If you have government-supplied insurance, then you have to have government regulation of people's financial activities. There is no way to avoid this conclusion. In a world without such regulation, banks would make excessively risk loans because they get the upside and the taxpayer bears the cost of the downside.
Indeed, I have made it myself. But I wonder if it is actually true.
Almost everything in the world has negative and/or positive externalities. But despite this, we do not intervene to subsidize everything with good negative externalities, or punish everything with bad. That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount. For example, if I am a bus driver, the negative externality of my suddenly jerking the steering wheel to the left and driving the bus off a cliff is much higher than the cost to me--many lives against my one. But my own life is very valuable to me. The threat of its loss is enough to deter such behavior 99.9999% of the time.
Bankers take risk in order to make money, and they control risk in order to avoid losses. But the losses they are most interested in are not to their shareholders. Rather, they are worried about the loss of their jobs. As long as the bank regulators fire any managers who put the bank in receivership, I can see no difference between an unregulated private system without deposit insurance, and a system with. That isn't to say that there is enough regulation in either situation. But if there is a problem, it is that bankers have a socially less-than-optimal risk appetite, or that the punishment for driving a bank into insolvency is insufficient. The moral hazard from deposit insurance doesn't much enter into it.
The moral hazard for depositors may be large. But I doubt it. Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either.
The reason that desposit insurance requires tighter regulation is that the government wants to minimize the cost to itself--not society, for whom the losses would be the same whether the government or the bank paid them. I think this is wise, for many reasons. But not because of moral hazard.
Megan,
I don't know how the current banking model would adapt to a world without deposit insurance.
I would think that without deposit insurance small banks wouldn't be at all viable. Then how, you might ask, were small banks viable back in the 1920's before deposit insurance?
As I understand it, back in the 1920's, branch banking was illegal in most states. If you wanted to put money in a bank you had to put it in a small local bank.
Do regulators have the power to wipe out bad bank managers? Don't they have what we colorfully call parachutes?
We'd be in bad moral territory if it was acceptable for pilots to be the only ones on planes with parachutes, and it if was socially acceptable for them to use them.
And yet, that seems to have been the norm in this housing bubble.
"Rather, [bankers] are worried about the loss of their jobs."
Not completely accurate. They are worried about the loss of their jobs before they can make a huge money pile; after that pile is secured in the Caymans, they don't give a rip. Reference:
http://www.nytimes.com/2008/12/25/business/25sandler.html
Tony:
Not only that, but I think she has the moral hazard problem backwards.
Tony brings up an important point
"They are worried about the loss of their jobs before they can make a huge pile of money"
More generally there is a mismatch between management compensation and actual realization of economic benefits of their labor. For this reason I'm skeptical of the efficacy of management firing's as a deterrent. This might also produce some detrimental incentives for successful/ethical managers who might not want to join firms in order to "right the ship" for risk of being the one punished if the firm fails.
We need some criteria to judge the integretity of managements decision making process. From a governments prospective this means establishing some bounds of easily observable behavior (leverage, reserves, etc.) within which firms can operate.
I think Tony has it right: it is about the bonuses.
The point of being a banker is to work your way high enough up the ladder so that you have one, two, maybe five years making 8 or even 9 figure bonuses. Or perhaps even just 7 figure bonuses, and then jumping to a position at a hedge fund where there is more money waiting, and less scrutiny. If you want a life, you can always jump to ca corp development job with lots of options. Losing your job is fine as long as you have had a few of these years beforehand.
After all, as Megan has pointed out, most bankers assume they will lose their job in a downturn because of the job stability associated with this profession, and many of them don't want to be lifers anyway because of the lifestyle you have to lead to hold these jobs. Your long-term results won't haunt you after you are gone.
Perhaps the real deterrent is changing the bonus structure so that you can still earn outrageous bonuses, but each bonus is paid over several years (and back-loaded), so they can be cancelled later if the results on which they are based are illusory. Otherwise, the incentive as you near the top is to pump your short term results and ignore the long-term risk.
"That's because things with substantial negative externalities often contain sufficient punishment to deter the individual; likewise, things with positive externalities often carry enough reward to produce a socially optimal amount."
Really?!! What about greenhouse gasses. What about production of highly toxic agricultural checmicals? What about pig CAFOs where the effluvient shit is paid for by local sanitation? I could go on and on about things for which the externalities are neither painful nor paid for. In fact, a gigantic story about economics which often never discussed is the "problem of the commons"; that is; what do you do about externalities?
MM's problem and the problem with all libertarians is that they believe that the market actually punishes externalities; reality says otherwise.
Corporate Flunky- Of course there are negative and positive externailities that need to be regulated. I believe MM's point was that almost every activity one does has negative/positive externalities of some sort and it's not worth it to subsidize/regulate them all. If you eat cereal for breakfast it could be good for national economic productivity because you're not hungry and work harder. It affects how much we pay for health insurance because you're healthier or not. Not to mention the affect it has on all employees in the supply chain who you're employing etc. Deposit insurance certainly has externalities, but that does not immediately imply that there is any point to regulating them. (although in this instance I agree that we should.)
This brings to light a much larger question with regard to government regulation. If the government's primary function is to act as a meta-insurer, securing contracts and protecting against disaster or attack, why exactly are we arguing that an entity which is in essence an insurance company should be limited in stipulating conditions under which it will or will not back a given contractual arrangement?
For instance, if the government secures the conditions necessary for a financial market to exist, via force of arms and rule of law, should it not also be able to regulate the transactions taking place in that market in order to limit risk to itself?
The venerable Byron Wien recently noted that when he entered the investing industry in 1965, salaries for bankers and doctors were pretty similar, but now it's not even close:
The average doctor makes about one-third that of the average banker... and no doctor makes as much as even the lowest paid VP of a Fortune 100 company. Sure the bull market has caused some exuberance, but the amount of inefficiency is astounding.
http://www.cnbc.com/id/28379201
C'mon Mike. Libertarianism is the most foolish of all political stripes because the logic that comes to it is logically flawed.
Put simply, Libertarianism only works in a world where trust is implicit, because in order to embrace it, one must believe that the world will not revert to our historic past wherein the most ruthless and powerful forces ran roughshod over everyone else. It refuses to recognize the role that government plays in enforcing rules which protect various interest groups or individual from interference from others.
The mistrust of government since it requires the acquiescence of the people to maintain order is a logical non-sequiter unless that trust doesn't exist. If the trust doesn't exist then libertarians have to admit that their core philosophy exists only in dreams and fantasies.
But given how much of her post you ignored after that sentence, I guess the question is whether you read any of it.
Given that Megan was specifically talking about externalities, it's a particularly odd claim to say that they're not discussed or to act as if she's unaware of them.Externalities are regularly discussed by libertarians; the difference between liberals and libertarians is not that libertarians ignore the issue, but that libertarians have a different solution most of the time: privatize, rather than regulate. (No commons => no tragedy of the commons.)
Megan did not say that the market punishes externalities, although it often does. What she said is that there are often sufficient internalities in a given situation that the externality issue isn't a problem.
The venerable Byron Wien recently noted that when he entered the investing industry in 1965, salaries for bankers and doctors were pretty similar, but now it's not even close
Question: In 1965, could a banker and a doctor both take the same company car, the same vacation time, the same personal discretionary expense account, the same weekend at a corporate-sponsored country club, etc.?
There are more ways to provide compensation than just money, and the ones that aren't money are often very un-transparent.
The real problem, as several commenters have hinted at, is an issue of timing. It isn't that a few people win and lots of people share the loses. It is that once a person wins he gets out, he quits, he retires, he moves on. If the chickens ever come home to roost the people responsible are often not part of the company anymore. All these people need to do is make sure they win short term and then walk away. And then if the risky system collapses they are nowhere to be found. As long as the original risk taking was legal, there are no incentives to NOT behave like this. And that is the problem.
Megan:
The problem is that while just about all jobs give you a limited downside (you get fired), some give you an unlimited upside (due to bonuses and options and whatnot). This gives you an incentive to pursue riskier strategies than you would otherwise.
One possible solution to this problem is restricted stock grants: Instead of stock options, the company gives executives shares of stock that vest over a period of time. This greatly increases the potential downside for executives, and more closely aligns their incentives with the investors' (and, to some extent, to those of society as a whole).
I'm trying to figure out precisely why if one's goal is to make money, why they would they be so risky with it? Insurance is not a way of making money, nor is it risk averse since it would carry at least the lemon-plum crap car dilemma. The closest analogy would be the Rental car hazard. Since your not liable for any part of the upkeep of the car you drive it like you don't care. But in fact you don't really drive the car as hard as you think you do. If people did it would cost substantially more to rent a car. The reason? One doesn't want the hassle of explaining to a company why their rental car is on the side of a road somewhere. Or the threat to their own personal safety.
Yet here we are with our current set of bank problems. It seems to me that the underlying cause of the credit issue is more than housing. It seems reasonable to me that the building block cause was that nobody was doing the research, putting in the legwork, and checking on their subordinates. It was all done in handshakes, which and I mean this wholeheartedly, is inexcusable. The foundational idea of trust is that it is necessary to do business. But it is the quickest way to ruin.
Sorry Megan, I don't think so. Here's why:
More relevant to the day-to-day decisions of most managers than keeping their jobs by not letting the bank fail is the question of whether they'll lose their jobs (or not be promoted) because they aren't pursuing high returns aggressively enough.
Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either.
Megan, Megan. Of course they aren't. They also can't, as individuals, figure out how much it costs to manufacture a tire or fabricate a CPU. But in aggregate, they form a free market that bets on whether a given institution will fail. We have essentially removed that from the equation.
Now, there may be enough value in keeping institutions solvent to justify such intervention. But let's not kid ourselves that it comes without cost. Tanstaafl!
Ben,
You assume people didn't know it was all going to end badly - I'm sure many thousands did know.
I was recently watching "Downfall" about Hitlers last days in the Führerbunker. Now, one might ask, at what point did 80% of the German General Officers know it was all going to end badly? But, none of them did anything until the very last days of the war. Why? Well, they had seen what happens to the few who tried to put an end to the madness.
I think we all wildly over estimate the likelyhood of someone standing up when doom is imminent. I'm sure the executives at Bear, or Lehman, or Merrill thought that if the company was headed toward the shoals someone would speak up. What they didn't realize is how many people they had fired for "not being team players." They failed to realize what little chance there was of anyone comming forward.
I'm trying to think if there are some institutional safegards we can add to corporate america to protect those who warn of impending doom. Ideally, I would want them to be rewarded in addition to being protected.
I guess we don't have to worry about Napoleon or Hitler trying to conquer Europe because, you know, the negative externality of losing their Head of State jobs would outweigh the benefits of world domination.
This is all way above my pay grade, but I've often wondered whether it might do some modest bit of good for the FDIC to charge premiums based on the riskiness of a bank's portfolio and the institution's overall financial strength (perhaps they already do this) and then require the bank to 1) charge each depositer a separate, explicit fee to cover this premium, and B) disclose this fee prominently.
It's not the bank executives who create a moral hazard, but the shareholders. Given access to a large pool of very cheap capital, which permits very high leverage, the temptation is to go for broke. On the downside, because of limited liability, you only lose a samll fraction of the total capital invested in the venture; the upside is unlimited. And so the shareholders will hire managers who take big risks. In most large public companies, the bondholders restrain the shareholders from excessive risk (that's why bond indentures contain 100 pages of covenants), but, in a bank, insured depositors have no incentive to take on that role, so the government has to step in.
The moral hazard has already happened. This current crisis the consequence of it, and the bailout money is the long promised payment.
It goes as far back as the billion dollar bailout of the Hunt silver speculators, to the '84 Continental Bailout, to the Long Term Capital Bailout, to the Greenspan Put and the lowering of interest rates in '01.
In the Congressional hearings overseeing the 1984 bailout, the Comptroller of the Currency admitted that they would step in to prevent any of the large banks from failing.
The result was leverage ratios shooting up to 40 to 1, a credit expansion rate of >15% a year, and the proliferation of extremely complicated schemes to make money from risk premiums while hiding the risk from regulators. By 2007, Wall St. accounted for an insane 50% of corporate profits. All of those profits were built on top of insane risk taking.
As Greenspan himself said: "Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of leverage in banking than market forces alone would support."
That's the understatement of the decade.
Despite the latest job losses, everyone in the Wall St. industry the past thirty years has been a massive beneficiary of the moral hazard. The bankers in the industry made far more than they would have had they been forced to make an honest living as engineers or middle managers. An 80% chance of making $500,000 and a 20% chance of losing your job is far better than a 90% chance of making $100k and 10% chance of losing your job. That's the payoff scheme Wall St. employees actually face, and that's why they've taken so many risks.
The "Too big to fail policy" was made official in 1984. How can this crisis be see as anything but the final consequence of that policy?
Yes, it is moral hazard. But it is not the greatest repository of moral hazard, which is the near lifetime tenure voters have granted to Senators and Representatives of the United States Congress.
Re: 1) charge each depositer a separate, explicit fee to cover this premium, and B) disclose this fee prominently.
Which would drive depositors away from that bank, thereby making it even less sound. So a clear case of the law of unintended (but easily foreseen) consequences.
Which would drive depositors away from that bank, thereby making it even less sound. So a clear case of the law of unintended (but easily foreseen) consequences.
That's just the point: it would explicitly price the cost of risk to banks by making them "pay" for that cost in the form of fewer depositors. Under status quo rules, depositors have no incentive to shop for a prudently run bank. Make depositors realize that insurance comes right off the top of the interest they earn, and perhaps they will have such an incentive.
Re: That's just the point: it would explicitly price the cost of risk to banks by making them "pay" for that cost in the form of fewer depositors.
???
That's counter-productive. You don't want to make banks less sound, for crying out loud! This is the same mindset that thinks charging sick people who can't work high insurance premiums makes sense.
JonF,
Is that what they wanted to do? I thought they wanted to charge fat smokers more. I don't know about you - but to me that makes sense.
You don't want to make banks less sound, for crying out loud!
I'm not saying you'd want to introduce such a policy tomorrow morning, mind you. But, when the economy recovers, I see only upside in giving consumers some small personal stake in whether or not where they do their banking is soundly managed. Remember no depositor would be without deposit insurance -- it's just that they would see what that insurance costs. A less risk averse bank would translate into a higher cost. If such an institution can make up for that higher cost by offering more interest (or better services, or whatever) more power to them.
Megan,
You seem to have forgotten the S & L debacle of the 70s and 80s. Here's a reminder of what happened:
S & Ls were losing money. If they kept on going the way they were going, the S & L would go belly up, and they would lose their jobs. So they made risky loans at high interest rates, because if those loans all worked out, they wouldn't go broke. Surprise, surprise, the loans didn't all work out ("high risk" == "high risk" == many will fail. What a surprise). So the executives took even bigger risks. Why? Well, why not? It didn't matter if the S & L went bankrupt with $10 million in debt, or $1 billion, either way they were out of a job. So they pushed, and pushed, and probably kept their jobs a few more years, but did so at a large cost to the taxpayers. And a large cost to society, since a lot of money was poured down various rat holes in search of large returns, instead of being spent on more reasonable ventures that would have actually been useful.
So no, the regulators aren't merely protecting the taxpayers, and they're not just stopping small problems.
Sheesh. Strange comments on this comment. A lot of people seem to think that commercial banks and investment banks are the same, and that commercial banks pay high salaries and have grand bonuses. They don't. And they're the ones who maintain deposits for depositers.
The investment banks are the high flying ones in the banking industry.
And the S&L debacle in the late '80's was the result of TEFRA 86 doing away with passive loss real estate investment tax treatment, which depressed the real estate market, and since S&L's are only permitted by law to invest in real estate, they bore the brunt of the market drop. Then, in reaction, Congressional changing of the rules in mid-stream caused a lot of performing loans to instantly become non-performing loans (under the new laws) and a lot of innocent people lost their shirts.
And the "average" doctor makes a lot more than the "average" banker, unless you are talking about the average bank **president**, who becomes such after many years of service, while a doctor becomes a doctor right after finishing his/her internship.
Re: Is that what they wanted to do? I thought they wanted to charge fat smokers more. I don't know about you - but to me that makes sense.
You believe in a rational world in which people can control the future.
I don't see that world at all. I see a world where the future is largely governed by randoness and contingency. The vast majority of our "risks" are not incurred voluntarily but come out of no where, unforeseeable and uncontrollable by anyone less than God.
Rex,
You miss the point. It doesn't matter how the S & Ls got into deep trouble, what matters is what happened once they got there.
And, once they got there, because of the moral hazard of deposit insurance, and the incentive structure it created, they behaved in ways that made things worse for taxpayers, and worse for society. Which is directly opposite what Megan is claiming would happen.
Great Post, thanks.
Happy New Year