Political equilibrium, OBR, and deposit insurance

There has been some discussion of deposit insurance, the open bank resolution plan, and the types of risks being faced by New Zealand savers.  This is actually a hugely important issue, and as a broad matter of principle I actually find myself agreeing more with Labour and the Greens than National and the Reserve Bank.  My view is that deposit insurance should be announced, it should be explicit, there should be certainty around it, and it should be treated as a form of “compulsory insurance” with the payment of an associated “insurance levy on debt financing” for financial institutions over a certain size.  Of course, even with this the OBR still has a place (it is actually a very separate issue) – and that is why the RBNZ was right in saying this.

In order to see why this is the conclusion I’ve drawn, one that differs from current policy, let’s have a brief look at my thought process through a post.

Political equilibrium, credibility, and expectations

Bailouts are a topic that the government, Treasury, and the RBNZ are justifiably wanting to avoid talking about too much in public.  Why this is justifiable, but the reason why we may need to be more transparent about it, comes from thinking about the expectations of people both within and outside of a bank run.

Governments and central banks are perceived by people in the economy to be the lender of last resort – due to a view on bank runs.  Having a functioning lender of last resort means that, in the worst case scenario, these institutions will act as a lender of last resort.  In this way, the NZ government is expected to bail out large financial institutions (in the NZ case banks) if they fail.

Now on the face of it we might not like this.  We don’t bail out other large companies.  And with an implicit backstop, financial institutions will take on too much risk (and the people funding these institutions will assume there is far less risk) – this is the problem of moral hazard.  In this way, the expectation of a bailout creates a difference between the “full social riskiness” associated with lending and the risk that private individuals and firms face when deciding to lend and borrow between each other, through a bank.

The Treasury, government, and RBNZ acknowledge this moral hazard issue – and so they want to introduce the open bank resolution policy settings as a way of avoiding bank runs (which is why we have deposit insurance in the first place), insuring the bankruptcy is orderly for financial institutions (to make the costs to everyone involved, from negotiating about who gets what, as small as possible), and limiting the number of situations where “bailouts” will really be required.

This is good, this is exactly what they should do.  However, the scheme lacks three things when it comes to thinking about “expectations”:

  1. Clarity about how losses are determined and split in a typical situation that requires bankruptcy – an issue that will be solved soon.
  2. Clarity around how this links to the lender of last resort function of the central bank.
  3. The political incentives to bailout banks.

Let us be honest here.  The government will not let a bank fail.  They will not let depositors lose money.  It is in the government’s interest during a bank failure to have taxpayers pick up the tab.  People know that the government will do this (or at least form expectations based on this) as so will lend to banks in a way where they are seen as riskless!  There is an implicit deposit guarantee scheme for banks at the moment!  This is the key point – even if we aren’t admitting it, there is a deposit guarantee running at present that we aren’t acknowledging.

As a result, it makes sense to turn around and make this explicit.  Note:  If the government thinks it can costlessly credibly commit to not bailing out institutions, and the RBNZ can solve the issue of bank runs without full deposit insurance, then this is good.  But we do not have that right now, not in the slightest, and it should be admitted as policy relevant.

This doesn’t seem particularly fair on the taxpayers

No it doesn’t.  The tax payer is essentially subsidising loans.  The subsidy is then split between depositors, the banks, and the borrow due to relative elasticities, information, and bargaining positions.  Overall “too much” is invested due to what is socially optimal … this is where we have the “too much debt” business.

If we make the deposit guarantee explicit instead of implicit and we completely remove the loss from default – if anything it will exacerbate the moral hazard issue issue!  So what do we do?

Deposit guarantees are a form of insurance.  Generally, you pay for insurance with an insurance levy.  If we have an explicit guarantee scheme on deposits, then there should be a levy on those deposits.

Yes this will reduce investment, yes this will see lower returns to depositors, but without doing this we have a deposit guarantee scheme that just costs everyone in NZ and in turn makes the entire financial system more unstable.

The kicker with all this is that the insurance scheme will have to be compulsory for all institutions over some type of nominal size.  The type of bank failure we are concerned about, and which will lead to bail outs, stems from an episode where there is systemic risk to the banking sector as a whole.  In that case the incentive to take on the insurance for an individual firm does not match the full social return associated with it.  Furthermore, if the bank decides to take on insurance it may be seen as a signal of weakness (given asymmetric information) making banks unwilling to take on the insurance for signaling reasons.  Finally, the political eqm argument suggests that a government may well bail out the bank irrespective of whether they have taken on the insurance – making a bank unwilling to pay for insurance they can expect to get anyway.

Conclusion

At the moment there are two ways forward when thinking about banking policy in NZ:

  1. Explicit deposit insurance, with an associated deposit levy.
  2. A credible commitment by government that it won’t guarantee deposits combined with RBNZ regulation that can avoid bank runs.

Current policy is trying to push towards the second (which is admirable), but in the current environment I do not believe it is credible given the idea of “political incentives”.  Which is why I find the idea of explicit deposit insurance combined with a deposit levy to be the best way forward.

Note:  Concern about levies is a fair point.  If we are the only country “not subsidising”, what does that mean for us?  I’d note that the big runs here come from trying to introduce this during a crisis – it doesn’t rule out the effectiveness of the policy outside of a crisis.  In a number of ways this would be similar to the FDIC – just with appropriate insurance premiums (which are ex-ante pretty danged hard to determine), and with an appropriate scale to ensure that the government can commit to no more additional bailouts.

Note 2Good post by Eric stating why he thinks the government can commit.

RBNZ cannot bind future governments. But setting up the regime well in advance of a bank failure specifying that, no matter what else happens, the equity and (subordinated) bond holders get burned first gives those agents reasonable expectation that they should try to make sure that doesn’t happen. If some future government defects by bailing out depositors, I’d expect it to happen only after burning through the equity and bondholders.

Note 3The Economist points out research by the IMF that shows explicit deposit insurance makes the moral hazard problem more acute – this is a pretty easy to understand idea, and we mentioned the concept above (just under our second subtitle).  This is why we both require a levy, and have to accept that it is “inefficient” relative to a situation where the government commits to not bailing out banks AND we have a way to prevent bank runs (where by this I mean optimally reduce the probability of a bank run so the expected cost of it happening is equal to the expected cost of introducing preventative measures).  If we can do that second bit – then do it, and scrap the compulsory insurance.

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.

Where the moral hazard comes from

I have a sneaking suspicion that the term moral hazard is getting a bit abused at the moment.  Let’s use the Wikipedia definition:

A moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk

Cool, and in the case of the bank bailouts that have occurred around the world, who were the people who knew that the cost of their “risky behaviour” would fall on someone else … bondholders.  This is from Garett Jones:

So by their estimate over 90% of the benefit to banks’ balance sheets went to bondholders …

If most political battles need a villain to succeed, it’s easy to see why bondholders have largely escaped the wrath of voters: Bondholders make poor villains.  The bank promised to repay, and now the bank can’t.  The bondholder wasn’t out there making the loans; the bondholder didn’t vote for the directors who led the company to the brink of destruction; the bondholder just handed some cash to the bank and hoped for the best.

Bondholders have had good luck getting government guarantees, and I suspect their luck will continue.  That means rational investors will dump more cash into the megabanks with minimal scrutiny: The megabanks are the new Fannie and Freddie.
The fact is, if we wanted to “get rid of moral hazard” we’d have to accept the inherent riskiness of our lending – we don’t get paid an interest rate for kicks, it covers inflation and a rate of return stemming from lending that has some inherent risk.
The reason economists have generally shown no sympathy for people when the finance companies collapsed here isn’t because we are heartless, it is because people wanted to act as if their lending was riskless.
Remember, if you are complaining about “moral hazard” you are attacking bondholders – not so much the banks (who are easy to demonise because they wear suits), but the people who leant money without considering risk and those who advised them.

Will macroprudential regulation succeed?

It is common to hear politicians and financiers these days saying that things are different now. That lessons have been learned. That changes to regulation will ensure that this sort of thing is unlikely to happen again in future. Of course, people say these things after every crisis. Now Vox reports a study that attempts to estimate whether learning actually takes place after a crisis and whether the institutional changes reduce the risk of future crises.

…past occurrence of a banking crisis, on average, does not reduce and may even increase the probability of future crises. … we find no evidence that the history of previous exposure of the banking sector to systemic crisis episodes seem to matter.

A possible explanation for our failure to detect a learning process from past banking crises is that regulators and policymakers are learning, but at a speed that does not catch up with the dynamic evolution of modern banking. The regulator is frequently preparing to prevent the last crisis, and not the future one.

This hypothesis reminds me a lot of Bruce Schneier’s writing on airline security in the US:

If we spend billions defending our subways, and the terrorists bomb a bus, we’ve wasted our money. To be sure, defending the subways makes commuting safer. But focusing on subways also has the effect of shifting attacks toward less-defended targets, and the result is that we’re no safer overall.

Regulation of some financial products may make them more stable, but the regulation will push people to develop new, more profitable products that evade the rules. Have we then made the system any safer? I haven’t followed macroprudential regulation closely enough to know if that’s a problem, but we can only hope that history doesn’t repeat in this case.

A book I have just preordered

Via Economist’s View comes this excellent post by Economic Principals.

That the world economy received a “shock” when US government policy reversed itself in September 2008 and permitted Lehman Brothers to fail: what kind of an explanation is that?  Meanwhile, the shadow banking industry, a vast collection of financial intermediaries that included money market funds, investment banks, insurance companies and hedge funds, had grown to cycle and recycle (at some sort of rate of interest) the enormous sums of money that accrued as the world globalized. Finally, there was uncertainty, doubt, fear, and then panic. These institutions began running on each other.  No depositors standing on sidewalks – only traders staring dumbfounded at comport screens.

Only a theory beats another theory, of course. And the theory of financial crises has a long, long way to go before it is expressed in carefully-reasoned models and mapped into the rest of what we think we know about the behavior of the world economy.

This is all in preparation for a new book coming out – misunderstanding financial crises – which I have now preordered.

There appears to be a vein of distaste for DSGE models in this post, and this is the one bit I don’t agree with.  Economic methodology isn’t about having a “single model” – we try to be as reductionist as we can, but we have to instead rely on a suite of models that provide a narrative of different causal mechanisms that exist when people interact.  DSGE models are incredibly valuable, but they were never made to explain shocks – or to illustrate what happens when the shock is sufficiently large that we may not return to our previous equilibrium.

I’m also a bit confused about why the author appears to be hinting that modern economists don’t think that way – I clearly remember being taught about stability, multiple pareto ranked equilibrium, and the issue of bank runs.  I also remember being taught all this as part of “New Keynesian economics” and being told that DSGE models were in themselves only a subsection of the models we should look at when trying to understand what is going on around us.  And this was in 2005.

A more nuanced discussion of all this can be found here and here.  I am, as often, in agreement with Simon Wren-Lewis in this.  I fully agree with this statement:

However what seems to me critical in avoiding future crises is to understand why leverage increased (and was allowed to increase) in the first place, rather than the specifics of how it unravelled. As I suggested here, we may find more revealing answers by thinking about the political economy of how banks influenced regulations and regulators, rather than by thinking about the dynamics of networks.

While also accepting that the analysis of complex networks with multiple equilibrium is useful.  Why are economists so determined to create simple models rather than just making a full complex system that can be calibrated t fit data?  Easy – because these complex systems don’t tell us anything about causal mechanisms, and we need to understand causal mechanisms in order to determine what policies “make sense”.  It is a co-operative venture between multiple forms of modelling, not a competitive venture IMO.

Anyway, I’m looking forward to the book – and I’m currently reading the prequel, slapped by the invisible hand 😉

Why macroprudential regulation?

With the RBNZ asking for comments on the upcoming countercyclical capital adequacy  regulation, and the RBA/APRA releasing a report on macroprudential policy now is a good time to ask – why?

I have seen many people justify these types of policies based on “debt being high” – but this doesn’t answer “why”.  I’ve heard a large number of people say it is because government savings made the private sector borrow, leading to financial instability – this not only doesn’t answer why, but it doesn’t involve any sort of sensible role for private agents and so is incoherent.

However, economists aren’t keen to let this issue slide – thank goodness!  The key concern, as previously mentioned, is trying to figure out what the market failure involved is.  What factors drive the systemic risk in the financial sector?  One interesting approach to microfound the incentives through the cycle that lead to this market failure is found here – one I found interesting at least, as there are many more 🙂

Now, it is useful to ask why for a couple of reasons:

  1. We can explain why these policies are actually a good idea – remember, just because something is volatile doesn’t make it bad instead we have to explain why to understand it in this sense.
  2. We can understand the impact of the policies – remember that it is likely that some financial regulation will involve a trade-off between output and stability.  When that is the case, we want to actually decide whether this trade-off is worthwhile.

If we can answer these, we can put in place good policy, policy we can explain, with impacts we can describe, and outcomes we can understand (and hopefully anticipate).