Could Bank Regulation be Privatized?
In a new essay, I propose privatization
In Financial Reform After Silicon Valley Bank, I write
A bank is normally solvent but illiquid. It is solvent in the sense that its assets are worth more than its liabilities. It is illiquid in the sense that if it had to sell its assets in a hurry, it would receive less than what those assets would ultimately be worth, and probably less than its total liabilities, including deposits. This is because the bank's loans are best understood by its own experts. Other institutions, which understand those loans less well, will be reluctant to pay full price to purchase a failing bank's loans, meaning selling those loans to other banks in a hurry is difficult.
If this is correct, then there is something to be said for a program of deposit insurance. But this does not necessarily need to be provided by the government. The government is great at being able to supply the funds to back deposit insurance. The problem is that it is not so great at disciplining banks.
as a government agency, the FDIC has an incentive to "extend and pretend" — to allow the bank to keep operating longer than it should, and to overvalue the assets on the bank's balance sheet to make it appear that there is no reason to close it. Compared with leaving a shaky bank open, closing the bank takes more effort and exposes the agency to more political flak. Extend-and-pretend is an attractive alternative, especially for high-level political appointees: If the strategy backfires, the problem will blow up on someone else's watch.
I proceed to propose a scheme in which private insurance providers, with access to government as a lender of last resort, discipline banks. These insurance providers have skin in the game, unlike government bureaucrats. So they should be more pro-active in limiting risk-taking by banks.
Such a scheme may or may not be good solution. I also suggest,
Another viable policy approach would involve backing away from making the financial system difficult to break and focusing instead on making it easy to fix. The first method lulls households, businesses, and policymakers into a false sense of security, amplifying the severity of each new crisis. Instead, we should accept the fact that the financial system will experience shocks. We should also realize that the key to real stability is encouraging institutions to fail gracefully and ensuring that no one institution's ruin triggers havoc across the financial sector.
But maybe we get a crisis-prone financial system that relies on government because that is the natural state of affairs.
In the end, the March banking crisis can be traced to the debt problem. The large deficits, and the quantitative easing used to finance them, triggered inflation. This in turn led to higher interest rates and large losses at banks holding long-term securities. Such developments underlined the reality that governments sometimes have goals that differ from, or even conflict with, the aim of maintaining a robust financial system. The government's incentive to channel credit to its own needs may override the goal of encouraging banks to take the right risks at the right time.
As you can tell, the essay ranges widely. Read it carefully before commenting.
A pellucid, incisive, well-balanced essay. Thank you from a layperson.
Thanks for a really good, clear article on banks & financial crises, after SVB & other issues, especially the two issues of Moral Hazard plus … “the Houdini of bank risk” which always escapes any “regulatory straitjacket.”
This is so, so true. Because of gov’t schizophrenia, it will “subsidize risk-taking, while safety and soundness regulations (such as capital requirements) amount to a tax on risk-taking.” Gov’t is inevitably in bed with the financial banking system – and politicians promise to be more safe than the “market”, but the politicians lie.
One of the key issues NOT quite mentioned is that Big Government likes and wants there to be Big Banks, so that there will be fewer “key” decision makers to do what the gov’t wants. 10 huge banks, (or social media companies) are much easier to jaw-bone influence than 100, and making it more than 1000 reduces it further.
GREAT note on What Banks Do – take riskless short term assets and lend to risky projects. The note on Bank Runs correctly notes that there is disagreement about whether SVB was insolvent, with Arnold suggesting it was. Tho not quite mentioning the SVB failure to differentiate between riskless short term & long term US Treasuries, where he has previously claimed “duration risk” was well understood and known. Yet Arnold has another great example of the $100 10-year bond going down in value when interest rates rise – which is the main reason SVB & other banks are insolvent.
Noting that nobody at FDIC was fired for the regulatory failure is very important, as was the note that the optimal # of banks failing is not 0 (for society & economic growth). Private insurance would likely be better with insurance contracts, as Arnold describes. But they’d make different mistakes, more of them, as the banks are “allowed” by their insurance companies to pay a bit more to try more.
I fully agree with the desire to make bank problems easier to fix, rather than assume it’s possible to make all banks totally safe. Unfortunately, “for policymakers, each crisis represents an opportunity to take on more authority over the financial system.” Both Gov’t and Big Business folk like this.