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.


I'm with Kling on this one.

What causes the prerequisites for a run? The search for yield in a market with excess liquidity (low returns), and that in turn implies a commensurate acceptance of risk. That's why the shadow banking system comes to exist at all. It's at times of excess liquidity (accompanied by solid GDP growth) that things like CLOs and bank check companies come into vogue.

On the asset side, if all debt is backed by equity, then it seems that I can't collateralize my house for a mortgage. The collateral value is the equity (it's a counter liability), although it's not liquid equity. In Cochrane's vision, it would seem a mortgage would require equity rates of return (ie, it would either be uncollateralized or collateralized twice over, depending on the system), and there would be fewer houses and smaller ones at that.

There is and will continue to be a mismatch on the asset and liability side of a bank's balance sheet. While I understand the Scott Sumner can't see a bubble, you can pretty easily see them if you use binding constraint analysis. It can't take a top 3% income to purchase the median home. So policy at the Fed is the first line of defense. If the Fed blows bubbles, sooner or later they will tend to pop.

Otherwise, I'm probably with Kling--make a crisis easier to fix. And I could be persuaded along the lines of Gorton--still the alpha and omega of bank runs for me--about chartered institutions for the shadow banking system.

Comments for this post are closed

I agree totally that insolvency is the proper focus for our attention. Contemporary banks are over-selling the safe asset, and bank accounts should be structured better so that there is less risk of insolvency. Now, there is a problem of them being too correlated to fail - an economic downturn affects the system as a whole, leading to crises and bailouts. If banks were insured against macroeconomic risks, bank problems would be less correlated and there would be less moral hazard.

Comments for this post are closed

Insolvency will be a much much smaller problem when banks are all equity financed. The shareholder will go away with zero but otherwise nothing will happen. The insolvency under this regulation can't be compared with the insolvencies in the past years.


Pure equity-financed companies cannot become insolvent, except for something like a legally-incurred liability (e.g., a tort), so, yes, insolvency will become a much smaller problem. Other problems will result.

Cochrane is still talking about depositary institutions and allowing short-term financing (not pure equity) but argues that these funds be placed in short-term Treasuries. Same idea, though - there's virtually no insolvency risk in his proposal, or at least until the U.S. Treasury becomes insolvent or in the case of legal risks per NP.

Comments for this post are closed

Comments for this post are closed

Yes! In fact, I would say that the specter of illiquidity is one of the main factors through which the insolvency of a major institution damages the economy. If Firm A becomes insolvent, the reason there is pressure to bail them out is that Firms B and C own Firm A's debt. The sudden evaporation of assets at Firms B and C (say, Firm A's debt becomes worthless) makes these firms less solvent. But if B and C are 100% equity financed, they are at much less risk of becoming insolvent themselves when A goes under.

Comments for this post are closed

Comments for this post are closed

Murray Rothbard would be rising from his grave to shake Cochrane’s hand.

Ed Prescott is making similar proposals about narrow banking.

This type of banking reform is pie in the sky as is free banking

The old question I was asked when working in a Prime Minister’s Department in Canberra was “That is not going to happen so what are we going to do now.”

That last question is where libertarianism - in fact all of the "isms" - crash on the rocks. All of the grand ideologies contain an element labeled 'something magical happens" somewhere in their org chart.

I think that's quite correct. It's the whole point of Gorton's "Slapped by the Invisible Hand". He argues that there are inversions during financial panics which prevent ordinary valuation systems--upon which normal libertarian property rights depend--from functioning properly. For example, the notion of mark-to-market fails because there may be no market and the information requirements for a fair valuation may be missing. In Gorton's terms "information insensitive" securities become "information sensitive", and this impedes the proper functioning of the market.

Thus, the appropriate prescription during these events calls for suspending market-to-market, terminating bank-by-bank disclosures, and restricting withdrawals. None of these are liberal (libertarian) policies, and yet they appear to be the correct prescription during financial crises.

If you're a liberal (libertarian), "Slapped by the Invisible Hand" should be required reading, if for no other reason than because it illustrates the limitations of libertarian ideology. (I myself fall into the liberal (libertarian) tradition.)

I agree with this entirely, right down to the punctuation. In a crisis, you do things you would never think to do in peaceful times. The easiest example is physical threat. If a maniac bursts into your home, you will do whatever it takes to eliminate the threat, like shooting him. In normal times you don't go around shooting people.

This idea has a long history amongst the intellectual descendents of Rousseau as well as with Burkean Conservatives. The manufactured crisis has been a part of radical politics since the 19th century. It has also been a justification for suspending civil rights in responding to radical assaults.

Comments for this post are closed

Bravo Steven...when Barney Frank announced that strict mark-to-market would be changed BACK to the looser 'mark-to-cash flow' rules that prevailed from 1935(ish) to 2007, the stock market literally bottomed that day and began the recovery (March 9, 2009). It was silly to value mortgages as what you could sell them for in early 2009, but that's just what was done so banks looked 'insolvent'. They weren't, under any normal market condition.

Comments for this post are closed

Comments for this post are closed

Comments for this post are closed

Comments for this post are closed

>>>Citicorp arguably has been insolvent a few times since the 1980s, although not transparently so.<<<

I'm not sure that accurate. It has been blazingly obvious to anyone bothering to look that Citi is a zombie bank. One of the great mistakes of policy makers in the crash was not dissolving Citi. Instead they were allowed to level powerful friends to avoid it. That compounded the error as it signaled to everyone that the best asset to have is powerful allies in government. Then even the worst offenses will be forgiven.

Why is Citi a zombie bank, outside of crazy MTM crisis valuations?

Comments for this post are closed

Comments for this post are closed

Some forms of taxation (Pigouvian included) seem always to be the solution for practically everything except funding the functions of governments.

Comments for this post are closed

Aside from the tax differences, I don't understand people's fixation with capital structure. Does it really make you feel so much better if we call subordinated debt preferred stock, and instead of allowing investors the ability to force a bankruptcy we give them the power to force a liquidation when too many coupons are missed?

Comments for this post are closed

If we privatized deposit insurance, the insurers would decide these issues without even asking us, and we could move on to functional questions like whether teachers are paid enough or whether grad students should get free birth control.

Comments for this post are closed

Most banks' leverage is about 20 to one. Bank (FDIC-insured) capital is a check on management risk taking and on asset growth.

A bank that is not well-capitalized, per the federal regulations, may not accept, renew or roll over brokered deposits. If the capital ratios decrease below certain levels ideally the bank would be closed by the chartering authority, FDIC-insured deposits paid and bank assets liquidated by the FDIC

Since 2008, it seems as if any company that isn't a saloon or sewage treatment plant is called a "bank."

We need to distinguish FDIC-insured depository institutiions from the rest. Since late 2008, approximately 400 FDIC-insured banks went "belly up", costing the FDI fund (and all FDIC-insured instituitions that pay FDI assessments/premiums) about $90 billion. There was no run on the subject banks.

However, many of the 400 failed banks had, in addition to insured core (small denomination, stable, from the local people) deposits, approximately 30% of their funding in volatile liabilities (repurchase agreements and brokererd deposits). Not only is that money subject to "run", it may evidence too much risk-taking in that more money likley was loaned into the local economy compared to the core funding supply from that community.

Commercial banking is heavily regulated and there is excessive competition. As such, margins are low, which incentivizes managements to reach for yield, i.e., take excessive risks.

The risky demand deposits were all uninsured in Sep 2008 thanks to the deregulation efforts in the 60s, 70s, and 80s that specifically promised that NO ONE would ever consider funds put in the Reserve Primary Fund as liquid demand deposits because EVERYONE would understand money market funds are not bank deposits but purely equity funding of debt.

The run on money market funds in 2008 was something conservatives promised would never ever happen because the chicken littles who said letting Reserve Primary Fund deliver withdrawals multiple times per month and with no waiting period would cause people to think the funds were just like checking and savings were just totally wrong. NO ONE would ever treat Reserve Primary Fund as a demand deposit checking account.

I remember the debate and the name of the fund, Reserve Primary Fund, from the late 60s and early 70s.

Comments for this post are closed

Comments for this post are closed

As long as we are talking about things that will never pass, how about we move income taxation to non-equity net cash flow taxation? For both individual and corporate taxation, we would tax the receipts of loans, but not the repayment of loans. The incidence would be about the same (setting aside the issue of defaults and bankruptcies), but the timing would be very different, as would the optics.


Comments for this post are closed

"One significant effect of an all-equity capital structure would make insolvency more transparent and this in turn might make zombie banks less likely. "

Well, regulators wanted to turn the problem depository banks into equity structured banks but Wall Street and the shadow banks protested making money market funds price shares at actual market price of the underlying assets.

The real depository banks large and small were not a problem in 2008 because of deposit account liquidity problems. And business checking account for making payroll was fully liquid at BofA, Citi, et al.

The problem was the money market funds, where the payroll or dividend or accounts payables were stashed, that presented the liquidity problem - if the funds could not be wired from the money market fund into the checking account to make payroll or to pay bills or dividends, the business was in trouble, not the bank (BofA, Citi,...).

This was a problem that was predicted in the 60s and 70s as conservatives were pushing loosening bank regulations like Regulation Q.

Conservatives were calling for increased competition with banks, money market funds being able to be like banks without the regulations. The promise from Wall Street was almost specifically that no depositor in in Reserve Primary Fund would ever view it like a checking or savings account and seek to withdraw funds and get them that day, so the regulators placing restrictions on withdrawals limiting them to once per month and to a minimum 3 day delay before withdrawals are paid was totally unnecessary.

I remember the pro-regulation factions predicting September 2008 back in 1969. Conservatives said September 2008 would never come. Milton Friedman being one of them, I guess he knew he would die before his policies caused a major bank run.

In any case, marking money market funds to market every day would make money market funds purely equity banking.

Comments for this post are closed

Does the evidence really support the claim that insolvency was the big problem in 2008, at least in the US? Note that essentially all of the financial-sector TARP recipients have paid back the government in full, with interest. That suggests a temporary liquidity problem, not a fundamental solvency problem. Yes, Lehman and Reserve Primary were probably insolvent, but they appear to be the only major examples.

Comments for this post are closed

There's not really such thing as "all equity financed". In every industry there are short term transactions that involved a lot of trust. As an example most retail is paid for on a 45-90 lag. So you give a shop your merchandise and they either return it to you or pay for it 45 to 90 days later. That could involved a 0% loan of money for a full 90 days with regular recurring cycles.

In finance there are lots of these types of transactions because for derivatives at the time of the trade neither position has value, but the losses / gains can mount pretty quickly as the underlying valuation moves. That's what margin is for for exchange traded products, but you still need to post the margin somewhere. What if there were a run on the CME or LCH because of one of their members losses? Unlikely, but the chaos would not be great.

Plus, the real problem with runs is that banking serves a useful purpose outside of just interest payments for the customers (that's why customers still use banks even in a low interest rate environment). If they were equity financed they'd be less leveraged, but they'd also have a lot less use for their banking clients (which I think it's fine to separate somehow, but I don't think the basic idea of banking is a completely failed experiment, just when it's financing further leveraged derivative transactions).

Comments for this post are closed

Excellent post. I was checking continuously this weblog and I'm impressed!
Extremely useful info particularly the remaining section :)
I handle such info a lot. I was looking for this particular info for a very long time.
Thanks and best of luck.

Comments for this post are closed

If you allowed businesses and individuals to have checking accounts at the Federal Reserve, then that would be the most efficient way to avoid bank runs. Interest payments on these accounts could be an approximation of the Monetarist Dream of predictable money supply expansion. No need for narrow banking laws or 100% reserve banking.

However, that would be looking at banks as if their only role is to be money supply pumps. In fact, the value added that banks provide is underwriting loans (bank assets) on behalf of the investors (depositors and stock holders). The management of the portfolio of these assets is a separate function that improves with technology and time. These loans can be (and are currently) sold off to funds that are better at diversifying the risk and taking these assets outside of the monetary system where their price fluctuations won't cause bank runs. However, there are information costs incurred and "seasoning" required where the loan portfolio's performance can be observed before such sales outside the banking system are possible.

To understand why bank liabilities (checking and savings accounts and CDs) are convertible into money instead of fluctuating in price on a market, you have to contrast what an bank does to what an investment banker (IB) does with an initial public offering (IPO). An IPO is an expensive matter. To create and sustain a market for a company's debt or equity instruments is not cost-free. By offering to convert their debt offerings into a fixed sum of currency, banks essentially make a signal to their investors that lowers the costs investors have to make to investigate the quality of the bank's underwriting prowess.

In other words, even in a world where you have individuals and businesses holding Federal Reserve checking accounts, you're still going to have a real need for bankers to underwrite small business loans that don't merit and IPO. So regulating or taxing this activity with an eye to diminishing its scope is a formula for impairing the most efficient means of allocating capital.

All the screw-ups of our banking system and money market funds in 2008 can be traced to loans and/or debt instruments that were in one way or another guaranteed by the government. Underwriting standards were far lower than for traditional, non-SBA commercial loans. So if we eliminate government guarantees that encourage making risky loans without direct consequences to the entities who originated the loans, and if we encourage policies that permit banks to sell their assets to non-bank investment funds, then those would be the best measures to employ to reduce bank runs while preserving an efficient allocation of capital.

Comments for this post are closed

The economists who supported or support today a version of narrow banking include Irving Fisher, Frank Knight, Henry Simons, Milton Friedman, John Kay, Kevin R. James, Laurence J. Kotlikoff, Alessandro Roselli, Mervyn King, Andrew Haldane, Amar Bhide, James Tobin, Paul De Grauwe, and Satyajit Das. All of them have written about this issue, and are worth reading. There is also this IMF Report talking about resuscitating the Chicago Plan of 1933:

Comments for this post are closed

I haven't read the paper yet. But is the all-equity bank functionally equivalent to turning your brokerage account into a checking account (and not letting the brokerage invest your cash in anything except treasurys?)? If so, the bank would not become insolvent because all investment losses would be absorbed by "depositors." Depositors lose money, but they don't run. There's investment losses, but no financial crisis.

Personally, I would love to be able to do full blown checking with my brokerage account. Seems simple and clean to me. No more transfers money from checking to brokerage. One account. Select your investments. Make deposits. Write checks. All from the same account.

Comments for this post are closed

I needed to thank you for this fantastic read!!
I absolutely loved every bit of it. I've got you saved as a favorite to
check out new stuff you post…

Comments for this post are closed

Hello, i read your blog occasionally and i own a similar one and
i was just curious if you get a lot of spam responses?
If so how do you reduce it, any plugin or anything
you can suggest? I get so much lately it's driving me crazy so any support is very much appreciated.

Comments for this post are closed

All equity-funded? Equity being liability what room does that leave for current accounts (on the liability side of the balance sheet)? All equity funded is not a bank.

Comments for this post are closed

These are actually impressive ideas in regarding blogging.
You have touched some fastidious points here. Any way keep up wrinting.

Comments for this post are closed

This is my first time go to see at here and i am genuinely happy to read everthing at one place.

Comments for this post are closed

Simply desire to say your article is as amazing.

The clarity for your publish is simply great and that i could assume you're knowledgeable in this subject.
Fine with your permission allow me to clutch
your feed to stay up to date with coming near near post.
Thanks one million and please carry on the gratifying work.

Comments for this post are closed

Comments for this post are closed