18 Comments
founding

A pellucid, incisive, well-balanced essay. Thank you from a layperson.

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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.

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2 new notes after another reread - before closing that tab (so as to have room for new links!)

"The debt-to-GDP ratio cannot keep rising forever. " Why not? [Forever is a long time, but 1% per year for 200 years is still only 200%]

When will Japan's stop rising? it's now over 240% after being 200% just a few years ago.

Investors in Japan could invest, instead, in USD - but don't, tho most investors do.

There is no "better investment" for USD investors to invest in, despite Balaji's ideas of Bitcoin, (he does argue it's better), so the USD can certainly rise to more than Japan's has risen to.

It's a bit like saying - the stock market, or the S&P 500, cannot keep rising forever. Of course it can. In fact, as the gov't deficits get monetized, that's exactly what has been, and will be, happening. Asset inflation, instead of consumer products. And rich (& powerful) folks (& decision makers) like increases in asset prices, aka "Return on Investment".

2) "The large deficits, and the quantitative easing used to finance them, triggered inflation. " I think of a forest fire, triggered by a spark (lightning or even an arsonist). The severity was based on the fuel available.

Our current US inflation is fueled by the QE to monetize the large deficits, but the spark triggers were a) Biden's disastrous energy policy choices to decrease US oil supply (increase prices) - higher oil prices look like inflation, and

b) the anti-China sanctions, biting into a lean, high-performance / high profit supply chain with little waste nor reserves available for bad times.

c) the Covid supply chain disruptions (related to but different than b)

Thanks for the bet about 3% core cpi inflation in 2023 - we'll see who wins next year; you if higher, me if lower.

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founding

Re: "The debt-to-GDP ratio cannot keep rising forever. How will it be contained? Neither political party has an appetite for large spending reductions. Large tax increases are unlikely, and even if enacted, they may not do much to close the deficit. Explicit default is unthinkable. That leaves only implicit default, via inflation. But inflation will not reduce the debt burden unless interest rates remain below the rate of inflation. That may require financial repression. " — Arnold Kling, at link embedded in his blogpost above.

It is *conceivable* that innovations in artificial intelligence will increase productivity sufficiently quickly, broadly, and deeply to increase GDP faster than debt. What is the probability of 'rescue by new technology'? I hesitate to conjecture. But it would be imprudent to bank on it.

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Lots of things are unlikely until they happen, tax increases to reduce, ideally to close the structural deficit among them.

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"To effectively cover all deposits at SVB, federal regulators extended deposit insurance beyond the $250,000 legal limit."

Probably a naive question, but why doesn't CDARS and the $50 million FDIC guarantee limit ever get discussed with regard to SVB and bank regulation and government bailouts?

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Hi Dr. Kling,

In the essay referenced in this post ("Financial Reform after Silicon Valley Bank"), the author highlights the absence of skin in the game on the part of regulatory authorities [1] as one possible reason leading to sub-optimal bank supervision and proposes that private insurance companies could improve the situation due to their presence of skin in the game [2].

To recap, the essay argues that regulatory authorities lack skin in the game because the employees at these regulatory agencies continue to keep their jobs even if the banks they regulate fail due to ineffective regulation. In contrast, private insurance companies would be financially incentivized to not head down the same morally hazardous path that regulatory agencies take with banks since private insurers would bear hefty losses should the insured bank become insolvent. For instance, a private insurer could charge different premiums to different banks based on a bank's riskiness. Also, a private insurer could set standards for distinguishing an illiquid bank from an insolvent one, and use these standards to perhaps close or sell the offending bank [3].

In an ideal world, private insurers have complete skin in the game and perfectly gauge the premium amount to charge so that the insurance pool is kept at a robust quantity to weather difficult periods. However, this ideal may detract significantly from reality should the following two questions be answered in the negative.

1. How confidently can financial risk be measured?

2. How much skin in the game do private insurers realistically possess?

In late 2008, the federal government bailed out AIG, a large insurance corporation, for $180 billion believing that its failure would endanger the financial system. Post-crisis, the Financial Crisis Inquiry Commission issued a report stating that AIG failed primarily because its enormous sales of credit default swaps (CDS). The common belief prior to the 2008 crisis was that mortgage CDSes were low risk because housing prices would never decline steeply. This belief was reflected in AIG's models, worked on by experts, and expressed in AIG's business.

There are two aspects of AIG's case study that shed light on how questions (1) & (2) might be answered:

(i) It can be genuinely difficult to measure risk even for those incentivized to avoid catastrophic failure. In hindsight, AIG could have sold fewer CDSes to avoid defaulting on claims filed, but being a for-profit entity could have incentivized employees to sell more CDSes.

(ii) Related to (i), the AIG employees incentivized to take on more risk (sell more CDSes) were not necessarily AIG shareholders who suffered losses. This asymmetric risk profile between a service provide and customer isn't uncommon in finance (e.g, fund management). Realistically, the de facto actors at an insurer (the employees) may not have skin in the game (little downside in default). In theory, the shareholders & board of directors could have intervened to temper risk appetites. When things eventually blow up due to excessive risk-taking, management along with employees are typically laid off with severance, leaving shareholders to bear the losses.

Besides the AIG case study, there are two more phenomenon that I think could aid in answering questions (1) & (2):

Moral hazard cascade. It would appear to be possible for private insurers to be incentivized to do a "half-baked" job of bank supervision knowing that the government would step in should private measures be ineffective at stemming the woes at an insured bank. In effect, the moral hazard associated with the close relationship banks have with the government hasn't disappeared but rather, cascaded to the private insurer. Thus, to answer question (2), perhaps private insurers have less skin in the game than ideally intended.

Regulatory capture is the phenomenon of regulatory agencies being dominated by the interests they regulate and not by the public interest. Analogously, there exists the capture of private firms (auditors, credit rating agencies). Here, one may imagine a situation where banks prefer lower premiums for the same amount of insurance leading private insurers to undercut one another resulting in insufficient funds to weather difficult periods. This will be exacerbated by the fact that bank insolvency are uncommon events (tide rarely runs out and before then we don't know who is swimming naked) and other facts listed above.

I would be happy to hear your thoughts on the points raised in this comment, and I hope I have not misinterpreted the essay in question.

[1] "The Federal Deposit Insurance Corporation (FDIC) does a poor job of dealing with moral hazard. The problem arises in part from the fact that its employees have no skin in the game; they get paid regardless of whether the FDIC manages the banking system well." - Excerpt from "Financial Reform after Silicon Valley Bank"

[2] "The problem with deposit insurance is that it reduces a bank's incentive to take only prudent risks. If the insurance kicks in regardless of how reckless a bank's loans are, banks will be more willing to make risky loans — after all, the greater the risks they take, the larger their rewards may be. At the same time, taking greater risks increases the chance that a bank will become insolvent. This problem is called "moral hazard." Private insurance companies address moral hazard by using a combination of incentives and rules. If you install a home security system, for instance, firms will often offer you a discount on your homeowners-insurance premiums." - Excerpt from "Financial Reform after Silicon Valley Bank"

[3] "Much the way the FDIC is supposed to operate today, a private insurer would be responsible for setting standards for distinguishing an illiquid bank from an insolvent bank. It would use these standards to close a bank before it becomes insolvent, and then sell the failed bank to another bank." - Excerpt from "Financial Reform after Silicon Valley Bank"

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This article, "Deposit Insurance Around the Globe: Where Does It Work?," is more than 20 years old, but may be helpful:

https://pubs.aeaweb.org/doi/pdfplus/10.1257/0895330027319

This more recent article, "The case for private administration of deposit guarantee schemes," may also be of interest:

https://link.springer.com/article/10.1057/s41261-021-00188-8

Most deposit insurance has been compulsory because otherwise most banks, or at least the banks holding the bulk of assets, typically will not join.

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There are many proposals out there for addressing the needs of depositors and what is quite clear is this: the banking industry is not the banking industry of one's grandfather or great grandfather of the past. Hence something needs to be done to see depositors money is safe and available for withdrawal at par when depositors want their money.

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The proposal to privatize deposit insurance seems like it just shifts the focus of regulation from banks to deposit insurers. In that case, we should want to understand how this new regulation might cause moral hazard, insufficient risk-taking, and all the other problems that regulation can cause. So we should at least itemize the necessary regulations:

1. All banks must have a deposit insurance contract with a single deposit insurer. Can deposit insurers reinsure? If so, they might be less incentivized to manage risk than we think.

2. Deposit insurance contracts must be for a term of four years. A bank must not use the same deposit insurer for two consecutive terms. How do we know that four years is the right time? If it is not, who would decide that and how would they make the change?

3. If a bank does not acquire replacement deposit insurance, the incumbent insurer must take over the bank and wind it down at the insurer’s cost. What happens if the insurer sells the insured bank to a purchasing bank that the insurer also insures?

4. An insurer can block bank acquisitions and divestitures. Otherwise, they can’t control the risk that they are insuring.

5. The insurer has some relationship to the Fed’s facilities for lending to banks. It’s not clear what exactly: “ If the insurer believes a bank is insolvent, it will be able to meet withdrawals at the bank by borrowing from the Fed against the bank's good collateral at a high interest rate. “ Surely this isn’t just that the insurer can block the bank from accessing Fed funds -- when would the insurer ever want to do that? Maybe the insurer is on the hook for the liability to the Fed?

6. The sanctions that the insurer can impose will have to be set out in regulations if they do anything that the bank couldn’t do itself. For example, it file for bankruptcy. It can refuse to honor deposits (which creates legal liability, but it can do it). But the bank can’t itself write down liabilities, like the FDIC seems to do. (I’m not sure whether it actually does, or if that’s just my misimpression.)

7. The inspection provisions of the insurance contract might need to be enforceable by injunction and any document-presentation requirements by perjury. The concern here is that the insurer only has nuclear options in the face of recalcitrant bank employees. Perhaps increased premiums would be non-nuclear, but courts in the US don’t like to enforce penalties as such.

8. The insurer must maintain minimum capital. The article notes that deciding the right amount is problematic. Perhaps this would be a good point for a counter-Minsky approach, where the capital requirement increases as a function of the previous period’s change in economy-wide credit extension. Still, finding the right level seems difficult.

9. Banks must be prohibited from owning or loaning money to deposit insurers. Otherwise, the risk just comes in through a different door.

10. Implicitly, it seems like there must be a regulator who can shut down insurers who are not doing the job. What would, for example, prevent me from creating a crappy deposit insurer during good times, taking dividends, and letting it go bust when the crash happens? Perhaps the capital requirement is enough, but I suspect differences in incentives between officers and equity owners would be a real problem. Perhaps highly restricting the kind of capital an insurer can have, plus highly restricting the types of incentives it’s officers can have, would be enough. Perhaps there would be a requirement of having contingent capital -- loans that convert to common under some circumstances.

11. And speaking of that, it seems like insurers might require banks to issue such capital. It would both be a buffer against calls on the insurer’s capital and -- probably more importantly -- provide some basis for second-guessing the insurer’s examiners. But perhaps they wouldn’t. The amount of interest paid on that debt could have been premix, and the insurer could pool the risk of a conversion by issuing its own equity of that type.

Those are the things I can think of. It seems like a lot of touch points. I’m not saying that it is more than FDIC deposit insurance. I’m just saying that it is still has a lot of complexity, and complexity brings gamesmanship. This would be a new game, so we have to expect that the regulatory intent would lose the first round or two of the new game.

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To what extent does this already exist with preferred equity, e.g. contingent convertibles?

i.e. contingent convertibles are like private insurance — they're junior to any government insurance and "trigger" when a bailout would otherwise be required.

And so increasing capital requirements and allowing some of the capital to be filled with these is a akin to mandating private insurance and having government insure the insurers?

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author

The coco holder is purely passive. Has to sit back and wait while the bank loads up on risk. A private insurer should be pro-active.

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All depends on the terms and conditions of the insurance.

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It doesn't matter, Stu- the asset is only worth in market price what you can sell it for when you need to sell it.

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A very good essay, and if it has any flaw at all it lies in being too generous toward (and willing to believe) government claims of good intentions.

Indeed, a strong case can be made that the framers of our Constitution saw these problems and tried to prevent them, by putting in bans on federal or state laws that "impair the obligation of contracts." But the courts have not upheld that, so there may be no hope of reform that would stick.

What I would do to fix banking is to reset the banking system. Shut down all the existing corporate banks and investment banks, printing enough cash to pay out all deposits in full. Then require all new banks to be partnerships, with managing partners who stand to lose their own life savings if they make mistakes that lose us ours. This is the banking system Scotland had during Adam Smith's time, and it would solve moral hazard.

Along with that I'd replace the tax code with something much simpler to administer, like a sales or property tax, and enact a constitutional ban on laws that pry into anyone's private financial affairs, thus making the Bill of Rights mean something again. This goes directly against our last half century of so-called progress which seems to be all about introducing universal surveillance for the benefit of giant corporations and their natural partner, the deep state.

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What private entity might have the capitalization to not only insure a bank with over $3T in assets but spread its risk adequately?

I get that FDIC largely rescues from fees collected but does that tell us what this new insurance might cost? What about operating costs and profits? How much profit would this insurer(s) need in order to justify the risk? What would the fees be? Is this a case like flood insurance where some who need the insurance can't afford the market cost of the coverage?

Why wouldn't this private entity also have incentives to "extend and pretend"? Isn't this basically how Trump maintained control of his assets when he couldn't pay his bank loans? How does a govt lender of last resort not make this worse? Wouldn't the govt have the same "bad" incentives to help the insurers as it does currently with the banks? How is that better? Wouldn't it still be a situation where the insurers (instead of or in addition to the banks) would reap huge profits in good times and pass some or most of the risk to the govt in bad times?

I suspect the biggest banks have some loans best understood by their own experts but might this be a much smaller part of their portfolio than smaller banks? Might larger banks be given less leniency regarding mark to market? Would this make your proposal a little easier to implement?

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I question the opening assumption- that the assets are worth more than the liabilities. If you can't sell the assets for what they are "worth" when you need to, then they really were overvalued right from the start.

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Selling individual loans (as opposed to bonds traded on a market) is like selling a used car. The owner knows whether it's a gem or a dud. The buyer doesn't. Even if the buyer makes a good estimate of where the asset lies in that continuum, they are still going to offer less due to the uncertainty.

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