Hey Paul,

I’m pretty sure this is the sort of direction people are going in – let shareholders burn and all that. But it doesn’t cover the moral hazard problem off completely – TBTF financial firms get cheaper funding as they are viewed as risk-free for bondholders. This is all I’m trying to counteract by discussing deposit taxes.

The kicker here, shareholders were wiped out for a number of institutions and bondholders were fully protected by government actions. And as a result, cheaper funding and the corresponding low level of capital led to excessive risk taking. If we are going to hold banks up to be excessively risky, we are in territory which reeks of the worst form of implicit nationalisation – so I’m sarcastically saying why not just make it explicit 😉

As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.

From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies. AIG had to be saved, the argument goes, because it had trillions of dollars of credit default swaps with J.P. Morgan. These credit default swaps acted as hedges for trillions of dollars of credit default swaps that J.P. Morgan had with other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its stability and that of others at risk.

This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG’s obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG’s viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.

Hehehe.

I wouldn’t quite go that far – it is more that if they are effectively nationalised by government actions in the first place, why not make it official 😉

I’m being slightly facetious as well, as the moral hazard issue only exists in the case of large scale failure – the banks still have to eat losses in most states of the world.

And I can understand your cynicism. I’ve always thought that everything I do on the internet is being tracked in any case, so I haven’t had to change my behaviour!

You worry about incentives facing banks when govt can’t credibly commit to not bailing out; I worry about incentives facing government when they have potentially unlimited scope of action so long as they demonstrate inability to constrain themselves against bailing out.

Having a more anarchist Monday than is usual… stupid NSA revelations….