An intriguing new idea to address moral hazard

The recent crisis exposed a fundamental flaw with our banking system (actually it’s been there since 1934, but this was the worst manifestation of the problem.)  Because of various government backstops (FDIC, F&F, TBTF, etc) our financial system takes excessive risks.

Tim Congdon has an intriguing proposal to address this problem.  His plan would not eliminate moral hazard, but it just might reduce it:

Suppose that banks are short of capital because of bad asset selection and heavy losses, and that there is a risk of deposits not being covered by banks’ remaining assets-the situation allegedly facing Britain’s banks and economy in late 2008. Surely everyone ought to agree that, ideally, the job of replenishing banks’ capital should fall on the private sector, not the state, and that as far as possible accountability must lie in only one place. How might that be achieved?

I propose a structure which is almost the polar opposite of Buiter’s. In a 2009 monograph, Central Banking in a Free Society, I argued that the capital of the Bank of England should be provided by the leading banks, and that the functions of the central bank and deposit insurance agency should be amalgamated. Whereas Buiter wants, in effect, to nationalise the arrangements (and the costs) of cleaning up a banking system fiasco, I would privatise them.

My proposal is much less radical than it may seem. Recall that at present the banking industry as a whole can in fact be levied by the FSCS if its funds are exhausted as a result of losses at one or a handful of banks. So, making the commercial banks the shareholders in the central bank and giving the central bank an explicit responsibility to protect deposits, has two consequences. First, the central bank would extend loans only if confident they would be repaid. The well-behaved, risk-avoiding and profitable banks have a strong interest in preventing their risk-prone competitors from incurring losses and ruining the system. Secondly, if the system nevertheless ran into trouble, the first line of defence would lie in the private sector, via the capital-levying power of the Bank of England. If the government did have to come in, it would be only after the bankers had decided that they could not help themselves. It would indeed be a last resort.

I’d like to separate two questions:  Should there be a unified institution to handle deposit insurance and emergency capital provision, which is owned and financed by the banking sector?  And should this institution be the central bank?  I agree with Congdon on the first point, but don’t see the second as being essential, or even politically feasible (at least in the US.)  In America, banks already have partial ownership of the Fed (albeit less than people imagine) and that’s highly controversial.  So let’s look at the first question.

The beauty of Congdon’s idea is that decisions on bank rescue will be made by those with the right set of incentives.  Suppose a bank gets into trouble, but is not a systemic threat.  The socially optimal solution is bankruptcy, that’s how markets should work.  That sends a signal to the banks that they should take fewer risks.  It sends a signal to creditors that they should carefully monitor bank behavior.  It would be nice to send a signal to depositors, but that doesn’t seem politically feasible—at best we might be able to trim the maximum coverage a bit.

But what if the bank failure was a systemic threat?  In that case the institution would have an incentive to provide emergency capital injections–in order to prevent contagion that would threaten the rest of the banking system.  This institution basically internalizes externalities.  The money belongs to the banks, who would be shareholders (in some proportion to bank size.)  If funds were paid out, banks would have to chip in to re-capitalize the institution.

In once in 100 year disasters the Treasury might have to backstop the institution with Federal loans.  But as we saw with the TARP loans, the Treasury could simply require that these loans be repaid by the institution, once the banks got back on their feet.

In theory, taxpayers should monitor Washington regulators, so that they wouldn’t show favoritism to politically important special interests.  But we know from public choice theory that that doesn’t work very well.  The banks themselves are the best monitor, or perhaps a Board of Directors that is directly answerable to the banks.

Here’s another way of looking at the plan.  It’s politically difficult to get the big banks to hold enough capital to overcome the TBTF problem.  They’ll whine about picking up and leaving New York, London, or Zurich.  But it’s also unlikely that all big banks will get into trouble at exactly the same time.  This institution would pool capital in a way the could nip a potential financial panic in the bud, without requiring taxpayer money.

Of course the cost of this insurance fund will ultimately be borne by customers, so in that sense it is a tax.  But it has two advantages over a bailout using income taxes.  The tax reflects the external costs imposed by fractional reserve banking.  And second, the banks would have much more incentive than government bureaucrats to use the funds wisely.

OK, I’m not a banking expert—tell me what’s wrong with this plan?

‘Regulation’ is not restraint, it’s intervention

I usually agree with just about everything David Beckworth posts, but I can’t quite buy the argument he makes here.  David argues that low interest rates fed the 2001-06 housing boom.  And not just low interest rates, but a Fed policy of low interest rates (which I see as a completely different argument.)

When the tech bubble burst, business investment plummeted.   How should the economy react to that shock?  In a classical world interest rates should fall sharply (regardless of whether a Fed even exists) and other types of output, such as residential investment, consumer goods, and exports, should pick up the slack.  And that’s about what happened.

In my view interest rates are a very poor indicator of the stance of monetary policy.  Both David and I favor roughly 5% NGDP growth targeting.  As long as NGDP is growing at about 5%, monetary policy is on target, regardless of whether interest rates are 1% or 100%.  And if you look at NGDP growth during the Great Moderation, it was in fact pretty close to 5%, on average.

During 2001 and 2002 NGDP growth fell a bit below 5%, and that’s why the Fed cut rates to 1%.  In the subsequent expansion NGDP growth rose a bit over 5%, and the Fed reacted by raising rates sharply.  I can see how someone would have thought money was a bit too easy during mid-2003 to 2006, when NGDP growth was above 5%, but I can’t see any catastrophic failures that could account for the spectacular sub-prime fiasco.  We had even faster NGDP growth in the 1960s, 70s, 80s and 90s, none of which had a destructive housing bubble.

Update, 12/5/10:  Marcus Nunes sent me the following:

Having said all this, if I could go back in a time machine and run the Fed, I’d have raised rates faster in the 2003-04 period.  But that’s not because I would have expected a much superior NGDP performance, but rather as a second best policy to address a catastrophic failure in our regulation of banking.

There is a widespread view that economists on the right favor “deregulation,” and economists on left favor increased regulation of banking.  And the events of 2007-08 allegedly showed the left was right and the right was wrong.  And I can understand why many people feel that way.  Some right-wing economists did in fact offer poor policy advice–touting places like Iceland and Ireland as models of deregulation.  But I think that’s the wrong way to think about regulation, I’d argue that places like Canada and Denmark are the true models of deregulation.

The problem is that people tend to think of the term ‘regulation’ as meaning something like ‘restraint’ whereas in the left/right debate over the role of government it means something closer to ‘intervention.’  Consider the advent of zero money down, no income verification mortgages.  Does allowing banks to make those mortgages constitute “deregulation?”  Not in my book.  As I taxpayer I have always strenuously opposed all the federal interventions that make it easy to borrow money to buy a house–Fannie and Freddie, FDIC, FHA, etc.

Consider FDIC.   Despite the fiction that banks pay the cost of FDIC insurance (about as likely as assuming gas stations pick up the cost of the federal excise tax on gasoline), FDIC insurance is a burden on us taxpayers.  In a perfect world we’d have NGDP futures targeting and there’d be no need for FDIC.  But in the world we live in deposit insurance is unavoidable intervention into the free market.  I’d like to limit its reach as much as possible.  I resent my tax money insuring banks that make sub-prime mortgage loans, or risky construction loans.  I’d like to ban FDIC-insured banks from making housing loans with less than at least 20% down.  I am not opposed to allowing sub-prime loans, just not with FDIC-insured money.  If some unregulated financial intermediary wants to make such loans, that’s fine with me.  I am no expert on this area, there might be alternative regulatory fixes that involve substantial private mortgage insurance, or some mix of insurance and equity.  The point is that any and all acts that reduce the ability of banks to make FDIC-insured loans is “deregulation” in my book— it reduces the size and scope of the inefficient FDIC.  For instance, I consider the Bush administration’s attempt to regulate the GSEs more tightly (opposed by my Congressman, Barney Frank) to represent deregulation.

There are actually two Republican parties in America.  One wants to do real deregulation, to actually reduce the role of the government in the economy.  The other Republican party (which I fear is the more powerful one) wants to do “deregulation,” to remove all constraints on business, banking, the medical industrial complex, energy, for-profit colleges, etc, so that they can systematically loot the taxpayers by taking advantage of the enormous moral hazard that has seeped into almost all aspects of our modern regulated economy.

The Dems are more likely to want to try to tame the beast, but then keep passing laws that make the economy even more riddled with moral hazard.  Not much of a choice these days.

Which state had the most bank failures during 2008-10?

No, it’s not centers of sub-prime madness like Arizona or Nevada.  Nor is it big states like California or Florida.  It’s Georgia.  And Illinois is second.  Check out the graph in this link:

There is a good reason why most bank failures in 2009 did not occur in the sub-prime states; sub-prime loans were not the main problem.  Indeed mortgages of all types were not the main problem.  What was?  According to McNewspaper USA Today it was construction loans, often for commercial real estate:

The biggest bank killer around isn’t some exotic derivative investment concocted by Wall Street’s financial alchemists. It’s the plain old construction loan, Main Street banks’ bread and butter for decades.

Deutsche Bank has called them “without doubt, the riskiest commercial real estate loan product.” The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

That’s right, everything we were told about the financial crisis in 2009 (and which I also believed for a while) is wrong.  It’s a commercial RE crisis, not a mortgage crisis.   You might argue that it was housing loans that triggered the liquidity crisis of late 2008.  Yes, but the crash of late 2008 was caused by the Fed’s failure to do level targeting once rates hit zero.  The main public policy issue with bank failures is the cost to taxpayers, not the impact on the business cycle.

In earlier posts I argued that the commercial real estate market does not appear to have been a bubble.  It held up very well in late 2006 and 2007, even as residential housing was falling almost continuously.  Only when NGDP growth slowed in 2008, did commercial real estate begin a significant decline.  No big surprise there, commercial real estate is extremely sensitive to falls in NGDP produced by excessively tight money.  The same problem hit commercial RE in the 1930s, when NGDP fell in half.  There are stories of the Empire State Building being mostly empty after it opened in 1931.

Why were all those bad commercial real estate loans made?  After all, shouldn’t banks take into account the risk of recession?  Well nobody could have expected NGDP to suddenly fall 8% below trend.  But even so, there clearly is a problem here.  Indeed it appears that our current banking crisis, which was initially thought to be very different from the 1980s S&L fiasco, was almost an exact replay of that earlier crash.  Initially we were told that the big banks were the problem this time–it was all about “Too-Big-to-Fail.”   But they have been quietly repaying their TARP loans.  Even the worst banking fiasco in nearly 80 years will not result in taxpayer money being permanently transferred to big banks.  Even if you include the AIG bailout as an implicit bailout of the big banks, the small banks are still the main problem.  Our government insurance company let’s smaller banks run wild, just as in the 1980s (i.e. before the so-called “regulatory reforms” that were supposed to fix the S&L problem.)  The cost to FDIC of all these smaller bank failures in places like Georgia will be many times larger than the net cost of AIG plus the banking part of the TARP bailout.  And let’s not even talk about the cost of bailing out the GSEs.

It’s not about big banks and it’s not about derivatives:

It did not end well. Construction loans started blowing up when the real estate market collapsed and the economy tumbled into recession. The 10 biggest banks, facing problems of their own with subprime mortgages, were largely immune to the deterioration in construction loans, which accounted for just 2% of their assets in 2007, according to the Federal Reserve. By contrast, construction loans accounted for more than 10% of assets at banks that didn’t rank in the top 1,000. “What’s causing the problem is Main Street America, the construction loan made by the bank down the street,” says Bill Bartmann, who owns a debt advisory firm. “They built, and nobody came.”

Making matters worse: Community banks never sold the construction loans to investors the way banks unload auto loans and residential mortgages. “Most construction loans are so unique, so different, so non-homogenous, that you can’t securitize them,” Bartmann says. “They were kept on the books of the banks that originated them.” And there, many of them started to turn rotten.

Here’s an example of what banks did in Georgia:

Rollo Ingram witnessed one spectacular flameout up close. He was chief financial officer at Atlanta’s RockBridge Commercial Bank, which opened in 2006, backed by other members of the city’s business elite.

RockBridge told banking regulators it planned to specialize in business lending. It didn’t, plunging instead into real estate and construction loans. The bank told regulators in 2006 that construction loans would account for 5% of its portfolio. By the end of 2007, they accounted for 42%. Business loans, which were supposed to make up 50% of RockBridge’s lending, came to just 28%, according to an after-the-fact autopsy by Federal Deposit Insurance Corp.’s inspector general.

Nor did RockBridge recruit veteran loan officers with enough experience to safely assemble its risky portfolio, the inspector general concluded. “They hired younger, less-experienced ones, and didn’t hire enough of them,” Ingram says. He says he was forced out in 2008 when he complained about the risky direction the bank was taking.

Those on the left complained the banking crisis resulted from “laissez-faire,” forgetting that the federal government effectively nationalized most of the liabilities of the banking system in 1934.  That’s right; when you deposit $100 in your bank account you are actually lending the money to Uncle Sam, who re-lends it at the same rate to the bank.  FDIC is effectively a government institution, and the fees on banks are effectively taxes, which of course are passed onto the public.  The government didn’t seem to care that wildcat banks in Georgia colluded with property speculators and ran wild with government loans made at risk free rates.

But some on the right were arguably even worse, not paying enough attention to this problem and constantly harping on the need for “deregulation,” aka the doctrine of “business should be free of regulations that inhibit their ability to loot the Treasury.”

I’m amazed that after the S&L fiasco of the 1980s our government wasn’t able to figure out the problem.  Or maybe they do understand the problem, but are in the pocket of property developers.

And of course now if someone proposed a crackdown, there’d be complaints about how it would “starve the economy of capital, and slow the recovery.”  Just one more side-effect that results when hawks at the Fed prevent an adequate recovery in NGDP.

Update:  I just saw an example of the “blame it all on laissez-faire” meme discussed in Arnold Kling’s blog.  And Barry Eichengreen isn’t even very left wing.