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?
Tags: Deposit insurance, Moral hazard
15. July 2011 at 06:38
Doesn’t this sound vaguely familiar? Wasn’t the Bank of England in Bagehot’s day a privately-owned bank, both owned and managed by directors chosen from the other banks?
Judging from Ireland’s recent experience, the amount of capital required might be massive. There, the problem is that not even the government was considered to have enough wealth to be able to backstop the banks without making itself insolvent.
15. July 2011 at 06:41
Nick Rowe,
Isn’t the point of preventing moral hazard to make that kind of massive emergency capital requirement unnecessary?
15. July 2011 at 06:44
Nick, I agree that there are cases where it wouldn’t work, but I think it would have worked in the recent US crisis, which was an unusually big one. We now know that even if the institution had to borrow from the Treasury, it could have repaid the loans rather quickly. (Tarp loans were repaid.) The smaller the banking system , the less you are able to diversify risk. Ireland should encourage foreign banks to do much of their banking, by having high capital requirements for domestic banks.
15. July 2011 at 06:52
I think I like this idea. In a way, is it not creating an institution that can systematically replicate what JP Morgan did in the Panic of 1907? (i.e. getting bankers to cough up the capital to bail out systemically important intuitions to prevent the spread of a financial crisis).
15. July 2011 at 07:12
“But it’s also unlikely that all big banks will get into trouble at exactly the same time.”
That is an entirely unwarranted assumption. In fact, the existing system is perfectly capable of dealing with some isolated banks failing. It’s the crash of the *whole banking system* (e.g. the cross-obligations, cross-lending, etc. crisis after the Lehman collapse) that needs to be better dealt with. And such a crisis is precisely the time when all banks get into trouble at the same time.
Consider, e.g., a sovereign-debt crisis. Would the scheme described help, say, the Greek banks?
Kaa
15. July 2011 at 07:34
IMO we need a system in which the failure of one or more banks strengthens the remaining banks. I think that a system where the banks make their own currency backed only in bank assets would be such a system. Perhaps gold would be used just to keep the various bank currencies on a par but the banks would not be contractually obligated to supply gold in case of a run. The banks would be like non euro nations today in that their currency would fall below par rather them running out of funds, liquidation would only occur if no one wanted their currency.
15. July 2011 at 07:38
In your scheme would the banks that take more risks be charged more for insurance by the unified institution that handles deposit insurance and emergency capital provision?
15. July 2011 at 07:52
The problem is that it would seem to require a level of trust among banks which currently doesn’t exist. The problem immediately after the crisis, for example, was that banks didn’t trust that others weren’t hiding immense risks and so wouldn’t loan to them.
How would that not be the problem in this case? Here we’ve placed multiple capital sources with a single one; it may actually be a more aggressive issue.
What might work well is if you could identify a separate service which needed the banks less than any individual bank needed it. For example, trading rights to a major derivatives market would be a must-have for the banks but no single bank a must have for it. That marketplace would have an interest in protecting banks from contagion, as it would close their market, but not in any individual bank and its trust level would not matter to it, only whether it thought contagion was a severe risk.
15. July 2011 at 08:39
Yes Nick, this sounds similar to my understanding of London’s old banking system. Although my knowledge of such things is zygotal.
15. July 2011 at 08:41
What Tim Congdon’s proposal amounts to is how the secondary banking crisis of 1973-1975 was handled through the BoE rather than directly by the Treasury.
http://en.wikipedia.org/wiki/Secondary_banking_crisis_of_1973%E2%80%931975
The BoE of course has been owned by the Treasury since 1946 when it was nationalised. However, the public do not have the same perception of bailing out banks when the BoE are involved compared to when the Treasury directly intervenes. His ideas essentially call for the BoE to be reprivatised and the banks to hold the equity and a proportionate share of the capital structure. The Treasury could retain a golden share like they do in BAE Systems and Rolls Royce, which protects them from takeover. In a crisis it would be the banks bailing out each other rather than taxpayers. Moreover, theoretically they all have an incentive to prevent each other causing a crisis in the first place.
There is still moral hazard with the same institution in charge of self regulation of the banking system and deciding appropriate monetary policy.
15. July 2011 at 08:43
It’s been awhile, but I think Larry White discusses a very, very similar idea in The Theory of Monetary Institutions.
15. July 2011 at 09:04
But what institution does emit high powered money?
I´m not libertarian, only because I´m sure that public need to trust in legal tender.
I can´t see solving a 2008 crisis without a public central bank emiting legal tender money.
Perhaps too rational.
15. July 2011 at 09:12
The plan assumes some heterogeneity in bank strategies: some banks will seek higher risk assets/high leverage, others the opposite. The idea is that the good banks will police the bad ones.
What we say from 2002-2008 instead was homogeneity in strategies. Virtually every bank of any size decided to increase risk concentration, increase leverage, increase its proprietary trading book, reduce liquidity and underprovision. In short, there were no real “good banks”. This points to two things: first, the banks were encouraged, through the Fed’s “extended period” language and the “Fed Put”, to take on more risk, and they did. Second, there is secular trend towards a larger agency problem. Bank managers can now produce inter-generational levels of wealth through their bonus pools. They have every incentive to take excessive risks and then let their shareholders, and the shareholder-owned central bank, pick up the tab.
Require large banks to be private partnerships, and the proposal might work (there is still the problem of homogeneity in strategies due to Fed policy). Of course, if you did that, the TBTF banks would have to shrink dramatically.
15. July 2011 at 09:19
Gregor, Good analogy.
kaa, You said;
“That is an entirely unwarranted assumption. In fact, the existing system is perfectly capable of dealing with some isolated banks failing.”
The bailout of LTCM and Bear Stearns and the non-bailout of Lehman shows that the current system is not capable–it doesn’t have the right incentives. Even in the worst crisis of my lifetime there were lots of big banks in America that did not need help. Perhaps in a small economy like Ireland it wouldn’t work, but I think it would work most of the time in America. I don’t think it could handle the Greek situation, but again, I was thinking of a large diversified economy with its own currency.
Floccina, I don’t know, but I hope so.
Hyena, First of all I think banks are better placed to estimate the risks of other banks than the government. Second, they’d have the right incentives, so trust isn’t really the issue. If they don’t trust a bank, and would prefer it collapse rather than bail it out–then by all means they should do so. You might respond that this would cause a systemic collapse. Yes, but the banks making that decision understand that risk.
Richard, But isn’t there a danger that the central bank does the monetary policy that is best for the banks, not the monetary policy that is best for the country?
Bacon, You may be right, as I read it I wondered if others had advocated the same.
Luis, You’d have both. This institution would bail out banks, and the central bank would do ordinary monetary policy to target prices or NGDP.
15. July 2011 at 09:22
David, I strongly disagree, there were plenty of banks that didn’t need bailouts. This institution could have easily handled the current crisis, even if a brief Treasury loan was required. The biggest problem was small banks and deposit insurance. We really need to cut that below $250,000. I’d suggest $25,000.
15. July 2011 at 09:47
Scott,
“There were plenty of big banks that didn’t need bailouts.”
All of the big banks, with the possible exception of Wells Fargo, were at risk of failure in November through March of 2008. Management at all of the banks created systemic risk through excessive use of leverage and overreliance on s.t. non-deposit funding. The system was extraordinarily dependent on asset prices, and it was bailed out by the Fed’s attempts to hold up those prices. You could argue the Fed never should have let those prices fall in the first place, but not that a Clearinghouse system would have been able to prop them up — it would have lacked the capital to buy up the necessary trillion dollars of securities.
Banks created systemic risk through the homogeneity of their balance sheet strategies, strategies that were essentially the desired outcome of monetary policy. A homogeneous, artificially-stable system is like a mono-culture forest with no small fires, vulnerable to disease and catastrophic fires. This was essentially what we saw in 2008: a plateau in home prices led to AAA-rated downgrades, collateral haircuts, large, localized shadow bank runs, and finally, a generalized run on the bank non-deposit funding. That generalized run occurred concurrent with the crash in NGDP expectations, not before it.
15. July 2011 at 09:54
Weren’t the TARP loans only necessary in the first place because the mark-to-market provision applied to regulatory capital requirements which meant institutions faced the prospect of being forced to raised additional capital on loans and securities that were performing but short-term price impaired. For a private investor or institution to provide the capital would have been suicide with the M2M provisions in place, because any further decline in the estimated market value of these performing/price impaired securities would have triggered additional need for capital.
Here’s an interesting piece of trivia for folks who believe that financial market movements can be closely linked to Fed Chairman comments; on 3/10/2009, Bernanke gave his speech at CFR and made clear that “we should review regulatory policies and accounting rules to ensure that they do not induce excessive pro-cyclicality, that is, they do not overly magnify the ups and downs in the financial system”.
The S&P 500 rallied 7% that day on heavy volume, led by financial stocks. When FASB suspended M2M a month later and the Treasury gradually abandoned interference through bank nationalization and PPIP proposals, the major institutions had no problem tapping the private markets for capital. May 2009 was the highest month on record for equity issuance, entirely because of banks raising private capital to repay TARP funds.
15. July 2011 at 10:03
Ok.
In Spain the institution charged of saving banks was The “Fondo de GarantÃa de Depositos” (FGD) fifty/fity private-public (Bank of Spain) owned. Obviusly, it has been insufficient in the crisis.
Perhaps it has not worked too bad in the past, but a high price to tax payers.
When a bank had serious problems wtih contagious risk, it was absorbed by de FGD until it got saved and resaled.
If I remember well, the main problem was to discover the real hole in the problematic bank. The trend of bankers was always to lie (I suspect that is a general trend)
I don´t mind i´m rebating the Congdon proposal. I only say that there is a lot of problems with true information about the true situation, and I don´t see improving that privatising the system. Why Bankers would not go to lie in that case? Perhaps They never are truly interested in saving the bank! I can imagine several strategies in a private isntitution to sink the parner with problems.
I don´t know, I´m not a banker.
15. July 2011 at 10:05
I’m with David Pearson, the overwhelming majority of large banks in the USA all got in trouble. He says Wells Fargo, I heard JP Morgan didn’t want the TARP money either, but the general idea is there is huge correlation in the strategies and allocation of bank capital across the major banks. The FDIC just just fine today for the small and medium size banks that primarily raise money with bank deposits and lend into housing markets but happen to have geographic concentration. We don’t need a fix for the idiosyncratic banking failures, just the correlated ones.
I’m concerned about collective action problems with this proposal. Maybe the bankers won’t be able to agree on bailouts (or to not bail out, depending on how it is organized) and result is a policy mess. How would you handle that? I guess you could do it like a private company, a CEO with full discretion that can be fired at any time by the board whose term is up for renewal annually by shareholders.
15. July 2011 at 10:08
I agree with TheNumeraire:
“Banks created systemic risk through the homogeneity of their balance sheet strategies, strategies that were essentially the desired outcome of monetary policy. A homogeneous, artificially-stable system is like a mono-culture forest with no small fires, vulnerable to disease and catastrophic fires. This was essentially what we saw in 2008: a plateau in home prices led to AAA-rated downgrades, collateral haircuts, large, localized shadow bank runs, and finally, a generalized run on the bank non-deposit funding. That generalized run occurred concurrent with the crash in NGDP expectations, not before it”
15. July 2011 at 10:09
It provides no alignment of interests.
Banks’ shareholders provide capital. Banks’ managers make decisions. In this crisis as well shareholders got wiped out, managers kept their golden parachute.
Modern capitalism suffers from this extremely hard to solve principal-agent problem, and no, financial incentives only make it worse.
Ridiculous CEO pay is another example of this problem in practice.
15. July 2011 at 10:09
Sorry, David Pearson
15. July 2011 at 10:33
I’d agree with David and Luis that homogeneity within financial institution structure and behavior was evident. Much of that can traced to regulation, which by definition creates greater homogeneity.
Arnold Kling wrote some of the best stuff on the subject as to how regulation of risk-weighted capital favored agency-rated securities over originated/held-to-maturity loans;
http://www.ncpa.org/pub/ba711
http://econlog.econlib.org/archives/2008/10/some_useful_not.html
http://econlog.econlib.org/archives/2009/03/regulatory_arbi_1.html
15. July 2011 at 12:06
“tell me what’s wrong with this plan?”
its not socialist enough. If I am an ambitious young politician I need opportunities to cater to specialized interest groups, ideally in an extremely complex and convoluted manner so that the voters don’t see who I am catering to. If it somehow involves punishing “unpopular” groups such as banks, the wealthy or religious minorities all the better.
I could imagine an asset backed facility that would provide reinsurance to banks that would be financed by a tax on emigrants, pawn shops and payday lenders. Even better, we could force the facility to provide loans only to banks who are rated as ethical by an agency whose charter comes from the trial lawyers association of america!
🙂
15. July 2011 at 13:02
“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 must have been the only reader who found this highly comical. This is a kind of Historical Seesaw. When a Big Crisis Occurs, The Govt, which is the only entity that has the resources to stop a Financial Run of any sort, jumps in. Some people argue that we all might just as well formalize this Understood Guarantee, while others want the Banks to prepare for the next crisis.
Sadly, the Banks, over time, will set aside far less resources than are necessary for any real efficacy, assuming they even could. They’ll be trying to get the other banks to pay more while they pay less, for example. This is also my problem with a Clearing House. See, the Banks have a lot of Money and, so, Influence. They purchase a very inexpensive form of Insurance through Lobbying & Donations.
Bagehot made a point, in my reading of him, at least, of saying that Dithering at the Beginning of a Financial Run was Extremely Costly. The system proposed would turn into a Lobbying Morass that would impede any quick and effective action. “We Don’t Have Enough!!”: “I Say You Do!”.
If you want a somewhat effective firewall, try Limited Use/Narrow/Utility Banking. The fact that it has hardly been mooted, & terrified the banks in the 1930s, leads me to believe that the banks actually think it might work, meaning they will be picking up more of the tab going forward. Of course, in the end, Govt will always come to the rescue, and, if we don’t know that, I can assure you that the Banks do.
15. July 2011 at 19:39
Scott,
Why not just give the executive the authority to seize financial institutions if the Fed doesn’t prevent a crisis, and wipe out all of the stakeholders? Then, the assets can be sold off later. Wouldn’t that help take care of moral hazard when the Fed falls down?
15. July 2011 at 19:40
Or, maybe it could work in conjunction with what you’re talking about.
15. July 2011 at 21:25
Institutionalizing what happening in 1907 would be the ideal solution, but I’m not sure it is possible. All institutions bring with generate their own institutional interests, and I think a large part of the reason 1907 worked as well as it did was because there were none of those, just the self interests of Morgan and his fellow bankers. The ad-hoc arrangement meant there was no principle agent problem because the principles were acting as the agents.
16. July 2011 at 07:33
I have the feeling that this is more or less trusting monetary policy and systemic risk management to a cartel of banks. So the payer of all this won’t be the taxpayer nor the depositor of the a particular failing bank, but all the depositors of the banking system.
I think that the Fed founders had roughly the same idea, since as you know, the Fed is still formally owned by private banks (this is also the case of bank of Italy…).
What worries me is what would prevent banks taking a seignoriage too far from the socially optimal level. Before the 1929, the gold standard played this role (a bit too well of course). I think that it is no coincidence that central banks were nationnalised when the end of the gold standard ended.
I don’t know where, but I also remember a study saying that small banks were not helped enough by the Fed (either directly, either through a less tight monetary policy) because great banks had a too much important role in the management of the Fed.
16. July 2011 at 09:32
David, You are mixing up two very different problems, liquidity risk and default risk. Some of the big banks didn’t even want TARP loans, but the Feds basically forced it down their throats. In any case, liquidity problems can be handled through the discount window, that’s what it’s for. My point is that most didn’t face default risk, which is why the TARP loans were quickly repaid.
People keep assuming this proposal is some sort of discount window operation–it’s not. It’s to help banks facing default risk. Those banks not facing default risk can borrow through the discount window. The Fed was created to be a “lender of last resort” not to bailout failing banks (or LTCM).
But even if I am wrong, and the institution needed a temporary loan from the Treasury, it would have been quickly repaid–no big deal. People here seem blind to the fact that it would have worked well in the worst banking disaster in my lifetime. That’s pretty good.
The Numeraire, I hope everyone reads your post on mark-to-market.
Luis, I very much doubt the institution you describe was what Congdon proposes. Are the banks in Spain paying the full cost of their bailout? Was it adequately capitalized?
OneEyedman, You are completely wrong about the big banks, see my response to David. You said;
“The FDIC just just fine today for the small and medium size banks”
The FDIC is a disaster, which has blown up completely twice in the past 25 years. It should be abolished.
You said;
“I’m concerned about collective action problems with this proposal. Maybe the bankers won’t be able to agree on bailouts (or to not bail out, depending on how it is organized) and result is a policy mess. How would you handle that?”
The whole point is this internalizes the problem (currently an externality.) They don’t need to be unanimous, just a majority. If it’s in their interest to avoid a banking collapse, why wouldn’t banks support a bailout?
Luis, But this institution would have worked fine in the worst crisis in my lifetime, so the homogeneity problem can’t be that bad.
Tomasz, I don’t see how your comment relates to this proposal. Don’t managers and shareholders both suffer when the banking system collapses? Do we need other regulatory changes to overcome moral hazard? Of course.
Donald, You find this amusing eh, well I find your comment amusing:
“Sadly, the Banks, over time, will set aside far less resources than are necessary for any real efficacy, assuming they even could.”
You really think the banks would be free to set aside as much money as they wished? Yeah, I’m sure Congress will set up this institution with the express purpose of preventing future bank disasters, and allow the banks to set aside 10 cents in total capital if they wish.
CAN I HAVE SOME COMMENTS THAT ACTUALLY ADDRESS THE PROPOSAL!!
Mike, We are doing this because governments have shown themselves too corrupt and/or too incompetent to do the job. Why would we expect anything different in the future. The UK government expressly told the banks not to expect any bailouts, just a couple years before the crisis. Then they bailed them out.
cassander, Why isn’t this in the same spirit as 1907?
jean, You said;
“I have the feeling that this is more or less trusting monetary policy and systemic risk management to a cartel of banks.”
That’s why I propose that this institution be separated from the central bank.
You said;
“I think that the Fed founders had roughly the same idea, since as you know, the Fed is still formally owned by private banks (this is also the case of bank of Italy…).”
No I don’t. To most people “the Fed” is the Board of Governors, which is not at all owned by the banks. They have 90% of the power. They could do a highly expansionary policy (like cutting IOR) without even consulting the regional Fed banks, which are partly owned by banks.
16. July 2011 at 12:53
The problem with the discount window is that it has a stigma. In the midst of a liquidity squeeze borrowing from the discount window is sending out a huge signal to the market that a bank has liquidity problems. During the the 2007/08 financial crisis the Fed and the other main central banks could not get financial institutions to use the discount window. Hence, the introduction of things like TAF, and forcing capital through TARP to firms who did not need it to alleviate the stigma for those who did need the capital.
16. July 2011 at 22:47
Scott,
A bit slow, but to answer your question: in the presence of unregulated banks or banks not sharing in this scheme (who says this would be a natural monopoly) and pursuing inherently low risk (try to figure out how!) strategies instead of being insured by this entity, you would get adverse selection problems. Unless all de facto deposit taking and lending institutions, plus the foreign headquartered ones would be obliged to participate. And that would create yet another nasty regulatory externality. There is simply no way to do this right, unless you believe that society would be
(a) prepared to accept a highly pro-cyclical (unregulated but also credibly uninsured -bar regulating purely the payments system) financial system relying on NDGP targeting to smooth non-supply shock related fluctuations in activity or
(b) a highly exclusive (i.e. no one is allowed to be a non bank bank) anticyclical system with languishing shares, cronyism (IT, landlords, developers), poor service, high costs, no innovation and highly entrenched, risk averse managers possessing mainly lobbying skills.
Some kind of mix of the two is the likely outcome in the real world and from my experience, I think that anything in the middle is worse than the extremes. But explain that to the politicians.
17. July 2011 at 11:04
It really only partially internalizes the problem. You can’t get full ex-ante optimal behavior unless they capture all of the upside and all of the downside of an intervention.
The surviving banks need not have have incentive alignment with the government or the whole economy. When their competitors fail they can expect to make higher profits, which creates a wedge on the downside between the economy and the surviving banks. When failing banks are rescued the rescuing banks have limited upside (a repaid capital injection) and serious downside in the form of higher contributions to the rescue fund. Therefore there is a wedge on the upside as well. In failed and successful interventions there is daylight between the private and social outcomes.
In your reply to David you talk about the difference between liquidity and default risk as though it was clear at the time who was going through which. This is under dispute. Every institution in trouble claims to be having a liquidity crisis until it is impossible to deny they are actually in risk of default.
17. July 2011 at 14:16
Scott> I agree it is in the spirit of ’07, but not sure it is sustainable the way you envision. If it remains controlled by the banks, it becomes a commons, with the members incentivized to underinvest in it which will mean it will still need to be bailed out by the government once the crisis comes. If genuinely independent, it will develop its own institutional incentives and inertia. Either way though, it’s probably a better solution than out current structure.
17. July 2011 at 16:38
Richard, If banks would rather go bankrupt than be embarrassed, isn’t that their problem? In any case, if they can’t get funds through the fed funds market, they are probably in trouble, and should go to the institution I propose instead.
Rien, You said;
“A bit slow, but to answer your question: in the presence of unregulated banks or banks not sharing in this scheme (who says this would be a natural monopoly) and pursuing inherently low risk (try to figure out how!) strategies instead of being insured by this entity, you would get adverse selection problems.”
FDIC is mandatory, so I assume this would be too.
If they have FDIC, then obviously you need regulation. Obviously the government would need to decide which institutions had systemic risk, and I don’t doubt they’d make a few mistakes. They would have missed AIG. But small companies that lack deposits but offer consumer loans or car loans would not need to be regulated, would they?
Let’s not make the perfect be the enemy of the good.
OneEyedMan, You said,
“In your reply to David you talk about the difference between liquidity and default risk as though it was clear at the time who was going through which. This is under dispute. Every institution in trouble claims to be having a liquidity crisis until it is impossible to deny they are actually in risk of default.”
I suppose the next question is who is best placed to make that distinction. Discount loans are supposed to be for liquidity problems, not default risk. So the Fed already needs to make that judgment. This system doesn’t call for anything extra in that area. But it’s arguable that the institution should also provide liquidity services. I suppose one could argue that any bank unable to borrow in the fed funds market faces default risk.
cassander, You said;
“I agree it is in the spirit of ’07, but not sure it is sustainable the way you envision. If it remains controlled by the banks, it becomes a commons, with the members incentivized to underinvest in it which will mean it will still need to be bailed out by the government once the crisis comes.”
Once again, they would obviously not be able to underinvest, as the capital levels would be set by the government. That’s the whole point.
17. July 2011 at 18:15
Scott
“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? ”
Separating those questions is useful, of course, since both are functions in the public interest but not necessarily combined and/or not necessarily controlled and/or owned and/or operated by one or more government divisions.
I think my previous post gave the extremes in the absence of a status quo in a specific country with specific institutions, from the country’s constitution downwards. Those extremes are a comprehensive system (where all financial institutions -including certain mutual funds, partnerships etc- are licensed and obliged to contribute to the risk fund and the cost of operating the supervisory function) under gvt supervision (but not necessarily backstopped by the gvt) or a system of very narrow banking, populated by all kinds of specialized firms that rely mainly on financial markets for their funding. Such a system would have no money market funds investing in FDIC insured instruments and probably no banks owning large portfolios of investments, because they would rely on payment and custodial fees and have only relatively small (M1) balance sheets. Such a system would clearly be politically unfeasible in the US, probably more so than the other extreme.
Various posts have highlighted the incentive problems that a privately owned (and of course operated) “mutual” insurance entity would face (and having a private entity does not solve the problem of how to PRICE deposit insurance sustainably in a manner that compatible with a high level of competition, lack of pro-cyclicality. The problem of parasitic outsiders was not mentioned. There is an example of deposit insurance completely at arms length from the gvt (Netherlands), That scheme did not do well during the past three years (partially due to the presence of aggressive and weak foreign institutions in the retail market facilitated by the internet) and it will be radically revamped, probably with more gvt involvement.
Preliminary to structuring the right incentives is the problem of how to set adequate forward looking premiums (a big difference with health insurance schemes that are basically loss recovery systems with little forward perspective) that cover the business cycle (in order to avoid procyclical behaviour with a sudden onset due to eg the fire sales problem) and up to what level of severity and how to differentiate those premiums across the spectrum of financial institution activity. Maybe catastrophe insurance would still be needed to make insured medium term CDs safe enough.
Hand in hand with that problem is macroprudential supervision (I assume that would still be on the table), which if done right should make the system less risky (and lead to lower premiums if done right). However, a solely industry owned and operated fund would not solve the problem that macroprudential supervision is focusing on, since (assuming a comprehensive scope for the fund, which is unlikely, so defections should precede and exaggerate any adequacy problems) the mother of all systemic risk would be insolvency of the deposit insurance fund. At present FDIC capital adequacy is a quaint issue like the Federal debt ceiling, but a private scheme might get into circumstances similar to Freddie and Fanny and be a real political problem. I suspect that the rating agencies would not know how to rate this thing or what sort of qualitative and quantitative characteristics it should have. Then on top of that would be very difficult governance, given the diversity of the members.
So all in all the problems are politically similar to healthcare: no regulation and highly differentiated provision with maybe socially unacceptable outcomes, or a system that is highly comprehensive and hence riddled with inefficiencies, especially given the scale of the US.
As to the question of the Central Bank involvement: the monetary authority should not de the capital provider in last resort (and hence also not the insurer), for the simple reason that it is also the supervisor of the largest financial institutions. It could end up favoring the banks it has rescued in order to boost their franchise value prior to privatization.
17. July 2011 at 20:30
Scott
>Once again, they would obviously not be able to underinvest, as the capital levels would be set by the government. That’s the whole point.
Regulatory capture is what I fear. The member banks would lobby over the required capital levels and the rules surrounding them. A great deal of mischief would also surround questions such as who gets to be a member bank and how one becomes one, how the central bank can regulate the member banks and non-member banks, and so on.
Anyhow, like I said, I’m not at all certain this scheme is worse than what we have now. In fact, I’m pretty sure it would be better. But you asked for what’s wrong with the plan, not what’s right with it.
18. July 2011 at 08:52
Rien, The original sins of US banking were branching laws and deposit insurance. Canada has never had branching laws, and they didn’t have deposit insurance until 1966 (and still don’t really need it.) And their system has done fine, with no problems I’m aware of. We should just abandon the US banking system entirely, and adopt the Canadian system (preferably pre-1966, but even post-1966 would be much better than our current system.)
As far as health care, I think the Singapore regime (HSAs) would be much better than our current system, although the Swiss system is also pretty good (probably higher quality.) The key reform is to get people to pay for health care out of pocket.
18. July 2011 at 08:53
Cassander, Yes, but “regulatory capture” can be used against just about any public policy reform, can’t it?
18. July 2011 at 10:42
Scott> Of course, which is why do nothing is often not a terrible idea, but some structures are more susceptible than others. I am inherently skeptical about public-private hybrids, and out new bank would be no more private than Fanny and Freddie are. The Fed, for all its faults, is fairly immune to traditional regulatory capture, though the recent crisis has shown it is quite vulnerable to intellectual capture. In particular, I fear that the new bank would become a closed club rather quickly, and become a tool that bankers could use to make their industry even more oligopolist than it already is.
19. July 2011 at 08:41
Cassander, But doing nothing is also susceptable to regulatory capture. (BTW, I do favor complete laissez-faire in banking.
19. July 2011 at 19:39
Scott,
The Canadian outcomes (as far as crises and taxpayer expense) have been fine, as in many developed countries of Canada’s size (the state of california?) That was actually a system at the extreme end on my scale, with enormous barriers to entry once the incumbents had established themselves. Canada has long been (like Germany, Italy and especially The Netherlands) a graveyard for foreign invaders*.
However in those countries there tend to be two groups of critics: those that do not like the high barriers to entry (non-incumbents and customers rejected by uniformly conservative lending standards). And of course creative and ambitious staff who would like to see a little more action and bonuses…
However the thing is quite complex: bank cost efficiency across countries is extremely diverse (unsurprisingly, much of the US in the high cost segment, partially due to the persistence of obsolete payments systems, partially due to endemic productivity problems in established service industries (similar to healt care). One should expect that a much narrower banking system (where banks would not have the option to cross-subsidize businesses) would be able to suddenly swing towards walmart-like cost management approaches.
What is also diverse is approaches to consumer and small business lending. In the smaller markets there is insufficient scale for specialized businesses (credit cards, mortgage banking, asset based commercial finance, etc. These things are typically part of universal banks (and in the US many of the highly efficient specialist firms have been bought by bank holding companies. The problem for those firms was that under the old regulatory system (limitations on location especially) they were able to overcome their competitive disadvantage (much higher funding costs) by being able to operate across markets and thus have higher diversification. In the 1990s all of that changed.
But these specialists indicate for me at least that service provision in an insured narrow banking system (payments, custody, trust business) with lots of specialist firms providing uninsured finance and investment services would not necessarily be worse of less efficient than the current US verion of universal banking. Plus such a narrow banking system would approach your ideal environment for NDGP targeting using market information, because the main channels for monetary policy would be unregulated.
I am not so sure such a system (politically unfeasible of course, too much at stake for the incumbents) would present a greater macroprudential challenge, but I suspect the specialists would be as procyclical as the Basle II would be. But, successful NDGP targeting might make most macroprudential avtivity redundant..
20. July 2011 at 09:07
Rien, I’m no expert on banking, but those comments seem reasonable to me.
4. April 2012 at 06:30
“…banks are short of capital…” They have always been short of capital. Do not be fooled, our banks do not have enough in liquid assets to pay us all if we ever needed our money at the same time.