Tag Archives: moral hazard

Globalize the Banks, Redux

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Tyler Cowen’s essay on the inequality generated by the political economy of finance has received deserved attention. I think Tyler is exactly right that financiers are going short on volatility, that this is hard to detect and therefore regulate, that politicians have incentives to bail out the banks following increases in volatility, and that it leads to severe problems.

Please excuse the self-congratulation, but as far as I can tell, I am the only person to propose a reform that could plausibly reduce this problem. In April, I wrote,

[A]n important factor in the stability of the financial sector is its degree of globalization…

The second and deeper reason for more financial globalization is political. The doctrine of Too Big to Fail creates a moral hazard problem: banks reap the benefits of successful investments but don’t suffer the losses of failed investments, so their incentive—whether conscious or evolved—is to take a lot of risk. Politicians, as much as they claim to want to enact market discipline, face a time-consistency problem. They want banks to be sound, but they lack the political will to let unsound banks and their creditors suffer when the time comes to feel the pain.

Greater globalization reduces the time-consistency problem. American voters do not want to pay taxes to bail out banks that operate just as extensively in Europe, Asia, and Latin America as in the US. The fact that a bailout would convey these uncompensated externalities would strengthen the political will to let unsound banks fail. This is not to say that I hope lots of banks fail—rather, I want politicians to be able to make more credible claims that Too Big to Fail is over, so that banks take note and invest accordingly. In equilibrium, there would be fewer bank failures, not more of them.

My claim is not that globalization of banking is a panacea. But to extent that we can reduce the time-consistency problem that politicians face, we can reduce the incentive that financiers face to write naked puts on volatility.

To Fix the Banks, Globalize Them

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As politicians and pundits debate what regulations are needed to fix the financial industry, I want to draw attention to a neglected issue: an important factor in the stability of the financial sector is its degree of globalization. All the big American banks have some international dealings. But true globalization of banking would be an improvement for both financial and political reasons.

The first and more trivial reason that banks should be more globalized is simply the logic of diversification. When investments are diversified, investors get higher return for less risk—it is a free lunch. Failure to internationally diversify is one of the biggest mistakes that American investors make (I’ve heard, as a rule of thumb, 30 percent of your investments should be foreign). But the big banks make this mistake as well! For instance, 90 percent of Bank of America’s revenues come from the domestic market. And of course, smaller banks frequently have no international holdings.

International diversification reduces systemic risk just as national diversification reduces systemic risk. If all banks could borrow from and lend to people in only a single town, we would see bank failures every time a factory shut down or a large business failed. By spreading that risk over thousands of towns, banks become more stable. But the logic of geographic diversification does not stop at national boundaries. In fact, because there are greater differences between countries than between towns in the same country, international diversification may be even more beneficial than national diversification.

The second and deeper reason for more financial globalization is political. The doctrine of Too Big to Fail creates a moral hazard problem: banks reap the benefits of successful investments but don’t suffer the losses of failed investments, so their incentive—whether conscious or evolved—is to take a lot of risk. Politicians, as much as they claim to want to enact market discipline, face a time-consistency problem. They want banks to be sound, but they lack the political will to let unsound banks and their creditors suffer when the time comes to feel the pain.

Greater globalization reduces the time-consistency problem. American voters do not want to pay taxes to bail out banks that operate just as extensively in Europe, Asia, and Latin America as in the US. The fact that a bailout would convey these uncompensated externalities would strengthen the political will to let unsound banks fail. This is not to say that I hope lots of banks fail—rather, I want politicians to be able to make more credible claims that Too Big to Fail is over, so that banks take note and invest accordingly. In equilibrium, there would be fewer bank failures, not more of them.

A number of commentators have argued that to deal with this political dimension of our financial troubles, we must break up the big banks. The argument is that if the banks were smaller, they would have less sway over politicians and the regulatory agencies. I have a lot of respect for many of the people making this argument, but I believe they are mistaken. One need only look at the sway that car dealerships, which are decentralized, have over state legislatures to see that small does not mean apolitical.

How can we achieve a more globalized financial sector? In truth, I don’t know. I suspect that only the insiders could say for sure. Perhaps we should ask them. At a minimum, we should consider repealing regulations that make it difficult or unprofitable for banks to operate internationally. Instead, regulatory reform will probably consist of a lot of rhetoric about getting tough with the banks—further proof that politics is not about policy.

Mutual Fund Banking

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In a post on moral hazard in the banking system, Megan McArdle writes,

Nor do I find the central story of how the FDIC induced this moral hazard very compelling. Supposedly, ordinary depositors don’t bother to check the soundness of their banks because they don’t actually have skin in the game.

Anyone making this argument cannot have met many ordinary depositors. If you stripped away my mother’s FDIC protection, she wouldn’t do any better of a job at evaluating Citigroup’s finances.

(HT: Scott Sumner. See his reply here.)

I don’t know Megan’s mother, but I suspect that this is correct. The problem with Megan’s argument, however, is that it is a partial equilibrium analysis. It is an extrapolation of what would happen if the FDIC were shut down and nothing else changed. A better way to approach the issue is to look at what changes the elimination of the FDIC would induce in the banking system: what would be the new general equilibrium?

Without FDIC protection, Megan’s mother and millions like her would probably not feel comfortable lending money to banks as we know them today, which would be prone to runs. Depositors have fixed claims, and banks have variable assets. Without deposit insurance, when people start to suspect that their bank’s assets have declined (that the bank is no longer solvent), they rush to withdraw their deposits. Because the bank is leveraged, this causes insolvency, whether or not the bank was insolvent in the first place.

An alternative to this model is described by Cowen and Kroszner in their 1990 Cato Journal article, Mutual Fund Banking: A Market Approach. They argue that in the absence of deposit insurance, depositors would seek alternatives to traditional banks that do not suffer from the tendency to experience runs. One such approach would be mutual fund banking.

We examine mutual fund banking as an alternative form of financial intermediation. Individuals would hold checkable deposits at financial intermediaries structured as mutual funds. Although the nominal value of depositor holdings would not be fixed, risk could be hedged through the choice of portfolios.

Here is the money quote:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

If Cowen and Kroszner are right that something like this would evolve in the absence of deposit insurance, and I think they are, then moral hazard would be greatly reduced by eliminating the FDIC, even if ordinary depositors are incapable of performing a significant monitoring function.