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RIFIFI Report Summary

Project ID: 263673
Funded under: FP7-IDEAS-ERC
Country: France

Final Report Summary - RIFIFI (Risk Incentives in Financial Institutions and Financial Instability)

The goal of the project was to develop theoretical economic models aimed at shedding light on the different forces that may contribute to create a financial system that is prone to instability. Three such forces have been identified : perverse incentives within trading desks, the arbitrage of prudential regulation by banks, and the perverse incentives created by the tax-arbitrage opportunities that most affluent agents can avail themselves of.

The project has generated three publications that share a common theme – the impact of informational asymmetries on the impossibility to enforce contracts and regulations in the financial services industry, and the resulting effect on financial stability.

The first paper, « Rewarding Trading Skills Without Inducing Gambling » develops a model of active asset management in which fund managers may forego alpha-generating strategies, preferring instead to make negative-alpha trades that enable them temporarily to manipulate investors’ perceptions of their skills. We show that such trades are optimally generated by taking on hidden-tail risk, and that they are more likely to occur when fund managers are impatient, and when their trading skills are scalable and generate a high profit per unit of risk. We propose long-term contracts that deter this behavior by dynamically adjusting the dates on which the manager is compensated in response to her cumulative performance.
The second paper, « Taxing the Rich » builds on the idea that affluent households can respond to taxation with means that are not economically viable for the rest of the population, such as sophisticated tax plans and international tax arbitrage. This article studies an economy in which an inequality-averse social planner faces agents who have access to a tax-avoidance technology with subadditive costs, and who can shape the risk profile of their income as they see fit. Subadditive avoidance costs imply that optimal taxation cannot be progressive at the top. This in turn may trigger excessive risk-taking. When the avoidance technology consists in costly migration between two countries that compete fiscally, we show that an endogenous increase in inequality due to risk-taking makes progressive taxation more fragile, which vindicates in turn risk-taking and can lead to equilibria with regressive tax rates at the top, and high migrations of wealth towards the smaller country.
The third paper, « Shadow Banking and Bank Capital Regulation » studies how the existence of a large shadow banking system affects the prudential regulation of banks. If banks can bypass capital regulation in an opaque shadow banking sector, it may be optimal to relax capital requirements so that liquidity dries up in the shadow banking sector. Tightening capital re- quirements may spur a surge in shadow banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions.

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