Why Did Sponsor Banks Rescue their SIVs? A Signaling Model of Rescues
H/T John Carney
Bank of Italy
At the beginning of the past financial crisis sponsoring banks rescued their structured investment vehicles (SIVs) despite of lack of contractual obligation to do so. I show that this outcome may arise as the equilibrium of a signaling game between banks and their debt investors when a negative shock affects the correlated asset returns of a fraction of banks and their sponsored vehicles. The rescue is interpreted as a good signal and reduces the refinancing costs of the sponsoring bank. If banks’ leverage is high or the negative shock is sizable enough, the equilibrium is a pooling one in which all banks rescue. When the aggregate financial sector is close to insolvency, banks’ expected net worth would increase if rescues were banned. The model can be extended to discuss the circumstances in which all banks collapse after rescuing their vehicles.
Why Did Sponsor Banks Rescue their SIVs? A Signaling Model of Rescues – Introduction
The 2007-2009 financial crisis was rife with situations in which banks provided support beyond their contractual obligations to sponsored entities in the shadow banking system. A prominent example occurred in the structured investment vehicles (SIVs) industry. These off-balance sheet conduits experienced problems to refinance their maturing debt due to investors concerns on their exposure to subprime losses.1 When the whole industry was at the eve of default, most sponsor banks stepped in and rescued their SIVs even though they were not contractually obliged to do so.
Commentators and regulators attributed these and similar voluntary support decisions to the reputational concerns of the sponsors. The following quote on HSBC’s rescue of its
two SIVs is a clear example of how these events were interpreted:
“HSBC’s motivation appears to be fear of the unknown. A huge SIV failure, especially if it triggered losses for the holders of its commercial paper, would be a reputational black eye. At the extreme, the financial consequences could be an increase in the bank’s perceived riskiness as well as a higher cost of funding in the capital markets.” Financial Times, November 28, 2007 [emphasis mine].
In addition, the potential negative impact of these rescues on bank capitalization opened a debate on the regulation of implicit support and “reputational risk” in banking. And as a result there is currently a regulatory move towards limiting or prohibiting some transactions between depository institutions and their sponsored entities in the shadow banking system. In particular, both under the final implementation of the Volcker Rule in the US and of the proposals of the Vickers Commission in the UK, banks will not be allowed to give support to their sponsored unguaranteed vehicles.23 In the EU, the proposals of the Liikanen report (2012) also point towards prohibiting these forms of voluntary support.
Yet, the precise nature of the reputational risk and why voluntary support decisions may weaken the banks is not obvious. In fact, the existing literature predicts that sponsors will not give support during a severe downturn (Gorton and Souleles, 2006, Ordoñez, 2013, and Parlatore, 2013). So, why did sponsor banks rescue their SIVs? What reputation was at stake and why was it so valuable during a crisis? And finally, should regulators have intervened and banned these rescues in order to protect the banking system?
To address these questions, this paper develops a signaling model that explains banks’ voluntary rescue of their sponsored vehicles in the midst of a crisis. Although the theory may also apply to other sponsored entities such as money market funds or hedge funds, the model focuses, for concreteness, on the rescues of SIVs.4 Banks and their sponsored vehicles have long-term assets and short-term debt to be refinanced. At the initial date a negative aggregate shock affects the assets held by some of the banks and their vehicles and divides the bank-vehicle pairs into two types, say, good and bad. Crucially, the arrival of the aggregate shock is public information but the type of a pair bank-vehicle is private information of the bank. The negative shock is bad enough to trigger a run on all vehicles in spite of the fact that good vehicles are fundamentally solvent (i.e. with perfect information they would be able to refinance their debt). In this context, banks face a decision on whether to rescue their vehicles taking into account its non-trivial impact on the cost of refinancing their own debt. Banks finance these rescues by raising new debt that in the baseline model is assumed to be junior to banks’ preexisting debt.
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