed to cover the costs of future crises and more importantly establishing a Systemic Risk Authority endowed with special resolution powers, including the control of bankers' compensation packages during crisis periods.

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Abstract When discussing the financial crisis of 2007 and 2008, the risk of banks is a central point. Yet, banks have other functions which could as well be influenced by a crisis. One main function of a bank is liquidity creation. Liquidity creation states the fact that banks trans­ form liquid liabilities into illiquid assets and create thereby liquidity for the economy. Berger and Bouwman (2009) constructed measures to state the amount of liquidity banks are creating. These measures are used to analyze the two large Swiss banks, UBS and CS, and to link the results to the capital hold by banks as well as to the finan­ cial crisis of 2007 and 2008. The outcome shows that the Swiss banks create liquidity, however, the amount varies strongly over time. The influence of the financial crises and the new regulations, resulting as a reaction of the financial crisis, can partially explain the variation but not entirely.

Early regulator interventions into problem banks is one of the key suggestions of Basel Committee on Banking Supervision. However, no guidance is given on their design. To fill this gap, we outline an incentive-based preventive supervision strategy that eliminates bad asset management in banks. Two supervision techniques are combined: temporary regulatory administration and random audits. Our design ensures good management without excessive supervision costs, through a gradual adjustment of supervision efforts to the bank's financial health. We also allow random audits to be delegated to an independent audit agency and show how to induce agency compliance with regulatory instructions in the least costly way.

Empirical evidence shows that banks tend to lend too much during booms, and too littleduring recessions. Thus, instead of dampening productivity shocks, the banking sectortends to exacerbate them, leading to excessive fluctuations of credit, output and assetprices. We propose a simple explanation for this dysfunctionality of credit markets. Thisexplanation relies on three ingredients that are characteristic of modern banks’ activities.The first ingredient is moral hazard: banks are supposed to monitor the small and mediumsized enterprises that borrow from them, but they may shirk on their monitoring activities,unless they are given sufficient informational rents. These rents limit the amount thatinvestors are ready to lend them, to a multiple of the banks’ own capital. The secondingredient is the banks’ high exposure to aggregate shocks: banks’ assets have positivelycorrelated returns. Finally the third ingredient is the ease with which modern banks canreallocate capital between different lines of business. At the competitive equilibrium ofthe financial sector, banks offer privately optimal contracts to their investors but thesecontracts are not socially optimal: banks’ decisions of reallocating capital react too stronglyto aggregate shocks. This is because banks do not internalize the impact of their decisionson asset prices. This generates excessive fluctuations of credit, output and asset prices. Weexamine the efficacy of several possible policy responses to this dysfunctionality of creditmarkets, and show that it can provide a rationale for macroprudential regulation.Keywords: Bank Credit Fluctuations, Macro-prudential Regulation, Investment Externalities.JEL: G21, G28, D86

The last two decades have been characterized by several fmancial cnses of different magnitude and intensity. Especially the last one, the subprime mortgage crisis of 2007-2009, hit the whole financial system very badly causing repercussions also on the real economy of numerous countries. There is agreement among economists on the idea that nowadays financial stability is an issue that has to be treated on an international scale. The following paper presents the new Basel accords from this perspective. The implementation of Basel III will start to see the light of the day on January 2013 and will bring, in addition to enhancing the existing microprudential rules proposed by its predecessor, a new macroprudential overlay suited for tackling global financial instabilities both on a time- and on a cross-sectional dimension. The initial part of this work on financial stability and Basel III is better accompanied by the analysis of two recent papers both of which provide precious intuitions, advices, information and recommendations on how to achieve financial stability and how to relate to the risk faced in our everyday-life's decisions, given that predicting future with certainty still remains a super-terrestrial task.

This work considers the important aspects that arose over the last three decades in relationship to the phenomenon of systemic risk. Initially, this vague concept is defined and specified, as well as a review of cases which evolved, or could have evolved, into a concrete systemic crisis is illustrated. For this purpose, the literature on qualitative and quantitative aspects of this particular problematic is surveyed. The main part of the work consists of an analysis of the sources that allow systemic risk to spread out within the financial system, causing repercussions even on the rest of the economy, touching several countries. The way the analysis is conducted refers, in a first step, to a theoretical illustration of these drivers, such as institution size and financial interlinkages. Given that, in the second step, the sources are linked to the organizations via empirical studies aimed at identifying the systemically important institutions, which would require a special supervision from a hypothetical "systemic" regulator. The presented academic papers both decompose the aggregate quantum of system-wide risk, but they adopt two different allocation procedures. These are the participation and the contribution approach, which based on their own concept of systemic relevance, lead to substantial differences in the results. Abstract This work considers the important aspects that arose over the last three decades in relationship to the phenomenon of systemic risk. Initially, this vague concept is defined and specified, as well as a review of cases which evolved, or could have evolved, into a concrete systemic crisis is illustrated. For this purpose, the literature on qualitative and quantitative aspects of this particular problematic is surveyed. The main part of the work consists of an analysis of the sources that allow systemic risk to spread out within the financial system, causing repercussions even on the rest of the economy, touching several countries. The way the analysis is conducted refers, in a first step, to a theoretical illustration of these drivers, such as institution size and financial interlinkages. Given that, in the second step, the sources are linked to the organizations via empirical studies aimed at identifying the systemically important institutions, which would require a special supervision from a hypothetical "systemic" regulator. The presented academic papers both decompose the aggregate quantum of system-wide risk, but they adopt two different allocation procedures. These are the participation and the contribution approach, which based on their own concept of systemic relevance, lead to substantial differences in the results.

Introduction The subprime crisis has shown the need for establishing new institutions, in charge of designing and implementing macro-prudential regulation : - European Systemic Risk Board in the EU, - Financial Services Oversight Council in the US,… The precise mandate of these institutions is not clear, nor are the instruments they will be able to use. This presentation proposes some preliminary thoughts on what could be done on this front.

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In this paper, optimal derivative design when multiple firms compete for heterog-enous customers is studied. Ties in the agents’ best responses generate discontinuous payoffs. Efficient tie-breaking rules are considered: In a first step, the model presented by Carlier etal. (Math Financ Econ 1:57–80,2007) is extended, and results of Page and Monteiro (J Math Econ 39:63–109, 2003, J Econ Theory 134:566–575, 2007, Econ Theory 34:503–524, 2008) are used to prove the existence of (mixed-strategies) Nash equilibria. In a second step, thecase of risk minimizing firms is studied. Socially efficient allocations are introduced, andtheir existence is proved. In particular, the entropic risk measure is considered.