resilience, not stability

The Case For Allowing Banks to Fail

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In many previous posts on this blog, I outlined why allowing the incumbent banks to fail when they become insolvent is a pre-requisite for achieving macroeconomic resilience. In my previous post I outlined how allowing such failure can be managed without causing a deflationary economic collapse in the process. Nevertheless, there are many who believe that a no-bailouts policy is tantamount to ‘financial romanticism’. In criticising the no-bailouts approach, Krugman deploys three arguments:

Policy makers will intervene anyway

It is undeniably true that policy makers will almost certainly move to stabilise the banking sector in times of economic distress. The aim of my ‘program’ was simply to sketch out a possible alternative that could be deployed rapidly during a crisis. Although I have some sympathy for policy makers asked to stabilise the economy during the largest financial crisis since the Great Depression, it is worth noting that the same policy of implicit and explicit support has been extended to failing banks at almost every point since WW2 – even in many instances when the fallout would have been much smaller. It is this prolonged stabilisation that has left us with such a fragile financial system.

Are guarantees and safety net plus regulation the only feasible strategy?

I have no disagreement with the argument that “ bank regulation is important even in the absence of bailouts”. There are many industries which are regulated simply for the purposes of protecting their customers and banking is no different. However I disagree strongly with the notion that regulation can prevent the abuse of these guarantees. The history of banking is one of repeated circumvention of regulations by banks, a process that has only accelerated with the increased completeness of markets. Just because deregulation may have accelerated the extraction of the moral hazard subsidy (which it almost certainly did) does not imply that re-regulation can solve the problem. Banks now have at their disposal the ability to engineer synthetic exposures tailored to maximise rent extraction – the ‘synthetic CDO super-senior tranche’ that was at the heart of the losses in the investment banks in 2008 was one such invention. It is the completeness of this menu of options that banks possess to game regulations that distinguishes banking from other regulated industries. Minsky was well aware of the impact of financial innovation on the resilience of the financial system which is why he understood that the so-called golden age of the 50s and the 60s was “an accident of history, which was due to the financial residue of World War 2 following fast upon a great depression”.

Maturity Transformation and the Diamond-Dybvig framework

The core rationale of the Diamond-Dybvig framework is that banks are susceptible to self-fulfilling runs due to their unstable balance sheet comprising of long-maturity illiquid assets and on-demand liquid liabilities i.e. deposits. The implicit rationale is that maturity transformation has a beneficial impact. As William Dudley explains it, “the need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation—borrowing shorter-term in order to finance longer-term lending”.

But what if there is no maturity mismatch for banks to intermediate? In a previous post I have argued that “structural changes in the economy have drastically reduced and even possibly eliminated the need for society to promote and subsidise maturity transformation.” The primary change in this regard is the increasing assets invested in pension funds and life insurers. Through these vehicles, households provide capital that strongly prefers long-maturity investments that match its long-tenor liabilities.

But how significant is this phenomenon and what does it mean for the economy-wide mismatch? In a recent research report, Patrick Artus at Natixis dug out the relevant numbers which I have summarised below:

In both the United States and Europe, household long-term savings (which includes pensions) is more than sufficient to meet the long-term borrowing needs of both the corporate and the household sector. In the case of the United States which issues its own currency, the need for maturity transformation can simply be eliminated by adjusting the government debt maturity profile accordingly. It is worth noting that even a significant proportion of the government debt in the above table is of a fairly short maturity.

The expansion that ended in 2008 was characterised by an expansion in the volume of long-term credit investments, but as Lord Adair Turner observed, in the United Kingdom “only a small proportion of those ended up in the balance sheets of long term hold-to-maturity investors such as pension funds or insurance companies. Instead the majority of UK residential mortgage-backed securities (RMBS) in particular were held by investing institutions, such as SIVs and mutual funds, behind which stood – at the end of the chain – short-term investors.” As Minsky might have predicted, maturity transformation was simply a tool to enter into a levered carry trade at the taxpayers’ expense.

In a world where maturity transformation does not even improve the efficiency of the economic system, Diamond-Dybvig and much of the rationale for our current banking and monetary system simply do not hold. The implications of this are not that we must ban maturity transformation. As Rajiv Sethi points out, even non-banking firms engage in maturity transformation and any attempt to stamp it out is futile. However, it is crucial that firms (banks or otherwise) that engage in maturity transformation are allowed to fail when they run into trouble.

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Written by Ashwin Parameswaran

October 10th, 2011 at 3:53 pm

Posted in Uncategorized

55 Responses to 'The Case For Allowing Banks to Fail'

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  1. haha, fair point. It is indeed OT in this thread however it is I’m sure you’d agree really a rather fundamental issue that relates directly to the central theme of ashwin’s blog.


    24 Oct 11 at 6:21 am

  2. […] match long-term investment projects, such projects would not find adequate funding. But as I have argued and the data shows, household long-term savings (which includes pensions and life insurance) is […]

  3. […] needed to mediate exchanges across time of the right to use real resources. As Ashwin Parameswaran points out, there is no great mismatch between individuals’ willingness to save long-term and […]

  4. […] large chunk of the present demand for long-term borrowing comes from the government(see this post for data). Unlike the private sector for whom the avoidance of refinancing risk is worth issuing […]

  5. […] match long-term investment projects, such projects would not find adequate funding. But as I have argued and the data shows, household long-term savings (which includes pensions and life insurance) is […]

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