Banking and Moral Hazard
What Brad DeLong's analysis leaves out and Janet Yellen also ignores
There is a sequence that takes place in every financial crisis. I can summarize it in a two-stanza limerick.
It Won’t Happen Again
The regulators were asleep While the big bank went down in a heap The losers have clout So we must bail them out Before there's a crisis too deep Taxpayers start to complain About having to bear all the pain But no fear because We will pass some new laws And now it won't happen again
We have been passing laws saying “now it won’t happen again” since at least the 1930s. It always happens again.
Brad DeLong’s analysis of the Silicon Valley Bank failure pays no heed to this history. He blames various villains. On the one hand, he writes,
the loss created by the fact that the bonds it held had fallen in price was balanced by an expected capital-gain offset that was going to accrue on the bonds when they were held to maturity.
So SVB behaved reasonably.
On the other hand, he cites a law that exempted banks with assets under $250 billion from certain regulations
supported by 50 Republican and 17 Democratic Senators (and by 225 Republican and 33 Democratic House members), and signed into law by President Trump.
If not for this action of “regulatory relief”, SVB would have been subject to the original Dodd-Frank NSFR, and would have been unable to have taken on the asset portfolio it took on, and so it would not have crashed
So SVB behaved badly, and you can blame Trump.
Or even better, blame Peter Thiel.
I am told by sources who really should know, because they talked to people talking to people doing the deal, that SVB came within twenty minutes of getting enough additional cash to fix likely problems.
Then chaos monkey Peter Thiel showed up: advising companies to pull their money out of SVB.
He did so because deposits over $250,000 are uninsured. Brad argues that all deposits ought to be insured.
In fact, he is getting his wish. From the Fed yesterday:
After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer….Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.
So the tax will be paid by other banks, not “taxpayers.” Of course, shareholders of other banks, which will incur a loss of value, are taxpayers. And those shareholders did nothing to deserve any “special assessment.” Janet Yellen knows that, but she doesn’t care.
Insuring all deposits, as Brad recommends, would deter bank runs all right. But it worsens the problem of “privatized profits, socialized losses” that exists whenever the government either explicitly protects bank depositors and other creditors with deposit insurance or implicitly protects them by always coming to the rescue with a taxpayer-funded bailout.
Suppose I run an aggressive bank. I want to grow the bank’s assets, earn some profits, and get lots of personal compensation. With bank deposits now guaranteed to infinity, I can attract pension fund money in the billions.
I might do it this way: I tell the pension fund I will pay a deposit rate equal to the return on the S&P 500, minus 10 basis points. That is, if this year the S&P returns 5.00 percent, I will give the pension fund a 4.90 percent interest rate on the deposit. But here is the kicker: I guarantee a minimum return of 1.00 percent. If the S&P earns nothing, or declines, the depositor still gets a 1.00 percent return. To the pension fund manager, this is irresistible.
I invest the deposits in the S&P 500. Most years, the S&P returns more than 1.00 percent. On every $1 billion deposit, my bank earns $1 million in profit. But if the S&P ever goes down, I take a big loss, and my bank is busted. As long as I can go a few years before that happens, I take in nice compensation. And when the crash does come, the insurance fund is left holding the bag.
Until yesterday, a pension fund manager would never take my offer, because its deposit was not fully insured. But now, if the bank deposit is insured by the government, the pension fund manager has no reason to invest in the stock market himself, because any bank can offer a better deal.
If we have 100 percent deposit insurance with no upper limit, the financial system will eventually be one in which every risk in the economy is laundered through the banking system. Only a chump of an investment manager will invest directly in stocks, bonds, or other assets. Instead, put your money in the bank and let the bank do it for you, exploiting its government guarantee. Heads you win, tails the taxpayers lose.
Of course, the government will try to stop this from happening. It will issue regulations that limit the risks that banks can take. And that will certainly work. It’s not like financial regulation has ever messed up or anything.
Alfonso Peccatiello offers analysis that is much closer to mine.
Many people are now calling for a blanket bailout.
But the evidence that moral hazard was at play are too big to be ignored.
And we should not reward moral hazard.
Deposit insurance faces the problem known by the insurance industry as moral hazard. The more you are protected by insurance from suffering the consequences of taking risks, the less is your incentive to avoid risks. If you can get flood insurance on your home, you have an incentive to locate close to shore, rather than on a hill a mile away.
A few crises ago, some center-right economists came up with an idea for keeping limited deposit insurance while not socializing all risk. The idea was to have banks issue long-term bonds that convert to equity when the bank’s capital falls below some minimum level on a market value basis. When the bonds convert, the shareholders lose most of their stake, and the bondholders own most of whatever is left. The depositors lose nothing, because the restructured bank is solvent.
The holders of contingent convertible bonds will want to insert controls, known as covenants, to make sure that the company’s management takes only prudent risks. Not wanting to end up becoming owners of a troubled bank, the convertible bondholders will act like regulators.
The goal of this idea of contingent convertible bonds is to reduce the problem of moral hazard. If it works, then bank risk is borne by private shareholders and bondholders, not by uninsured depositors and taxpayers.
Maybe there are problems with that approach. In 2000, a staff study by the Federal Reserve Board reached an ambivalent conclusion, calling for further research (me: why not experiment?). In any case, I am confident that contingent convertibles stand a much better chance of working than where we are headed now: allowing banks to have infinite moral hazard, constrained only by the ability of regulators to design and implement controls.
Substacks referenced above:
I go back to the scene with my parents that always blows my mind. They went to a senior center during COVID and the lady working there offered them several $100 gift cards to major merchants. They said they didn't need them. The lady asked them repeatedly to say they did need them so she could give them away as part of the COVID stimulus they had been asked to give out.
I feel like that's our entire economy.
1) It seems likely to me that anyone who borrowed short and lent long the last few years is insolvent, including depositors.
2) If the fed backstops these people, it has to print the money.
3) If it prints money to bailout anyone who can't handle high rates, high rates will fail to tame inflation.
4) If it doesn't tame inflation rates can't come down.