The plain vanilla option for bank reform

I’m taking a quick break from my blog break to throw in some food for thought re. the bank-reform debate, which has been simmering in earnest.

I also feel pretty energized after a mind-blowing trip to Asia, which has forced me to rethink the definition of “construction boom”, “shopping mall” and... “exotic cuisine”!

Anyway, at the crux of the reform debate are measures to prevent banks from engaging in the risk-taking behavior that led to, yeap, “the worst financial crisis since the Great Depression.” Proposals have targeted, inter alia, bankers’ pay, with the view of curtailing greed and short-termism; and bank capital requirements, to basically make banks’ risky activities more expensive and less procyclical.

Personally, I’m against the former, and not because I have any particular affinity for bankers (unless they are economists!). I just happen to think that, per Econ 101, employee compensation, together with the return to shareholders, should be both derived from a firm’s profit-maximization exercise—provided this exercise also internalizes the systemic implications of the bank’s own risk-taking behavior.

Put differently, if we can make financial institutions pay explicitly for what is now an implicit, unpaid-for insurance provided by the taxpayer against a systemic banking crisis, I see no reason why banks cannot distribute any left-over profits to their workers and capital owners as they please.

For this same reason, while I partly see the logic of the second proposal—to introduce counter-cyclical capital requirements—, I don’t think it’s enough to do “the job”: Yes, it might well discourage banks from engaging in “excessive” risk-taking behavior in good times; but it still does not make banks pay in advance for the next financial bailout which, believe me, will happen again at some point.

Against this backdrop, one idea for making banks pay for systemic-risk insurance was put forward in a paper presented at the 2009 Jackson Hole symposium by MIT economists Ricardo Caballero and Pablo Kurlat.

Accordingly, banks would pay a fee to the Fed in exchange for potential access to insurance, which would be triggered if systemic risk exceeded a certain threshold. This access to insurance would take the form of "TICs" (or Tradable Insurance Credits)—securities that would be issued by the Fed to the fee-paying bank, providing access to Fed guarantees on a pre-specified pool of the bank’s assets.

The paper has some interesting insights and, actually, a somewhat different tilt than the issue I’m raising in this piece (Their point is, in part, that there is a need for a new policy tool to help remove market uncertainty about the depth of bank losses during a systemic financial crisis). So I recommend that you read the whole thing.

Insights aside, I think this type of proposal suffers from a number of flaws, some of which are fundamental. On top of that, it is far more complicated than what I think is a more straightforward solution, which could not only help generate a less procyclical risk-taking behavior, but also address the need to make the now implicit insurance explicit. Let me explain:

Flaw number one in the Caballero-Kurlat approach is the fact that the guarantees would cover a financial institution’s assets (instead of its liabilities).

Why is that a problem? It is, because it would make extremely difficult the failure of any too-big-to-fail financial institution, even if such an institution “deserved” to fail. This would unduly protect the owners of such an institution, despite what might have been excessive risk-taking, lack of oversight and/or sheer incompetence on their side.

As an example, rewind to March 2008, when a (clearly systemic) financial institution in the name of Bear Stearns is at the brink of going bust. Now, an eventuality of that nature is bound to trigger a TIC-like guarantee by the Fed to every financial institution holding TICs, including Bear Stearns.

This is despite the fact that Bear Stearns may be actually insolvent and thus “deserving” to fail (yes, we can debate this, but in a separate forum). The distinction between a liquidity and a solvency crisis is practically irrelevant in the TIC framework.

So this is how it would go… Bear Stearns is about to fail, systemic risk rises unexpectedly, Fed guarantees are triggered, Bear Stearns is saved, systemic risk subsides and all ends well… only that the principle of efficient resource allocation has been wildly damaged: The most short-sighted, over-levered and incompetent bankers on Wall Street are still allowed to roam around, feeling good and getting ready to go back into the game.

To be sure, the Fed (or the relevant supervising institution) might still decide to declare Bear Stearns bankrupt and wind it up, while providing guarantees to the remaining financial institutions. But that would trigger follow-up complications:

E.g. how would we (and the Fed) know ex ante that, urrrh, Lehmans or AIG, say, are soundly-managed institutions deserving to survive, courtesy of the Fed’s guarantees? Or, if the Fed were to trigger its guarantees on a selective basis, what would that do to market uncertainty—the very problem the TIC proposal was meant to address?

But let me go to the second fundamental flaw of the Caballero/Kurlat proposal: Which is that it confuses the roles of the fiscal and monetary authorities in a crisis resolution framework. Contrary to what they suggest, the provision (and, ultimately, the cost) of any guarantees on any financial institution should be the role of the fiscal authority (ie the Treasury), NOT the Fed.

True, the Fed did provide backstops against certain assets or liabilities of financial (and non-financial) institutions during the 2008 crisis, as the crisis escalated. But that was due to (a) the absence of a systematic framework for crisis resolution; and (b) the inability of Treasury and Congress to respond proactively to the dramatic events that unfolded. Yet, what we need is not the Fed taking the lead in what is essentially a fiscal activity; but a solution that would help avoid the need for the Fed to get financially involved, for the sake of its financial and political independence.

So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.

If you think this provides too nice a treatment to the creditors covered, think again: These guys would now be getting paid much less for their lending to the bank, since the default risk would now be minimal thanks to the explicit insurance the bank is paying to the government.

Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

What are the advantages of this approach?

* First, it allows for the failure of insolvent, poorly-managed institutions, inlcuding systemically important ones.
* Second, it makes financial institutions explicitly pay for the insurance that taxpayers have been implicitly providing to them.
* Third, it can be designed to be countercyclical and incentive-compatible.
* Fourth, it provides provides a more predictable framework for crisis resolution than the status quo, notably with regard to the treatment of the different parts of the capital structure, if it were to fail. Uncertainty about the treatment of shareholders and creditors of different seniorities was a major driver of the market volatility that prevailed in 2008 and early 2009.
* Finally, it makes it clear that any net costs from the resolution of a failed financial institution will be borne by the fiscal authority instead of the Fed.

So here you go, my first wonkish piece for the first official day of Fall. Pretty plain vanilla, dare I say, compared to some of the alternatives out there. And, believe me, after weeks of heated policy debates over silk-worm skewers, bamboo fungus appetizers and live squid entrees, plain vanilla sounds good to me!