resilience, not stability

Archive for January, 2012

The Public Deposit Option: An Alternative To “Regulate and Insure” Banking

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Many economists want to turn back the clock on the American economic system to that of the 50s and 60s. This is understandable – the ‘Golden Age’ of the 50s and 60s was characterised by healthy productivity growth, significant real wage growth and financial stability. Similarly, many commentators see the banking system during that time as the ideal state. In this vein, Amar Bhide offers his solution for the chronic fragility of the financial system:

governments should fully guarantee all bank deposits — and impose much tighter restrictions on risk-taking by banks. Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine…..Banks must therefore be restricted to those activities, like making traditional loans and simple hedging operations, that a regulator of average education and intelligence can monitor.

There are a couple of problems with his idea – for one it may not be possible to effectively regulate bank risk-taking. On many previous occasions, I have asserted that regulations cannot restrain banks from extracting moral hazard rents from the guarantee provided by the state/central bank to bank creditors and depositors. The primary reason for this is the spread of financial innovation during the last fifty years that has given banks an almost infinite variety of ways in which it can construct an opaque and precisely tailored payoff that provides a steady stream of profits in good times in exchange for a catastrophic loss in bad times. As I have shown, the moral hazard trade is not a “riskier” trade but a combination of high leverage and a severely negatively skewed payoff with a catastrophic tail risk.

Minsky himself understood the essentially ephemeral nature of the financial system of the 50s from his work on the early stages of the process of financial innovation that allowed the financial system to unshackle itself from the effective control of the central bank and the regulator. As he observes:

The banking system came out of the war with a portfolio heavily weighted with government debt, and it was not until the 1960s that banks began to speculate actively with respect to their liabilities. It was a unique period in which finance mattered relatively little; at least, finance did not interpose its destabilizing ways……The apparent stability and robustness of the financial system of the 1950s and early 1960s can now be viewed as an accident of history, which was due to the financial residue of World War 2 following fast upon a great depression.

Amar Bhide’s idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades. In particular, derivatives businesses will be forbidden for deposit-taking banks. This is a radical idea and one that is a significant improvement on the current status quo. But it is not enough to mitigate the moral hazard problem. To illustrate why this is the case, let me take an example of how as a banker, I would construct such a payoff within a “narrow banking”-like mandate. Let us assume that banks can only take deposits and make loans to corporations and households. They cannot hedge their loans or engage in any activities related to financial market positions even as market makers, and they cannot carry any off balance-sheet exposures, commitments etc. Although this would seem to be a sufficiently narrow mandate to prevent rent extraction, it is not. Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money? In the first post on this blog, I outlined how the synthetic super-senior CDO tranche was the quintessential rent-extraction product of the derivatives revolution. But at its core, the super-senior tranche is simply a severely negatively skewed bond – a product that pays a small positive spread in good times and loses you all your money in bad times. There is no shortage of ways in which such a negatively skewed payoff can be constructed by simple structured bank loans.

What the synthetic OTC derivatives revolution made possible was for the banking system to structure such payoffs in an essentially infinite amount without even going through the trouble of making new loans or mortgages – all that was needed was a derivatives counterparty. Without derivatives, banks would have to lend money to generate such a payoff – this only makes it a little harder to extract rents but it still does not change the essence of the problem. Even more crucially, the potential for such rent extraction is unlimited compared to other avenues for extracting rent. If the state pays a higher price for an agricultural crop compared to the market, at least the losses suffered by the taxpayer are limited by physical constraints such as arable land available. But when the rent extraction opportunity goes hand in hand with the very process that creates credit and broad money, the potential for rent extraction is virtually unlimited.

Even if we assume that rent extraction can be controlled by more stringent regulations, there remains one problem. There is simply no way that incumbent large banks, especially those with a large OTC derivatives franchise, can shed their derivatives business and still remain solvent. The best indication of how hard it is to unwind complex derivatives portfolios was the experience of Warren Buffett in unwinding the derivatives portfolio which he inherited from the General Re acquisition. As Buffett notes, unwinding the portfolio of a relatively minor player in the derivative market under benign market conditions and no internal financial pressure took years and cost him $404 million. If we asked any of the large banks, let alone all of them at once, to do the same in the current fragile market conditions the cost of doing so will comfortably bankrupt the entire banking sector. The modern TBTF bank with its huge OTC derivatives business is akin to a suicide bomber with his finger on the button that is holding us hostage – this is the reason why regulators handle them with kid gloves.

In other words, even if our dream of limited and safe banking is viable we have a ‘can’t get there from here’ problem. This does not mean that there are no viable solutions but we need to be more creative. Amar Bhide makes a valid point when he argues that “Why not also make all short-term deposits, which function much like currency, the explicit liability of the government?” But the solution is not to allow private banks to reap the rents from cheap deposit financing but to allow each citizen and corporation access to a public deposit account. The simplest implementation of this would be a system similar to the postal savings system where all deposits are necessarily backed by short-term treasury bills. If the current stock of T-bills is not sufficient to back the demand for such deposits, the Treasury should shift the maturity profile of its debt until the demand is met. In such a system, there would be no deposit insurance i.e. all investment/deposit alternatives except for the state system will be explicitly risky and unprotected.

One criticism of such a system would be that the benefits of maturity transformation would be lost to the economy i.e. unless short-term deposits are deployed to 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 more than sufficient to meet the long-term borrowing needs of the corporate and the household sector in both the United States and Europe.

The “regulate and insure” model ignores the ability of banks to arbitrage any regulatory framework. But the status quo is also unacceptable. However the system is sufficiently levered and fragile that allowing market forces to operate or simply forcing a drastic structural change upon incumbent banks by regulatory fiat implies an almost certain collapse of the incumbent banks. Creating a public deposit option is the first step in implementing a sustainable transition to a resilient financial system, one in which instead of shackling incumbent banks we separate them from the risk-free depository system.


Note: My views on this topic and some other related topics which I hope to explore soon have been significantly influenced by uber-commenter K. For a taste of his broader ideas which are similar to mine, try this comment which he made in response to a Nick Rowe post.

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Written by Ashwin Parameswaran

January 5th, 2012 at 12:18 pm