Quote of the day: On bank subsidies

Via this excellent review by John Cochrane, I decided to read “the banker’s new clothes“.  I’m only a small way in, but it already seem like a pretty good book, written for a non-technical type of audience.  Excellent.

My view has been that there is potentially some type of externality from bank’s actions (systemic risk stemming from asymmetric information and potentially linkages), and that there has been a implicit subsidy to  deal with this – and so the clearest solution would be to treat the lender of last resort function as enforced insurance … and make banks pay an insurance premium (*,*).

The book is taking a very similarish line, although it is focusing on capital ratios.  Essentially, banks become highly leveraged because debt is lower risk than capital funding when they go to borrow (as bondholders will get bailed out, but equity holders won’t) – so they appear to be pushing towards (as Cochrane is) much higher minimum capital ratios.  I would note that this is where the NZ Reserve Bank has been pushing regulation since prior to the crisis (to prove this I was looking for a paper I saw from 1999 … and ran into this bulletin from 1996!), and a number of measures have been introduced or are close.  By default I prefer price to quantity mechanisms, but I’m leaving myself open to be persuaded by the book.

In any case, the quote.  Here:

Subsidizing banks to borrow excessively and take on so much risk that the entire banking system is threatened is like subsidizing and encouraging companies to pollute when they have clean alternatives

On thing missing in the quote is the cost – we haven’t pinned down the true relative price for clean vs non-clean.  But adding a subsidy in the face of an externality is peverse, and is a good motivator for looking at the issue.

  • Blair

    #1 When I was in banking, we spent a hell of a lot of time in meetings trying to agree the regulatory capital treatment of various assets with the risk people. When we found a structure that had a favourable treatment, we obviously repeated it. (The rules are very arbitrary, with land and mortgages treated most favourably and corporate equity least favourably).

    #2 The hurdle rates on new activity in banks seems to be very high. I think this may be something to do with the very high leverage. At any rate, I think this hurdle actually dissuaded some investment in lower risk activities.

    #3 One of the things that deserves more discussion is how to persuade a bank to increase its amount of equity. They don’t like doing it, and I’m not sure how it’s been done in the past, other than waiting for the bank to go to the wall and then having Treasury subscribe for stock.

    #4 Matthew C Klein at the Economist has done some great posts on banking recently.

    • The equity issue is an interesting one, the two key areas of interest seem to be:

      1) Tell banks to hold more equity (this is part of the driver of CAR’s ratio)
      2) Convert bondholders into equity holders in the case of failure, implying that some of the risk equity holders bear goes onto bondholders.

      If the idea is that debt is prefered to equity due to the fact that debt is costlessly insured, then I’d suggest making this insurance costly. The design of such a scheme, and making sure it takes into account whatever the incentives are given current regulation, is pretty important though.

      I don’t think the goal is to remove the chance of anything ever failing, it is about really just making sure we are clear on costs and benefits … and that policy in the US banking system doesn’t seem to have been appropriately trading those off.

  • Blair

    Forgot #5. Overheads in banks these days are high, like crazy high. I see this as a legacy issue and one that has a pernicious effect on investment. I suspect it’s partly a legacy of the go-go days and partly to do with the expense of managing the regulators.

    • Overheads come partially from scale – there is a school of thought saying that banks have become too big because of implied regulation. In this case, it is the implied regulation we need to look at rather than the size and overheads themselves 😉

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