John Cochrane on taxing debt, or toward a run-free financial system

Here is John’s new paper (pdf):

The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology overcomes traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become.

I suggest that Pigouvian taxes provide a better structure to control debt issue than capital ratios; that banks should be 100% funded by equity, allowing downstream easy-to-fail intermediaries to tranche that equity to debt if needed. Fixed-value debt should be provided by or 100% backed by Treasury or Fed securities.

This idea has promise, but overall I am a little confused.  I don’t think of illiquid financial institutions as the major problem, as traditional lender of last resort functions of central banks can deal with those dilemmas.  The truly gut-wrenching issues in our financial crisis — or that say of Ireland or Iceland — involved insolvent financial institutions.  And if these institutions are insolvent, was a “run” really the nut-crusher?  Ex post you either nationalize or let them fail or somehow bail them out, no matter what the earlier capital structure had been.  The “run” from short-term capital might make some banks insolvent more quickly, but are equity prices really so much slower to react?

One significant effect of an all-equity capital structure would make insolvency more transparent and this in turn might make zombie banks less likely.  This may be a good way of forcing the hand of regulators or shareholders.  But it is a mixed blessing too, especially if your resolution facilities are highly imperfect.  Citicorp arguably has been insolvent a few times since the 1980s, although not transparently so.  What if this insolvency had been more obvious the first time around, namely if Citi had been made all-equity?  It might have prevented some financial structures — most of all Citi — from becoming too large or too difficult to unwind.  That said, in the short run volatility probably would have been higher, if only because a commonly revealed insolvency is indeed messier.  And over the longer haul, to the extent share markets overreact to new information, rather than just reflecting fundamental values, greater transparency for the financial sector could in some ways be dangerous.

An all-equity bank would avoid the problem of equity holders taking too much risk at the expense of debt holders, but it does not seem this was a major problem last time around.  Rather simple overconfidence seems to have been the culprit.  Furthermore this moral hazard problem might be recreated in some form through the evolution of differing forms of equity seniority.

Arnold Kling adds comment.

For the pointer I thank Samir Varma, a loyal MR reader.


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