This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk.
I’m still working on the longer piece. The general point is that banks are a mechanism for risk-sharing, as is debt for that matter.
genius! is that what you are paid for?
Suggests a reason why FDIC is in place?
Not sure I get this.
First: You say that banks exist to share risk. Is this because the bank gives 100 people loans, and maybe 10 of them are risky for default but the law of large numbers helps smooth out the uncertainties? So that the bigger a bank is, the more it is serving its “function” as a risk sharer by pooling more loans?
I’m not sure I see this as “sharing”, actually. The depositor at a bank has $X in an account. X is, I think, guaranteed not to go down (no downside risk– is this right?). Whereas the bank does have the downside risk that many loans are defaulted on. So the bank is not sharing its downside risk with its depositors.
The bank pools risk, but it seems they don’t “share” risk at all, at least with their depositors. That would be something like securitization.
Also:
“This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk.”
You mean, the more we subsidize their risk, the more we are taking on their risk, and the less they serve as a risk “firewall?”
I agree with the “firewall” image but the risk “sharing” image I don’t understand.
This will make a great commercial for a bank. Deposit with us and hare the risk of our screwups.
Could you write a few sentences explaining how having counterparties with 30, 40, or 70:1 leverage ratios is any different from lending money to a crackhead?
The art of regulation is to keep banks from taking foolish actions, not to protect them from the consequences of those actions.
OFFTOPIC: TC, I am a long time disloyal reader of this blog. My ad blocker was temporarily off and I noticed the anti gay marriage ads on your site(CA prop 8). I was wondering what your ad policy is ? Do you pick your ads/use a reseller/endorse the ads placed. As someone with libertarian tendencies, why would you endorse/place ads for something which has nothing to do with govt. If you have a somewhat nuanced take on it, would you mind explaining it. Googling your archives didn’t turn out much.
OFFTOPIC: TC, I am a long time disloyal reader of this blog. My ad blocker was temporarily off and I noticed the anti gay marriage ads on your site(CA prop 8). I was wondering what your ad policy is ? Do you pick your ads/use a reseller/endorse the ads placed. As someone with libertarian tendencies, why would you endorse/place ads for something which has nothing to do with govt. If you have a somewhat nuanced take on it, would you mind explaining it. Googling your archives didn’t turn out much.
Since the site is a private enterprise, why would it need to explain
its ad policies or are you suggesting that it should refuse
sponsorship from SOME political advocacy campaigns?
Actually, when I got married I had to go to my county courthouse to
obtain a marriage license. I had to answer a few questions and pay a fee.
Excepting “common law” marriages, you will not be held to be married by the
state without that license.
Any discord in a marital relationship can involve policy,
social services and ultimately domestic relations courts.
Do you want to explain how that “has nothing to do with govt”? Or was
the big fat curveball of lousy argument just meant to betray
the fact that you are just a “seminar poster”?
In any case, I prefer the label “affirming traditional marriage”.
I still maintain the true libertarian position on homosexual
relationships should be, dispose of your property under the
auspices of your private contractual and testamentary arrangements.
“This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk. †¦.The general point is that banks are a mechanism for risk-sharing, as is debt for that matter.” –Tyler Cowen
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1) Let’s broaden the role of banks in a market-oriented economy to include them and all other financial institutions of importance: not just commercial banks, but investment banks, mortgage brokers, insurance companies, credit-unions, stock and bond markets, mutual funds, money-markets, hedge funds, and no doubt others that don’t leap to mind.
The principal function they all share, at least in theory and maybe, if there is sufficient transparency and accountability — however achieved — to ALLOCATE CAPITAL EFFICIENTLY AND MANAGE RISK PROPERLY. And through all phases of the business cycle.
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2) Yes, an ideal — but one that sets up a good benchmark for how we should evaluate their overall functioning over time.
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3) To make all this more realistic, we could add to the above definition that the “management of risk” is, invariably, shared by capital-holders: households and businesses that have cumulative savings and hope to earn interest-dividends or capital gains or the like.
The role of financial institutions, then, seems to be to act as an intermediary between savers as creditors and would-be borrowing debtors — again, households and business firms, but also governments — and to equate S and D in loanable funds markets in ways, we hope, that are fully transparent and accountable . . . with accountability meaning, among other things, that the average creditor (say, a household depositing money in a bank account) and the average borrower (say, a household seeking a loan to buy a car) can understand what the market-exchange here amounts to.
And yes, as some posters have noted, this exchange can — given time-preferences — entail inter-temporal preferences.
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4) Stay with this simple model.
The problems arise with all the new innovations in the financial world since the start of the 1980s that have enormously complicated the transparency and accountibility of financial exchange between savers and borrowers, with the financial institutions as intermediaries.
Junk bonds; a misuse of claims by brokerage firms in the 1980s that personal computers will allow for a very speed shift between equity and bond markets if one or the other falls below a threshhold; the S&L mess, abetted by the new Mortgage Back Securities (MBS); the blurring of the lines even between commercial and investment banks (and S&L banks) even before the repeal in the late 1990s of the Glass-Steagall act that, in effect, shattered the boundaries. Plus the explosion of hedge-funds, one of which — Long-Term Capital Management (run by two Nobel-prize economists and 24 economic Ph.D.s) — that required a big Federal Reserve bailout.
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Worse yet, there was the creation — model-based, with the use of computers — of complex financial derivatives that most of the investors in didn’t even seem to understand (or, eventually, care about) . . . and the refusal in the Clinton-era of the US Treasury (and Federal Reserve) to regulate them. That worsened in the current decade with the explosion of the house-asset derivative market, global in nature — demanded by trillions of dollars of footloose capital from oil-rich countries and China (and Japanese yen-based, low-interest loans for investment and speculative purposes world-wide) — that then entail a huge world-wide chain of creditor-debtors that was not only not transparent and accountable, but — it seems — left the creditors, whether based in concrete buildings with a name, or just a special vehicle instrument operating on the Internet, with an interest only in gaining fees and possible future gains while trying mightily to pass on all the risks.
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And the response of the Bush-W appointees in Freddie Mac and the SEC and elsewhere, not to mention the Federal Reserve?
No need to regulate these genius-driven innovations. They were working to increase wealth globally, both tangibly (in house-purchases especially and rises in GDP) and on paper. And they were all self-regulating.
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5) So where are we?
What worked well in financial markets during the heyday of regulated financial markets — roughly by the end of the 1930s until 1980 or so, when the institutions and their financial instruments and their credit-analysis and risk-management were fairly easy to track: that is, they were transparent and accountable — started to rip apart under the pressures of financial innovations, one after another, on one side and the pressures on the other not to extend governmental regulations on the other. And when, to boot, there wasn’t $70 trillion dollars worth of footloose capital in the world by 2006 — a doubling of the cumulative $35 trillion that had taken centuries to accumulate around the world in capital eager to find good investment-returns (with low-risks entailed, it seemed) . . . a downside of globalizing trends that reflected tremendous imbalances around the globe.
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Funny thing is, in the era of effectively regulated financial institutions, say 1945-1980, none of these erratic, half-loony balloons and busts occurred. And oddly, nobody worried about moral hazard thanks to a variety of governmental innovations in financial regulation and the floor set to bank depositors by FDIC.
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6) A conclusion?
The burden would seem to be on those, then, to show how — on a cost/benefit basis — the big financial innovations since 1980 or so, largely unregulated — have had a benign overall effect on the US economy . . . or, for that matter, the global economy. Remember, on an “overall” basis. Not just pointing to this or that desirable effect, while ignoring the long-term costs, not to mention the recurring short-term financial shocks since the mid-1980s.
That is, whatever else might have dislocated the global economy after 1973, it was the combination of oil-shocks and misguided government policies (including central banks) that underpinned the dislocations . . . not financial institutions. These seemed, until the 1980s, to be doing fairly well what they should: allocate capital efficiently and manage risk properly. And for financial institutions to perform this role adequately again, they will have to be carefully regulated to keep pace with all the new financial innovations that have shot up and multiplied over the last three decades.
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Michael Gordon, AKA, the buggy professor
Isn’t the reason the crisis has been so broad basically due to the fact that financial systems were too efficient in spreading risk? It can be said that regulation works to increase robustness by isolatating risk through artificial barriers against efficiency.
Markets are often considered in evolutionary terms: the economy becomes collectively stronger when the ill-adapted perish.
While larger organisms are often more efficient, prosperous and robust during times of relative stability, the drawback is that it only takes a single bullet to the brain to kill even the cells in the toes. Smaller organisms are more evolutionarly agile and diverse, and better able to collectively withstand cataclysmic events.
As globalization continues, and the global markets become more connected and efficient, the world as a whole will become more able to protect itself from the usual smaller economic dangers, while ironically becoming even more exposed to the one crisis that dooms it all. The world is quickly becoming ‘too large to fail’, but who then will bail it out?
Ah, thanks Ricardo, that’s clearer. Access to credit smooths out any bumps of year-to-year (or day-to-day) income uncertainty.
But what about planned large purchases, like a couple buying a house, or a small business owner investing in a tractor? Here debt is primarily a means of stretching out the time frame of a large purchase, right? Does this “time stretch” function fit under “risk sharing” in some way I don’t get?
Hi, I need a sentence using the word dissimulation
Is it realistic?
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