B07
Regulation and Taxation of Financial Markets
Discussion Papers

Discussion Paper No. 162
June 26, 2019

Heads We Both Win, Tails Only You Lose: the Effect of Limited Liability On Risk-Taking in Financial Decision Making

Authors:

Ahrens, Steffen (TU Berlin)
Bosch-Rosa, Ciril (TU Berlin)

Abstract:

One of the reasons for the recent crisis is that financial institutions took "too much risk" (Brunnermeier, 2009; Taylor et al., 2010). Why were these institutions taking so much risk is an open question. A recent strand in the literature points towards the "cognitive dissonance" of investors who, because of the limited liability of their investments, had a distorted view of riskiness (e.g., Barberis (2013); Benabou (2015)). In a series of laboratory experiments we show how limited liability does not affect the beliefs of investors, but does increase their willing exposure to risk. This results points to a simple explanation for the over-investment of banks and hedge-funds: When incentives are not aligned, investors take advantage of the moral hazard opportunities.

Keywords:

moral hazard; cognitive dissonance; behavioral finance

JEL-Classification:

C91; D84; G11; G41

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Discussion Paper No. 161
June 26, 2019

Price Dynamics and Trader Overconfidence

Authors:

Ahrens, Steffen (TU Berlin)
Bosch-Rosa, Ciril (TU Berlin)
Roulund, Rasmus (Danmarks Nationalbank)

Abstract:

Overconfidence is one of the most important biases in financial markets and commonly associated with excessive trading and asset market bubbles. So far, most of the finance literature takes overconfidence as a given, "static" personality trait. In this paper we introduce a novel experimental design which allows us to track different measures of overconfidence during an asset market bubble. The results show that overconfidence co-moves with asset prices and points towards a feedback loop in which overconfidence adds fuel to the flame of existing bubbles.

Keywords:

overconfidence; experiment; asset markets

JEL-Classification:

C91; D84; G11; G41

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Discussion Paper No. 135
December 27, 2018

Sunspots in Global Games: Theory and Experiment

Authors:

Heinemann, Frank (TU Berlin)
Moradi, Homayoon (WZB Berlin)

Abstract:

We solve and test experimentally a global-games model of speculative attacks where agents can choose whether to read, at a cost, a payoff irrelevant (sunspot) announcement. Assuming that subjects exogenously believe some others to follow sunspots, we provide conditions for a unique equilibrium where agents follow a sunspot announcement depending on the realization of an informative private signal. Although most groups converge to classical global-game strategies that neglect sunspots, we find that about one-third of groups are eventually coordinating on sunspots, which is inconsistent with the standard theory. In line with the assumption of subjects expecting others to follow sunspots, subjects overestimate the number of subjects who follow sunspots by about 100% on average. We conclude that in environments with high strategic uncertainty, payoff irrelevant signals can affect behavior even if they are costly to obtain and not expected to be publicly observed.

Keywords:

creditor coordination; global games speculative attack; sunspots

JEL-Classification:

C09; D82; F31; G12

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Discussion Paper No. 132
December 20, 2018

Overconfidence and Bailouts

Author:

Gietl, Daniel (LMU Munich)

Abstract:

Empirical evidence suggests that managerial overconfidence and government guarantees contribute substantially to excessive risk-taking in the banking industry. This paper incorporates managerial overconfidence and limited bank liability into a principal-agent model, where the bank manager unobservably chooses effort and risk. An overconfident manager overestimates the returns to effort and risk. We find that managerial overconfidence necessitates an intervention into banker pay. This is due to the bank's exploitation of the manager's overvaluation of bonuses, which causes excessive risk-taking in equilibrium. Moreover, we show that the optimal bonus tax rises in overconfidence, if risk-shifting incentives are sufficiently large. Finally, the model indicates that overconfident managers are more likely to be found in banks with large government guarantees, low bonus taxes, and lax capital requirements.

Keywords:

overconfidence; bailouts; banking regulation; bonus taxes

JEL-Classification:

H20; H30; G28; G41

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Discussion Paper No. 99
May 30, 2018

Multinational Banks in Regulated Markets: Is Financial Integration Desirable?

Authors:

Haufler, Andreas (LMU Munich)
Wooton, Ian (University of Strathclyde)

Abstract:

We set up a two-country, regional model of trade in financial services. Competitive firms in each country manufacture non-traded consumer goods in an uncertain productive environment, borrowing funds from a bank in either the home or the foreign market. Duopolistic banks can choose their levels of monitoring of firms and thus the levels of risk-taking, where the risk of bank failure is partly borne by taxpayers in the banks' home countries. Moreover, each bank chooses the allocation of its lending between domestic and foreign firms, while the bank's overall loan volume is fixed by a capital requirement set optimally in its home country. In this setting we consider two types of financial integration. A reduction in the compliance costs of cross-border banking reduces aggregate output and increases risk-taking, thus harming consumers and taxpayers in both countries. In contrast, a reduction in the costs of screening foreign firms is likely to be eneficial for banks, consumers, and taxpayers alike.

Keywords:

multinational banks; foreign direct investment; capital regulation; financial integration

JEL-Classification:

F36; G18; H81

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Discussion Paper No. 90
April 4, 2018

Monetary Policy Obeying the Taylor Principle Turns Prices Into Strategic Substitutes

Authors:

Cornand, Camille (University of Lyon)
Heinemann, Frank (TU Berlin)

Abstract:

Monetary policy affects the degree of strategic complementarity in firms pricing decisions if it responds to the aggregate price level. In normal times, when monopolistic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications.

Keywords:

monopolistic competition; monetary policy rule; pricing decisions; strategic complementarity; strategic substitutability.

JEL-Classification:

E52; C72

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Discussion Paper No. 34
May 20, 2017

Bonus Taxes and International Competition for Bank Managers

Authors:

Gietl, Daniel (University of Munich)
Haufler, Andreas (University of Munich)

Abstract:

We analyze the competition in bonus taxation when banks compensate their managers by means of fixed and incentive pay and bankers are internationally mobile. Banks choose bonus payments that induce excessive managerial risk-taking to maximize their private benefits of existing government bailout guarantees. In this setting the international competition in bonus taxes may feature a 'race to the bottom' or a 'race to the top', depending on whether bankers are a source of net positive tax revenue or inflict net fiscal losses on taxpayers as a result of incentive pay. A 'race to the top' becomes more likely when governments' impose only lax capital requirements on banks, whereas a 'race to the bottom' is more likely when bank losses are partly collectivized in a banking union.

Keywords:

bonus taxes; international tax competition; migration

JEL-Classification:

H20; H87; G28

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Discussion Paper No. 11
March 25, 2017

The Power of Sunspots: an Experimental Analysis

Authors:

Fehr, Dietmar (University of Heidelberg)
Heinemann, Frank (Technical University of Berlin)
Llorente-Saguer, Aniol (Queen Mary University of London and CEPR)

Abstract:

This paper presents an experiment on a coordination game with extrinsic random signals, in which we systematically vary the stochastic process generating these signals and measure how signals affect behavior. We find that sunspot equilibria emerge naturally if there are salient public signals. However, highly correlated private signals can also lead to sunspot-driven behavior, even when this is not an equilibrium. Private signals reduce the power of public signals as sunspot variables. The higher the correlation of extrinsic signals and the more easily they can be aggregated, the more powerful these signals are in distracting actions from the action that minimizes strategic uncertainty.

Keywords:

Coordination games; strategic uncertainty; sunspot equilibria; forward guidance; expectations

JEL-Classification:

C92; D82; D83; E39; E58

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Discussion Paper No. 7
January 24, 2017

Regulatory Competition in Capital Standards with Selection Effects Among Banks

Authors:

Haufler, Andreas (LMU Munich)
Maier, Ulf (LMU Munich)

Abstract:

Several countries have recently introduced national capital standards exceeding the internationally coordinated Basel III rules, which is inconsistent with the `race to the bottom' in capital standards found in the literature. We study regulatory competition when banks are heterogeneous and give loans to firms that produce output in an integrated market. In this setting capital requirements change the pool quality of banks in each country and inflict negative externalities on neighboring jurisdictions by shifting risks to foreign taxpayers and by reducing total credit supply and output. Non-cooperatively set capital standards are higher than coordinated ones and a `race to the top' occurs when governments care equally about bank profits, taxpayers, and consumers.

Keywords:

regulatory competition; capital requirements; bank heterogeneity

JEL-Classification:

G28; F36; H73

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