ECB Lamfalussy Fellowship Wo r k i n g Pa p e r S e r i e s

Programme
N o 1 2 2 3 / j u ly 2 0 1 0

The Dark Side of

Bank Wholesale
Funding

by Rocco Huang
and Lev Ratnovski
 WO R K I N G PA P E R S E R I E S
N O 12 23 / J U LY 2010

ECB LAMFALUSSY FELLOWSHIP

PROGRAMME

THE DARK SIDE OF BANK

WHOLESALE FUNDING1
by Rocco Huang 2
and Lev Ratnovski 3

NOTE: This Working Paper should not be reported as representing

the views of the European Central Bank (ECB).
The views expressed are those of the authors
and do not necessarily reflect those of the ECB.
In 2010 all ECB
publications
feature a motif
taken from the
€500 banknote.

This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science
Research Network electronic library at http://ssrn.com/abstract_id=1311917.
1 We thank two referees of the Journal of Financial Intermediation, Viral Acharya (the editor of the Journal of Financial Intermediation),
Stijn Claessens, and Charles Kahn for very helpful comments. We also appreciate the feedback from the participants at the
Cleveland Fed Conference on Identifying and Resolving Financial Crises, Basel Committee-CEPR-JFI Workshop
on Risk Transfer Mechanisms and Financial Stability, RUG-DNB-JFS Conference on Perspectives on Financial Stability,
CREDIT (Venice), IMF-World Bank conference on Risk Analysis and Risk Management, Bank of Canada workshop
on Securitized Instruments, CesIfo- Bundesbank conference on Risk Transfer, Federal Reserve System Committee on
Financial Structure and Regulation, European Banking Center conference on Financial Stability, and
American Economic Association Annual Meeting (2010). Ratnovski is grateful to the ECB for
financial support through its Lamfalussy Fellowship. The views expressed in this paper are those of the
authors and do not necessarily represent those of the International Monetary Fund,
the Federal Reserve Bank of Philadelphia, or the Federal Reserve System.
2 Federal Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106-1574, USA;
e-mail: rocco.huang@phil.frb.org
3 International Monetary Fund, 700 19 th St NW, Washington DC 20431, USA; e-mail: lratnovski@imf.org
 Lamfalussy Fellowships

This paper has been produced under the ECB Lamfalussy Fellowship programme.
This programme was launched in 2003 in the context of the ECB-CFS Research
Network on “Capital Markets and Financial Integration in Europe”. It aims at
stimulating high-quality research on the structure, integration and performance of the
European financial system.

The Fellowship programme is named after Baron Alexandre Lamfalussy, the first
President of the European Monetary Institute. Mr Lamfalussy is one of the leading
central bankers of his time and one of the main supporters of a single capital market
within the European Union.

Each year the programme sponsors five young scholars conducting a research project
in the priority areas of the Network. The Lamfalussy Fellows and their projects are
chosen by a selection committee composed of Eurosystem experts and academic
scholars. Further information about the Network can be found at http://www.eu-
financial-system.org and about the Fellowship programme under the menu point
“fellowships”.

© European Central Bank, 2010

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ISSN 1725-2806 (online)

CONTENTS
Abstract 4
Non-technical summary 5
1 Introduction 7
2 The bright side of wholesale funding 12
2.1 Model 12
2.2 Retail deposits only 15
2.3 Wholesale funds: welfare maximization 15
2.4 Wholesale funds: private equilibrium 16
3 The dark side of wholesale funding 18
3.1 Welfare maximization 19
3.2 Incentives of the wholesale financier 20
3.3 Incentives of the bank 23
4 Discussion 26
5 Conclusion 28
Proofs 29
References 35
Figures 37

ECB
Working Paper Series No 1223
July 2010 3
 Abstract

Banks increasingly use short-term wholesale funds to supplement traditional re-

tail deposits. Existing literature mainly points to the "bright side" of wholesale
funding: sophisticated …nanciers can monitor banks, disciplining bad but re…nanc-
ing good ones. This paper models a "dark side" of wholesale funding. In an envi-
ronment with a costless but noisy public signal on bank project quality, short-term
wholesale …nanciers have lower incentives to conduct costly monitoring, and instead
may withdraw based on negative public signals, triggering ine¢ cient liquidations.
Comparative statics suggest that such distortions of incentives are smaller when
public signals are less relevant and project liquidation costs are higher, e.g., when
banks hold mostly relationship-based small business loans.
JEL Classi…cation: G21, G28, G33
Keywords: Financial Crises, Liquidity Risk, Wholesale Funding, Regulation

ECB
Working Paper Series No 1223
4 July 2010
 Non-technical summary

Banks increasingly use short-term wholesale funds to supplement retail deposits.

Through wholesale money markets, they attract cash surpluses from nonfinancial
corporations, households (via money market mutual funds), other financial institutions,
foreign entities, etc. How should this shift in the funding structure affect bank performance
and stability?
The existing banking literature has so far mainly pointed to the "bright side" of
wholesale funding: exploiting valuable investment opportunities without being constrained
by the local deposit supply, the ability of the providers of wholesale funds to provide market
discipline and to refinance unexpected retail withdrawals. However, these benefits were
clearly not realized in the recent mortgage banking crisis. Indeed, the crisis demonstrated
how banks can use wholesale funds to aggressively expand lending and compromise credit
quality, particularly when financiers exercise insufficient market discipline. Later, at the
refinancing stage, there is a risk that the providers of wholesale funds abruptly withdraw
upon a hint of negative news, triggering inefficient liquidations.
This paper attempts to reconcile the traditional view on the virtues of wholesale
funding with its potentially negative effects. The key insight we suggest is that wholesale
funding is beneficial when informed, but may lead to inefficient liquidations when
uninformed. We study the incentives of the providers of wholesale funds to become
informed, the choices of uninformed providers of wholesale funds of whether to refinance or
liquidate of a bank, and bank choices of whether to use short-term (and potentially
uninformed) wholesale funding.
In the key result of the paper, we show that the incentives of wholesale financiers to
monitor banks and impose market discipline can become distorted in the presence of a free
but noisy public signals on bank project quality. Examples of such signals include market
prices or credit ratings for traded assets (e.g., mortgage-backed securities), performance of
other similar banks, or various market- or sector-wide indicators (e.g., house or energy
prices). We show that the presence of such a signal:
ƒ Lowers the incentives of the providers of wholesale funds to monitor banks;

ECB
Working Paper Series No 1223
July 2010 5
 ƒ Gives the providers of wholesale funds excess incentives to liquidate banks based
on noisy public information;
ƒ Importantly, these distortions become stronger when the providers of wholesale
funds are more senior claimants to the liquidated assets – representing the cases of
short-term and/or collateralized funding.
These distortions also become stronger when public signal on bank quality become
more precise (but not too precise). The availability of relevant public information likely
depends on the type of assets that the bank holds. For example, while the market prices of
mortgage-backed securities (MBS) or house price changes can shed light on the
fundamentals of a typical mortgage bank, few similarly relevant public signals exist for
traditional banks that hold mainly relationship-based small business loans. The signal
precision can also be interpreted as the correlation between an individual bank's
fundamentals with system-wide outcomes or indicators. With the proliferation of "risk
transfer" and "risk dispersion" mechanisms, individual bank performances have become
increasingly correlated, so that public signals now provide more relevant information on an
individual bank's performance.
In a bank cross-section, our results suggest that the use of senior short-term funds is
likely to be beneficial in "traditional" banks that hold mainly opaque and nontradable
relationship loans, consistent with the traditional "bright side" view on sophisticated
wholesale funding. Yet the "dark side" negative effects of wholesale funding are likely to
play a significant role in banks with large exposures to standardized and tradable arm's length
assets with readily available public information, particularly when the providers of wholesale
funds are senior claimants.

ECB
Working Paper Series No 1223
6 July 2010
1 Introduction

Banks increasingly borrow short-term wholesale funds to supplement retail deposits

(Feldman and Schmidt, 2001). Through wholesale money markets, they attract cash

surpluses from non…nancial corporations, households (via money market mutual funds),

other …nancial institutions, etc. Wholesale funds are usually raised on a short-term

rollover basis with instruments such as large-denomination certi…cates of deposits, bro-

kered deposits, repurchase agreements, Fed funds, and commercial paper.

The existing literature mainly points to the "bright side" of wholesale funding: ex-

ploiting valuable investment opportunities without being constrained by the local deposit

supply, the ability of wholesale …nanciers to provide market discipline (Calomiris, 1999)

and to re…nance unexpected retail withdrawals (Goodfriend and King, 1998). However,

some of these bene…ts were not realized in the recent mortgage banking crisis (Acharya

et al., 2008; Huang and Ratnovski, 2009). Indeed, the crisis demonstrated how banks

can use wholesale funds to aggressively expand lending and compromise credit quality,

particularly when …nanciers exercise insu¢ cient market discipline. Later, at the re…-

nancing stage, there is a risk that wholesale …nanciers abruptly withdraw upon a hint

of negative news, triggering ine¢ cient liquidations.

This paper attempts to reconcile the traditional view on the virtues of wholesale

funding with its potentially negative e¤ects. The key insight we suggest is that whole-

sale funding is bene…cial when informed, but may lead to ine¢ cient liquidations when

uninformed. Formally, we consider a bank that …nances a risky long-term project with

two sources of funds: retail deposits and wholesale funds. Retail deposits are sluggish,

insensitive to risks (partly because they are insured), and provide a stable source of

long-term funding.1 Wholesale funds are relatively sophisticated, since their providers
1
The "sluggishness" of retail deposits is a well-established stylized fact (Feldman and Schmidt, 2001;
Song and Thakor, 2007). Retail deposits are typically insured by the government. Their withdrawals
are motivated mostly by individual depositors’ liquidity needs and thus are predictable based on the
law of large numbers. Another reason for the "sluggishness" is the high switching costs associated with
transaction services that retail depositors receive from banks (Kim et al., 2003; Sharpe, 1990, 1997).
As a result, although some accounts are formally demandable, retail deposits provide a relatively stable
source of long-term funds for banks. However, the local retail deposit base is quasi-…xed in size, since it is
usually prohibitively expensive to expand it in the medium term (Billett and Gar…nkel, 2004; Flannery,

ECB
Working Paper Series No 1223
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ECB
Working Paper Series No 1223
July 2010 11
 seniority can reduce monitoring and encourage ine¢ cient liquidations. Social welfare

is constrained-maximized for an intermediate level of seniority, which depends on the

bank’s funding structure (i.e., share of passive retail deposits on the liability side), the

precision of public signals on bank project quality (which often depends on the type

of assets held), liquidation value of bank assets, and interest rates o¤ered to wholesale

…nanciers. This is a novel result that usefully contrasts with CK and bears close resem-

blance to recent developments in the credit market, as well as some earlier instances of

bank failures. It reveals the "dark" side of short-term wholesale funding.

The rest of the paper is structured as follows. Section 2 sets up the benchmark

CK-type model of the "bright side" of wholesale bank funding. Section 3 introduces

the costless but noisy signal on bank project quality and analyzes the "dark side" of

wholesale funding. Section 4 discusses some features of our model and brie‡y outlines

policy insights. Section 5 concludes.

2 The Bright Side of Wholesale Funding

2.1 Model

We start by outlining a version of the Calomiris and Kahn (1991) model, which we use

to describe a benchmark "bright side" of bank wholesale funding. Consider an economy

consisting of a bank (with access to an investment project) and two types of …nanciers:

retail and wholesale. There are three dates (0; 1; 2), no discounting, and everyone is

risk-neutral.

The project A bank has exclusive access to a pro…table but risky long-term project.

For each unit invested at date 0, at date 2 the project returns X with probability p or

0 with probability 1 p, with a positive net present value: Xp > 1. The project may

also be liquidated at date 1 returning L < 1 per unit initially invested. The maximum

investment size is 1.

ECB
Working Paper Series No 1223
12 July 2010
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ECB
Working Paper Series No 1223
July 2010 13
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ECB
Working Paper Series No 1223
14 July 2010
bank and the wholesale …nancier are the socially optimal ones.

2.2 Retail deposits only

Consider a bank funded by retail deposits only. The initial investment D is lower

than the maximum possible investment size of 1; such spare capacity is ine¢ cient,

because the bank’s project has a positive net present value. Furthermore, the bank

always continues until date 2: the bank prefers continuation, while retail depositors are

uninformed and passive. This means that bad projects are not terminated at date 1 (to

preserve liquidation value L) but continue until date 2, returning 0. This is the second

source of ine¢ ciency. The monetary value of social welfare when the bank is …nanced

with retail deposits only is:

Dep = D(pX 1): (2)

2.3 Wholesale funds: Welfare maximization

Now consider a bank that also uses W of wholesale funds. In this section, we derive the

socially optimal monitoring and continuation decisions of the wholesale …nancier and

the amount of wholesale funds attracted by a bank.

Consider …rst the continuation decision. If monitoring produces precise information

on date 2 project return, a good bank should be re…nanced at date 1 (X > L) while a

bad one should be liquidated (L > 0). When monitoring yields no information, so that

project quality is unknown, a bank should be re…nanced, since Xp > L.

The optimal intensity of monitoring, m , and the optimal use of wholesale funds,

W , are obtained by maximizing the monetary value of social welfare:

= (D + W ) (pX + m(1 p)L 1) C(m): (3)

This yields the maximum possible amount of wholesale funds, so that the complete

ECB
Working Paper Series No 1223
July 2010 15
 initial investment 1 is undertaken:

W =1 D;

and m given by:

C 0 (m ) = (1 p)L: (4)

Comparing (2) and (3) highlights the bene…cial e¤ects of the use of wholesale funds:

higher investment volume D + W = 1 instead of D, and the preservation of some bad

banks’liquidation value m (1 p)L at the cost of monitoring C(m ).

2.4 Wholesale funds: Private equilibrium

We now study the private choices of the wholesale …nancier and the bank, and compare

the choices with the social optimum.

Wholesale …nancier Between dates 0 and 1, the wholesale …nancier chooses the

intensity of monitoring, and then observes the outcome of his monitoring. Then, at date

1, he chooses whether to re…nance or liquidate the bank. The …nancier’s continuation

decision is in line with the social optimum: when monitoring yields precise information

on project quality, he has incentives to re…nance a good bank (W R > sL(D + W )) and

liquidate a bad one (sL(D + W ) > 0). When monitoring yields no information, the

wholesale …nancier rolls over funding, since, by (1), pW R > sL(D + W ).

In choosing the intensity of monitoring m, the …nancier maximizes:

W
= pW R + m(1 p)sL(D + W ) C(m);

which obtains the private choice of mW , given by:

C 0 (mW ) = (1 p)sL(D + W ): (5)

ECB
Working Paper Series No 1223
16 July 2010
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ECB
Working Paper Series No 1223
July 2010 17
 s = s , m = m , and only a bank known by the wholesale …nancier to be a bad one is

liquidated.

3 The Dark Side of Wholesale Funding

We now turn to the analysis of the "dark side" of bank wholesale funding. In this section

we show how a plausible change to the "bright side" CK-style setup of Section 2 can

signi…cantly alter its results.

We introduce an additional source of information: a free but noisy public signal on

date 2 project realization, which the wholesale …nancier receives prior to date 1 but

after he has made a decision on the intensity of monitoring. The wholesale …nancier

can use this signal when his own monitoring yields no information (either because of

the low intensity of monitoring or merely by bad luck). Although the signal is free, it is

complex, and therefore not received by retail depositors.

We specify the signal to have the same distribution of outcomes as that of the

underlying project. It takes two values: "positive" or "negative" and is characterized

by a precision parameter (0 1; = 0 for complete noise and = 1 for precise

information). The probability of receiving a positive signal is p (the same as that for X

at date 2). Conditional on this, the probability of getting X at date 2 is [p + (1 p)],

and that of getting 0 is [(1 p) (1 p)]. The probability of a negative signal is 1 p.

Conditional on this, the probability of getting X at date 2 is [p p], and that of getting

0 is [(1 p) + p].

We show that such a relatively minor twist can generate outcomes contrasting to

those of the CK-style setup. Previously, the wholesale …nancier always re…nanced the

bank at date 1 if his private monitoring yielded no information. That was consistent

with both his private incentives and welfare maximization. Now, with the introduction

of the signal described above, the wholesale …nancier has lower incentives to monitor

and excess incentives to liquidate the bank based on noisy public information.

ECB
Working Paper Series No 1223
18 July 2010
3.1 Welfare maximization

We start by outlining the benchmark socially optimal decisions on monitoring, re…nanc-

ing, and the use of wholesale funds in the presence of a free but noisy signal on bank

project quality.

Re…nancing at date 1 When the wholesale …nancier’s monitoring before date 1

produces precise information on project quality, the noisy public signal cannot add

information. As before, a good bank will be re…nanced and a bad one, liquidated.

Without the noisy signal, continuation at date 1 is always optimal when private

monitoring produces no information on project quality. The noisy signal re…nes date 1

expectations of date 2 project outcome. When a noisy signal is positive, the posterior

of date 2 project success increases to p + (1 p), so it naturally remains optimal

that the bank is re…nanced at date 1. However, when a noisy signal is negative, the

posterior of project success falls to [p p], and the optimal continuation decision starts

to depend on the signal’s precision, . If the precision is low so that [p p] pX L,

it remains optimal to re…nance the bank. However, if precision is high enough so that

[p p] pX < L, it becomes socially optimal to liquidate the bank based solely on a

noisy signal. The threshold value of is:

L
=1 : (8)
p2 X

Monitoring Now consider how the noisy signal a¤ects the optimal intensity of moni-

toring and the amount of wholesale funding. Recall that, when the precision of the signal

is low, , it is optimal to disregard it. The maximization problem is the same as in

the benchmark case (3); the optimal amount of wholesale funding is W = 1 D and

the optimal monitoring intensity is m given in (4).

When the precision of the noisy signal is high, > , it is optimal to use it and

ECB
Working Paper Series No 1223
July 2010 19
 liquidate the bank when the signal is negative. The monetary value of social welfare is:

Liq = (D + W ) (m [pX + (1 p)L] + (1 m) [p [p + (1 p)] X + (1 p)L] 1) C(m):

(9)

The term m [pX + (1 p)L] re‡ects the payo¤ from private monitoring that pro-

duces precise information on project quality. The term (1 m) [p [p + (1 p)] X + (1 p)L]

is novel. It represents the payo¤ from using the noisy signal when private monitoring

produces no information and liquidating the bank upon a negative signal: p is the prob-

ability of a positive signal conditional on which the bank is re…nanced and yields X with

probability [p + (1 p)]; (1 p) is the probability of a negative signal conditional on

which the bank is liquidated to preserve L.

As before, the social welfare (9) is increasing in W , so that it is optimal to use as

much wholesale funding as possible: WLiq = 1 D = W . The optimal intensity of

monitoring mLiq is given by:

C 0 (mLiq ) = p (1 p) (1 ) X: (10)

Observe that mLiq < m . This is easy to verify by applying the condition for using the

noisy signal [p p] pX < L to (4) and (10). The intuition is that the availability of a

free but noisy signal makes the private information obtained through costly monitoring

less valuable.

3.2 Incentives of the wholesale …nancier

Now consider the private choices of the wholesale …nancier on (1) whether to liquidate

or re…nance the bank at date 1 and (2) how intensively to monitor the bank prior to

date 1.

Ine¢ cient liquidations As before, when monitoring yields precise information on

the quality of the bank project, the wholesale …nancier has incentives to follow its

ECB
Working Paper Series No 1223
20 July 2010
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ECB
Working Paper Series No 1223
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ECB
Working Paper Series No 1223
22 July 2010
Socially optimal seniority of wholesale funds Based on the incentives of the

wholesale …nancier identi…ed in Lemma 2, we can now formulate in Proposition 2 the

socially optimal seniority and use of wholesale funds.

W
Proposition 2 Consider the case with possible welfare-reducing liquidations: s=1 <

. The socially optimal creditor seniority of the wholesale …nancier is s = sW ,

sW < 1. Setting s = sW aligns the continuation decision of the wholesale …nancier

with the social optimum, and there are no ine¢ cient liquidations. It also maximizes

the intensity of monitoring, albeit at a level below the social optimum: mW (sW ) < m .

All else equal, the incentives of the wholesale …nancier for ine¢ cient liquidations are

higher, and hence the socially optimal seniority of wholesale funding is lower, when the

precision of the public signal is higher, the bank’s liquidation value L is higher, and

there are more deposits D serving as bu¤ er for wholesale funds’ exit.

Point sW can be thought of as the highest seniority consistent with the "bright side"

of wholesale funding. For s > sW , the wholesale …nancier becomes su¢ ciently senior

to undertake ine¢ cient liquidations of banks based on overly noisy public information,

and higher seniority leads to lower monitoring.

3.3 Incentives of the bank

The previous section has established the socially optimal seniority of the wholesale

…nancier: an intermediate sW . However, in practice the decision on creditor seniority is

taken by a bank with the objective of maximizing its private surplus. We now study the

bank’s choice of creditor seniority and show that it can deviate from the social optimum.

The bank’s choice of creditor seniority for the wholesale …nancier The bank

has no incentives to assign creditor seniority below the socially optimal level, because

for s < sW its surplus B given in (6) increases in s.

Consider, however, the private incentives for the bank to assign too high creditor

seniority, s > sW . The bank’s cost is similar to the social one: losses when good projects

ECB
Working Paper Series No 1223
July 2010 23
 are abandoned in ine¢ cient liquidations. However, the bank also has a private bene…t:

o¤ering the wholesale …nancier higher seniority reduces the interest rate R. Since the

interest rate on deposits RD is …xed, this leads to an increase in the bank’s surplus. If

the net e¤ect is positive (lower interest expense compensates the higher risk of ine¢ cient

liquidations), the bank has private incentives to o¤er too high seniority.

Indeed, recall that the bank’s surplus at sW is:

B
s=sW = p [D(X RD ) + W (X Rs=sW )] (17)

with R given by (7).

The bank’s surplus for s > sW is:

B
Liq = p (1 mW
Liq )p(1 )(1 p) [D(X RD ) + W (X RLiq )] (18)

with RLiq given by (16). (Note immediately that B increases in W , so that the bank
Liq

chooses socially optimal W = 1 D.) It is instructive to compare the two expressions

above. Observe that in B the …rst multiplicative term features a lower probability of
Liq

bank project success than that in B ; the di¤erence is the probability (1 mW

s=sW Liq )p(1

)(1 p) of ine¢ cient liquidations. The second term –the bank’s surplus conditional on

project success, at the same time, is higher in B than in B , since RLiq < Rs=sW
Liq s=sW

due to higher s. Indeed, consider the bank’s surplus as a function of s. Early liquidations

trigger a discrete drop in B at sW . The value of that decline is:

B B
s=sW Liq;s=sW = (1 mW
Liq )p(1 )(1 p) [D(X RD ) + W (X R)] : (19)

However, after the initial drop, B may start increasing in s.

s>sW

Consider the derivative of B w.r.t. s:

Liq

d B dmW
Liq Liq dRLiq
= p(1 )(1 p) [D(X RD ) + W (X RLiq )] p (1 mW
Liq )p(1 )(1 p) W:
ds ds ds
(20)

ECB
Working Paper Series No 1223
24 July 2010
 The …rst term on the right-hand side represents the impact of higher seniority on

monitoring and is negative, dmLiq =ds < 0, since with higher s the wholesale …nancier

monitors the bank less, resulting in more ine¢ cient liquidations. However, the second

term is positive, dRLiq =ds > 0, since with higher s the bank pays a lower interest rate

on wholesale funding (the wholesale …nancier is compensated more in early liquidations

instead). Therefore, the overall e¤ect of higher s on B is ambiguous.

Liq

The full analytical examination of B is complicated by the fact that its convexity
Liq

depends on the shape of C(m), including the third derivative. Since the shape of C(m) is

not at the core of our argument, we make a simplifying restriction to focus the exposition

on the e¤ects that we want to highlight. Speci…cally, we consider a very well-behaved

C(m), such that m is e¤ectively constant, m = mC , in the relevant range of parameter

values. This corresponds to C(m) having a sharp J-shape that is almost horizontal

until mC and almost vertical after that. Figure 2 depicts possible shapes of B that
Liq

are allowed or ruled out by this simpli…cation, to help us understand the dimensions of

generality we are preserving or losing.

The key impact of the restriction is that the …rst term in (20) becomes zero, while

the second term becomes a constant. We therefore are left with a linear and increasing
B , so that the global maximum of B is achieved in either s = sW when B =
Liq
B B is positive, or s = 1 otherwise. From (17) and (18),
Liq;s=1 s=sW

B = p [Rs=sW RLiq;s=1 ] W (1 mC )p(1 )(1 p) [D(X RD ) + W (X RLiq;s=1 )] :

The …rst term above re‡ects a lower interest expense for more senior wholesale funds,

while the second term re‡ects the probability of ine¢ cient liquidations.

We examine cross-sectional properties of B with respect to four key parameters

of the model: , L, D, and W , and summarize the …ndings in Lemma 3:

Lemma 3 B increases in and L; it increases in D and decreases in W .

Proof. See Appendix.

The intuition is that, higher , L, and D reduce the cost of early liquidations

ECB
Working Paper Series No 1223
July 2010 25
 for the wholesale …nancier, which translates into a lower interest rate charged by him

and accordingly higher surplus for the bank. Higher W has the opposite e¤ect since

W =1 D

We then conduct a simple numerical exercise, to demonstrate how, within a plausible

range of parameter values, B can be either positive or negative. The exercise validates

the existence of both "bright" and "dark" sides of wholesale funding. The outcome of

the exercise is illustrated in Figure 3.4

Based on Lemma 3 and the numerical analysis, we can now summarize in Proposition

3 the bank’s incentives of assigning too high seniority to wholesale funds despite the risk

of ine¢ cient liquidations:

Proposition 3 The "dark side" of wholesale funding exists: the set of parameter values

for which the bank assigns the wholesale …nancier too high seniority, subjecting itself to

the risk of ine¢ cient liquidations, is non-empty. All else equal, the bank has higher

incentives to assign too high seniority to the wholesale …nancier when the precision of

the public signal is higher, the bank’s liquidation value L is higher, and there are more

deposits D serving as bu¤ er for wholesale funds’ exit.

4 Discussion

This section discusses some features of our model and brie‡y outlines policy insights.

Comparative statics Propositions 2 and 3 o¤er cross-sectional predictions on the risk

of ine¢ cient liquidations in di¤erent types of banks. They identify that banks are more

likely to assign too high seniority to wholesale funds, and wholesale …nanciers are more

likely to undertake ine¢ cient liquidations, when the precision of the public signal on bank

project quality and the bank’s liquidation value L are higher. These two predictions
4
The simulation is based on the following parameter values: m = 0:5; = 1; p = 0:90; X = 1:15;
RD = 1:10. W takes the values of 0:25, 0:5, and 0:75, respectively, in three di¤erent scenarios. We
have considered alternative speci…cations, and con…rmed that the properties revealed by the …gures are
robust to choosing other parameter values.

ECB
Working Paper Series No 1223
26 July 2010
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ECB
Working Paper Series No 1223
July 2010 27
 practice, this would likely correspond to taxing the use of short-term wholesale funds

such as collateralized repo’s, because short maturity and over-collateralization are good

proxies for higher e¤ective seniority.

This tax shares intuition with the systemic risk tax proposed in Acharya et al.

(2010), in that both attempt to cause banks to internalize the negative externality that

their actions impose on the rest of the …nancial system. The proposal of Acharya et al.

is broader. It targets not just one risk factor but overall systemic risk and is therefore

more comprehensive and able to capture future sources of vulnerability.

5 Conclusion

This paper analyzes the "dark side" of bank wholesale funding –insu¢ cient monitoring

and ine¢ cient liquidations of banks by short-term wholesale …nanciers. The model

suggests that wholesale funds can indeed be bene…cially used in "traditional" banks

that hold mostly opaque and non-tradable relationship loans. In contrast, these funds

can create signi…cant risks in "modern" banks that hold mostly arm’s length assets with

readily available, but noisy, public signals on their values.

ECB
Working Paper Series No 1223
28 July 2010
A Proofs

Lemma 1 Recall that:

B
= p [D(X RD ) + W (X R)] ;

and:

W + C(mW ) mW (1 p)sL(D + W )
R= :
Wp

1a. Consider d B =ds. Observe:

d B dR
= Wp
ds ds
dC(mW ) dmW
= (1 p)sL(D + W ) mW (1 p)L(D + W ) :
ds ds

Since:

dC(mW )
= (1 p)sL(D + W );
dmW

we have:

dC(mW ) dmW
= (1 p)sL(D + W )
ds ds

Substituting gives:

ECB
Working Paper Series No 1223
July 2010 29
 
  
                      
  
       


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ECB
Working Paper Series No 1223
30 July 2010
  
              
   
     
  

            
          
   
    

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ECB
Working Paper Series No 1223
July 2010 31
 and:

W + C(mW
s=sW
) mW
s=sW
(1 p) (1 ) W pRs=sW
Rs=sW =
Wp
W
W + C(ms=sW )
= :
W p 1 + mW
s=sW
(1 p) (1 )

Similarly,

C 0 (mW
Liq;s=sW ) = p(1 p)(1 )W RLiq;sW ;

and:

W + C(mW
Liq;s=sW
) (1 p) (1 ) W pRLiq;s=sW
RLiq;s=sW =
mW
Liq;s=sW
Wp + (1 mW
Liq;s=sW
) [p + (1 p)] W p
W + C(mW
Liq;s=sW
)
= h i:
W p 1 + mW
Liq;s=sW
(1 p)(1 )

It is evident that the two systems, the …rst of which de…nes mW

s=sW
; Rs=sW and
n o
the other mW Liq;s=sW
; RLiq;s=sW , are identical.

QED

Lemma 3 Consider B; recall we established that a bank always chooses W = 1 D,

so that:

B
= pW [Rs=sW RLiq;s=1 ] (1 mC )p(1 )(1 p) [(1 W )(X RD ) + W (X RLiq;s=1 )] :

Substitute expressions for Rs=sW and RLiq;s=1 (using m = mC and C(mC ) = 0):

W
Rs=sW =
W p (1 + mC (1 p) (1 ))
W + C(mC ) (1 p)L
RLiq;s=1 = ;
W p [mC + (1 mC ) [p + (1 p)]]

ECB
Working Paper Series No 1223
32 July 2010
we obtain:

B W W (1 p)L
=
1 + mC (1 p) (1 ) mC + (1 mC ) [p + (1 p)]
W (1 p)L
(1 mC )p(1 )(1 p) X (1 W )RD W :
W p [mC + (1 mC ) [p + (1 p)]]

We can now establish the signs of the …rst derivatives.

3a. Note immediately that d B =dL > 0:

3b. Note that the …rst term of B increases in : Rs=sW increases in while

RLiq;s=1 decreases in .

In the second term, the …rst multiplier (probability of incorrect liquidation) decreases

in , while the second multiplier (surplus lost in incorrect liquidations) increases because

RLiq;s=1 declines. Yet the …rst e¤ect dominates, so that the second term increases in :

d W (1 p)L
(1 mC )p(1 )(1 p) W
d W p [mC + (1 mC ) [p + (1 p)]]
[W (1 p)L] (1 mC )(1 p)
= > 0:
[mC + (1 mC ) [p + (1 p)]]2

Therefore both terms increase in and d =d > 0.

3c-d. We examine d B =dW ; d B =dD is inverse since a bank chooses W = 1 D.

The …rst term of B decreases in W :

d W W (1 p)L
dW 1 + mC (1 p) (1 ) mC + (1 mC ) [p + (1 p)]
(1 p)(1 )
= < 0:
(mC + (1 mC ) [p + (1 p)]) (1 + mC (1 p) (1 ))

In the second term, two factors a¤ect the bank’s loss in incorrect liquidations. First,

RLiq decreases in W and therefore increases the bank’s surplus. Second, the shift from

ECB
Working Paper Series No 1223
July 2010 33
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ECB
Working Paper Series No 1223
34 July 2010
References

[1] Acharya V.V., Gale D., and Yorulmazer T., 2008, "Rollover Risk and Market

Freezes," Working Paper, NYU Stern.

[2] Acharya V.V., Pedersen L.H., Philippon T., and Richardson M., 2010, "A Tax on

Systemic Risk," Working Paper, NY Stern.

[3] Billett M.T., and Gar…nkel J.A., 2004, "Financial Flexibility and the Cost of Exter-

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ECB
Working Paper Series No 1223
July 2010 35
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ECB
Working Paper Series No 1223
36 July 2010
Figure 1.

The wholesale financier’s monitoring and liquidation decisions.

The left panel illustrates the benchmark case without a noisy public signal: the wholesale
financier’s intensity of monitoring m increases monotonically in his creditor seniority s. The
right panel depicts the case with a noisy signal. There, when seniority exceeds the threshold
value s=sW, the wholesale financier starts to reduce his intensity of monitoring in response to
higher seniority.

Without a noisy signal With a noisy signal

m m
m* m*

1s sW 1s
No inefficient Liquidations upon a
liquidations noisy negative signal

ECB
Working Paper Series No 1223
July 2010 37
 Figure 2.

The bank’s surplus depending on the wholesale financier’s seniority.

The figures depict the bank's surplus ΠB as a function of the wholesale financier’s creditor
seniority s. The left panel shows the bank's surplus in the benchmark case without a noisy
signal. The right panel shows the case with the noisy signal. There, the continuous lines and
the shaded area between them represent shapes complying with the m=mC assumption (all
linear), while the broken lines represent examples of shapes ruled out by that assumption.
The point sW is the threshold beyond which the wholesale financier liquidates a bank based
on a negative public signal.

Without a noisy signal With a noisy signal

ΠB ΠB

1s sW 1s
No inefficient Liquidations after a
liquidations noisy negative signal

ECB
Working Paper Series No 1 2 23
38 July 2010
 Figure 3.

The bright and dark sides of bank wholesale funding.

Line 1 represents pairs of signal precision θ and liquidation value L that satisfy ΔΠB=0. All
points below that line satisfy ΔΠB≥0 so that the bank has the incentive to assign socially
optimal seniority sW to the wholesale financier, corresponding to the “bright side” of
wholesale funding. All points above that line satisfy ΔΠB<0 so that the bank has the incentive
to assign too high seniority s=1 to wholesale funds, corresponding to the "dark side."

The other lines represent additional parameter restrictions used in the model. Line 2 is
θ>θWs=1 (existence of inefficient liquidations; indistinguishable from line 1 in the middle
graph). Line 3 is θ<θ* (early liquidations based on noisy signals are not socially optimal).
Line 4 is a tractability restriction pW>L, corresponding to non-negligible wholesale funding.

1 1 1

2 3
3
4

L L 4 L
3
1 1
1 4 2

0 θ 1 0 θ 1 0 θ 1

Low use of wholesale funding, Intermediate use of High use of wholesale funding,
W=0.25 wholesale funding, W=0.50 W=0.75

ECB
Working Paper Series No 1223
July 2010 39
 Wo r k i n g Pa p e r S e r i e s
N o 1 1 1 8 / n ov e m b e r 2 0 0 9

Discretionary
Fiscal Policies
over the Cycle
New Evidence
based on the ESCB
Disaggregated Approach

by Luca Agnello
and Jacopo Cimadomo