08 November 2010

Bankers and Prisoner’s Dilemma

What will banks do in the aftermath of financial crisis? Based on the past experience of huge losses, will they remain rather conservative in their activities? Well, considering their possible choices and the outcomes of these choices reveals that the answer is “no”. Bankers appear to face a prisoner’s dilemma like situation.

To explain this, let’s suppose there are only two banks in the economy, Bank A and Bank B, and that they do not co-ordinate their activities with each other (otherwise it were a cartel). What they can do as soon as they feel comfortable enough about their own capital base and functioning of financial markets (or the guarantees by central banks), is either to remain reasonably conservative or to get aggressive. The possible outcomes of their choices to do either this or that are summarised in the illustration below.


Bank B remains reasonably conservative

Bank B gets aggressive

Bank A remains reasonably conservative

Bank A: reasonably conservative portfolio; moderate and stable profits
Bank B: reasonably conservative portfolio; moderate and stable profits
No boom emerging; no bailouts needed

Bank A: small portfolio, small profits, difficult to attract customers and investors
Bank B: very large portfolio consisting of a mix of assets with different risk levels; very big profits in good times
Boom emerging; bailout of the big bank when the bubble bursts

Bank A gets aggressive

Bank A: very large portfolio consisting of a mix of assets with different risk levels; very big profits in good times
Bank B: small portfolio, small profits, difficult to attract customers and investors
Boom emerging; bailout of the big bank when the bubble bursts
Bank A: large portfolio consisting of a mix of assets with different risk levels; big profits in good times
Bank B: large portfolio consisting of a mix of assets with different risk levels; big profits in good times
Boom emerging; interconnectedness and systemic risks; both banks will be bailed out when the bubble bursts

As can be seen, the outcome would be the best, if both banks would remain reasonably conservative. But if they don’t agree with each other on that, the better strategy for a given bank is to get aggressive. In that case, when the other one decides to remain conservative, it can get very big with large distribution network, take almost all the profits and ultimately attract most of the customers and investors. When the bubble once bursts, because of the following economic crisis both of banks would get caught anyway. The difference is that the big one is likely to get bailed out while the small one is on its own. Now the other bank has a similar thinking. The outcome is emerging boom with systemic risks and interconnectedness.

The winners are those, who enter first to grab relatively better share of the market (which is the case because during the crisis there still has been some de-leverage), and stop and get rid of their most crappy assets just before the others when the market is still booming. Sure, there is lots of adrenalin involved.

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