Can vigilant creditors limit excess bank risk-taking?

I had promised to address that question.  Ideally, enforceable bond covenants should limit bank risk-taking, and ensure major bank solvency, but is that feasible?  I see a few problems with the idea:

1. It is very hard for a government or central bank to precommit to a "no bailout" policy.  This is partly because of powerful special interests, but most of all because political time horizons are short.  Most bailouts do patch things up in the short run, whether or not you like their longer-run consequences.  Bondholders know this, and they are less vigilant ex ante.

2. Bondholders don't and can't have much idea what is going on inside the trading book of a bank.  It doesn't matter how financially sophisticated the bondholders are; the point is that the trading book must remain fairly confidential and a lot of risk can be put in the trading book.

3. Some of the creditors — the short-term creditors — may be in on the deal.  They lend money to the banks, under the premise that risky strategies will be executed.  The short-term, collateralized creditors may not themselves be bearing much risk, given their superior "flight" capabilities and they also may be receiving a slight premium for such lending.

4. The net risk of a bank position is not determined solely by the bank's portfolio.  Say a bank lends money to homeowners and then those homeowners increase their leverage.  The bank is now in a riskier position, and de facto a more leveraged position, althoug it's measured leverage hasn't gone up a whit.

5. Experience with the ICE clearinghouse — one form of bank creditor — so far suggests that it serves bank interests, and indeed is largely controlled by the banks, rather than restraining them.

6. Let's say a no-bailout policy was credible, as indeed it was in the 19th century (there were no bailout facilities).  What does the equilibrium look like?  Is there less long-term lending to banks and more short-term lending?  Would that make banks more or less stable?  Few people think this is a positive development for countries.  Would banks be more subject to "capital flight" risk?

We also could expect greater mutualization of banks, as was the case before deposit insurance, and we could expect experimentation with corporate forms other than limited liability.  My view is this is what would be required to limit excess bank risk-taking.  Yet I believe that, for better or worse, it is politically impossible.  In a nutshell, big government needs big finance (or much higher taxes).

One reason that bailouts are so politically popular (not in rhetoric, but in their practice and in their effects) is that they make financial crises less common but, when they come, more severe because more leverage has built up.  That change in the structure of returns is usually a political winner, call it "Ticking Time Bomb."

Comments

Re: #2, why not require banks to make their trading book public? Bondholders could more easily limit risk taking by banks. Better, everyone in the market could see what the smart money is shorting, making it easier to foresee and forestall potential crises.

Clearly the banks don't like this because it robs them of their information rents. But isn't everyone else better off?

Tyler "Socrates" Cowen is still asking "Who will guard the guardians?" I suggest to read Plato again --and once you realized why he was wrong read at least Adam Smith and Jim Buchanan. And also read about the history of credit in the past 2,500 years, starting with Roman law. We don't need to reinvent the wheel every time a wheel collapses.

Isn't a lot of the problem with "too big to fail" -- something we've made worse over the last 3 years (e.g. Bank of America swallowing AMRO, Merrill Lynch, Countrywide)?

Smaller entities have less political pull.

Well said.

Point 1 is really the most important explanation. On point 2, creditors can always walk away if they don't understand banks' books as i explain here http://www.macroresilience.com/2009/12/28/informa... .

Point 3 is relevant and not emphasised enough - once there is a loot to be shared, it's rational for all parties to cooperate to maximise the size of the loot. On point 5, ICE really isn't a good example of a bank creditor given that its simply an insider's club of the banks.

On point 5, a world with a credible no-bailout policy would involve a lot less maturity transformation by banks. Given the rise of natural long-maturity investors like pension funds and insurers, this is no bad thing as I explain here http://www.macroresilience.com/2010/10/21/questio... . Indeed there's significant empirical evidence of banks laying off their liquidity risk to pension funds and insurers - The Bank of England even described it as a private sector replacement for their liquidity operations (ref http://ftalphaville.ft.com/blog/2010/12/17/439851... ). Of course if this is the case, it begs the question why the same result could not be achieved by pension fund and insurer assets being pooled into a mutual fund available for long-term investment rather than our current fragile system.

And the system would not be stable, but it will be more resilient i.e. we would have more frequent and less severe disturbances instead of infrequent systemic collapse.

1. I think we should move towards a system that they use in the insurance industry to manage or miminize insurance carriers failures.

Recognizing that the injured person is the policyholder, states have developed "insurance guarantee funds"--bascially a mutually owned insurance company that covers the policyholder if one of the state insurance carriers goes bankrupt. Each of the carriers is assessed for the clean up costs. What this does is make carriers more vigilant of the financial condition of the other carriers, and, ironically, support vigorous financial oversight and even regulation since they are at risk if one carrier begins to get too creative. It certainly aligns incentives. ( I would even go for minimal pre-funding of such a plan by banks.) You could even require that bond offerings have part of the offering be set aside in such a fund initially, and let the money revolve back to bondholders if there is no problem...that would insure bondholders and also incentivise them to monitor their bank or other banks.

2. I think this mutualization insurance approach gets this off the backs of the public.

3. The problem that this post and my comments do not address is how to handle international banks. The large banks accept deposits from abroad and, more imporantly, lend abroad. Things we do to bail out lenders or assist risk taking by banks to lend to foreign lenders is a cost to our financial system. Since bonds are purchased by US persons and foreign persons, using bond proposals above handle part of this problem, but, to the extent that the government has to step in and clean up a mess, they may be cleaning up a mess for the benefit of foreign lenders and customers. This seems unfair--to allocate the costs to the US, and the benefits to foreign customers or lenders. So, focus on this issue sometime.

If this were a serious problem, no one would make long-term loans to banks. And indeed, when you look at investment banks, which do engage in risky activities, you'll find that their own borrowing is skewed to short maturities. If their creditors become uncomfortable with the bank's activities, they can refuse to roll over the debt.

So risky investment banks can't sell their bonds? That's not a bug, it's a feature!

John Hussman says:

4) We did not avoid a second Great Depression because we bailed out financial institutions. Rather, the collapse in the economy and the surge in unemployment were the direct result of a gaping hole in the U.S. regulatory structure that prevented the rapid restructuring of insolvent non-bank financials. Policy makers then inappropriately extended the "too big to fail" doctrine to ordinary banks. Following a striking loss of public confidence that resulted from arbitrary policy responses, coupled with fear-mongering by exactly those who stood to benefit from public handouts, the self-fulfilling crisis was contained by a change in accounting rules that effectively disabled capital requirements for all financial companies. We are now left with a Ponzi scheme.

@ Andrew

The FASB change was to merely restore the rules that they had been using up until....2007.

Marking performing assets made illiquid in a crisis to those crisis levels (hey, how much can I buy that house of yours for if a fire is burning 500 yards away?) and then requiring reserves to be calculated off those fire-sale marks is pro-cyclical lunacy and was probably the primary reason a containable, '1980s S&L crisis'-level problem metastasized into an almost total wipeout of all major US banks.

One of the reasons banking got so ugly in the 1930s was the existence of those ridiculous MTM rules. They were suspended in 1937, and that worked exceedingly well for 70 years (including during the aforementioned S&L crisis), until they were restored to early-1930s lunacy in 2007. Gee, what kind of things happened in banking right around then?

It works both ways, this isn't a call for bankers to get to screw everyone in a 'Ponzi scheme'. When a bubble is bubbling, the lunatic 'strict MTM' rules allow banks to keep less and less collateral against rising assets that are marked vs market prices, not cashflow. Instability is enhanced.

Brian Wesbury at FirstTrust has a lot of very good writing on this topic.

Isn't another key point to this that you can always abstain from lending?

However, if you can't lose by lending because lenders get bailed out, then you have to lend. Wouldn't that be incredibly (infinitely?) inflationary?

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