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."


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