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This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk.
I'm still working on the longer piece. The general point is that banks are a mechanism for risk-sharing, as is debt for that matter.
Posted by Tyler Cowen on October 30, 2008 at 10:07 AM in Economics | Permalink
Comments
genius! is that what you are paid for?
Posted by: mishka at Oct 30, 2008 10:13:40 AM
Insurance is risk sharing, banking is an exchange of time preferences.
Posted by: Superheater at Oct 30, 2008 10:17:44 AM
Suggests a reason why FDIC is in place?
Posted by: Dave Prychitko at Oct 30, 2008 10:27:42 AM
I see the trouble is less about trickled-down risk mitigation capacity than about the tradeoff between future risks and return. By regulating banks to avoid overexposure to future down-size risks, a necessary tradeoff is to let go some future returns. It is the nature of playing games with time. Derivatives are great when they are working; but when they fail, they fail big. It is a gamble with calculated or seemingly calculatable risks. The question is always how far we could push our luck – the further we could push it without hitting a breaking point, the more upside we could reach with borrowed resources from the future that both depends on us, and sometimes, tricks us. It is true though that if our banks are no longer allowed to borrow as much from the future, they would no longer be able to protect us as much when we need their help. From that perspective, there is a trickling down of risk mitigation capacity. On the other hand, with less borrowing, many businesses won’t fall as far as they would if they borrowed more to begin with.
Posted by: Yan Li at Oct 30, 2008 11:12:17 AM
Not sure I get this.
First: You say that banks exist to share risk. Is this because the bank gives 100 people loans, and maybe 10 of them are risky for default but the law of large numbers helps smooth out the uncertainties? So that the bigger a bank is, the more it is serving its "function" as a risk sharer by pooling more loans?
I'm not sure I see this as "sharing", actually. The depositor at a bank has $X in an account. X is, I think, guaranteed not to go down (no downside risk-- is this right?). Whereas the bank does have the downside risk that many loans are defaulted on. So the bank is not sharing its downside risk with its depositors.
The bank pools risk, but it seems they don't "share" risk at all, at least with their depositors. That would be something like securitization.
Also:
"This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk."
You mean, the more we subsidize their risk, the more we are taking on their risk, and the less they serve as a risk "firewall?"
I agree with the "firewall" image but the risk "sharing" image I don't understand.
Posted by: mk at Oct 30, 2008 11:44:41 AM
Arrggh Tyler! Superheater is all good: banks are about time.
Banks channel and grow blind capital flows; the big multinational banks channel and grow global blind capital flows. This stuff just doesn't slosh around by itself.
They take these flows and create money-value in the economy through loans, which is where Superheater's time comes into it. I loan out money I don't need now for interest (with the exception of Sharia banking, which we can talk about later).
Look, I'm a bank. You give me E100, and I'm going to loan it out, up to the reserve limit set by my governing Central or Reserve Bank. Generally this limit's something like 3-10% of total deposits, depending on location. An important thing to remember is that the limit can be held as cash on hand or in a reserve account with the Governing Bank.
So given a 10% limit, The StreetWalker Bank lends out 90 to Joe the Plumber at interest, who goes about purchasing goods & services, as a result of which said 90 ends up in the Tyler Bank, which then lends out 81 to Worthwhile Small Business X, which does the same thing, so that the cash ends up in the Superheater Bank, etc.
In this way, money grows and flows throughout the community in a much greater amount than physically exists. Alternate forms of flow management just don't seem to be as efficient and trustworthy, so banks remain crucial institutions even if now we are reminded of their fragility.
Posted by: StreetWalker at Oct 30, 2008 11:44:57 AM
This will make a great commercial for a bank. Deposit with us and hare the risk of our screwups.
Could you write a few sentences explaining how having counterparties with 30, 40, or 70:1 leverage ratios is any different from lending money to a crackhead?
Posted by: David at Oct 30, 2008 11:57:38 AM
Sorry one more thing:
"This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk."
Well, we could regulate by subsidizing risk (depositor guarantees), or by hobbling banks' abilities to do risky things (capital/reserve requirements).
Subsidizing risk does indeed expose the taxpayer to the bank's risk. The second one, hobbling banks' ability to do risky things, affects the volume of loans given by a bank. This will reduce the "pooling" effect, perhaps. And that means -- what? That each bank is more at the mercy of variance? Does this really measurably increase the risk for the rest of us? I have a feeling you don't mean this.
So your comment, maybe, refers only to subsidizing risk?
Posted by: mk at Oct 30, 2008 12:00:31 PM
The art of regulation is to keep banks from taking foolish actions, not to protect them from the consequences of those actions.
Posted by: ogmb at Oct 30, 2008 1:22:25 PM
I have no problem with a bank taking risks with my money. But, before I put my money into the bank, I want to know what the risk is.
I think that is the reason that this financial crisis occurred. No-one accurately assessed the risk of the loans and of the financial paper.
Find me a way to insure that I am, indeed, taking the risk that the bank is telling me I am taking and let me decide how to invest my capital.
Posted by: Allan at Oct 30, 2008 1:35:45 PM
OFFTOPIC: TC, I am a long time disloyal reader of this blog. My ad blocker was temporarily off and I noticed the anti gay marriage ads on your site(CA prop 8). I was wondering what your ad policy is ? Do you pick your ads/use a reseller/endorse the ads placed. As someone with libertarian tendencies, why would you endorse/place ads for something which has nothing to do with govt. If you have a somewhat nuanced take on it, would you mind explaining it. Googling your archives didn't turn out much.
Posted by: Jesus Saves America Spends at Oct 30, 2008 1:37:02 PM
"The art of regulation is to keep banks from taking foolish actions"
I must disagree, ogmb. Regulation is about creating trust. The only regulations that are useful are those that increase transparency and build trust.
There are many "wise" things you could ask a bank or bank-like entity to do, but that would divert them from their purpose of harnessing high trust to create liquidity and growth. And such diversions, as we have seen, end up in the medium-term being fatal to trust.
Posted by: StreetWalker at Oct 30, 2008 1:37:20 PM
OFFTOPIC: TC, I am a long time disloyal reader of this blog. My ad blocker was temporarily off and I noticed the anti gay marriage ads on your site(CA prop 8). I was wondering what your ad policy is ? Do you pick your ads/use a reseller/endorse the ads placed. As someone with libertarian tendencies, why would you endorse/place ads for something which has nothing to do with govt. If you have a somewhat nuanced take on it, would you mind explaining it. Googling your archives didn't turn out much.
Since the site is a private enterprise, why would it need to explain
its ad policies or are you suggesting that it should refuse
sponsorship from SOME political advocacy campaigns?
Actually, when I got married I had to go to my county courthouse to
obtain a marriage license. I had to answer a few questions and pay a fee.
Excepting "common law" marriages, you will not be held to be married by the
state without that license.
Any discord in a marital relationship can involve policy,
social services and ultimately domestic relations courts.
Do you want to explain how that "has nothing to do with govt"? Or was
the big fat curveball of lousy argument just meant to betray
the fact that you are just a "seminar poster"?
In any case, I prefer the label "affirming traditional marriage".
I still maintain the true libertarian position on homosexual
relationships should be, dispose of your property under the
auspices of your private contractual and testamentary arrangements.
Posted by: Superheater at Oct 30, 2008 4:42:31 PM
Insurance companies pool risk, as noted above. Banks facilitate payments, act as financial intermediaries, and in a free market (i.e. under free banking) issue hand-to-hand currency. How does debt mitigate risk?
Posted by: Bill Stepp at Oct 30, 2008 6:18:24 PM
"This trade-off points to a dilemma of financial regulation. The more we protect banks from potential losses, the less banks can protect the rest of us from financial risk. ….The general point is that banks are a mechanism for risk-sharing, as is debt for that matter." --Tyler Cowen
......
1) Let's broaden the role of banks in a market-oriented economy to include them and all other financial institutions of importance: not just commercial banks, but investment banks, mortgage brokers, insurance companies, credit-unions, stock and bond markets, mutual funds, money-markets, hedge funds, and no doubt others that don't leap to mind.
The principal function they all share, at least in theory and maybe, if there is sufficient transparency and accountability --- however achieved --- to ALLOCATE CAPITAL EFFICIENTLY AND MANAGE RISK PROPERLY. And through all phases of the business cycle.
...
2) Yes, an ideal --- but one that sets up a good benchmark for how we should evaluate their overall functioning over time.
...
3) To make all this more realistic, we could add to the above definition that the "management of risk" is, invariably, shared by capital-holders: households and businesses that have cumulative savings and hope to earn interest-dividends or capital gains or the like.
The role of financial institutions, then, seems to be to act as an intermediary between savers as creditors and would-be borrowing debtors --- again, households and business firms, but also governments --- and to equate S and D in loanable funds markets in ways, we hope, that are fully transparent and accountable . . . with accountability meaning, among other things, that the average creditor (say, a household depositing money in a bank account) and the average borrower (say, a household seeking a loan to buy a car) can understand what the market-exchange here amounts to.
And yes, as some posters have noted, this exchange can --- given time-preferences --- entail inter-temporal preferences.
.....
4) Stay with this simple model.
The problems arise with all the new innovations in the financial world since the start of the 1980s that have enormously complicated the transparency and accountibility of financial exchange between savers and borrowers, with the financial institutions as intermediaries.
Junk bonds; a misuse of claims by brokerage firms in the 1980s that personal computers will allow for a very speed shift between equity and bond markets if one or the other falls below a threshhold; the S&L mess, abetted by the new Mortgage Back Securities (MBS); the blurring of the lines even between commercial and investment banks (and S&L banks) even before the repeal in the late 1990s of the Glass-Steagall act that, in effect, shattered the boundaries. Plus the explosion of hedge-funds, one of which --- Long-Term Capital Management (run by two Nobel-prize economists and 24 economic Ph.D.s) --- that required a big Federal Reserve bailout.
....
Worse yet, there was the creation --- model-based, with the use of computers --- of complex financial derivatives that most of the investors in didn't even seem to understand (or, eventually, care about) . . . and the refusal in the Clinton-era of the US Treasury (and Federal Reserve) to regulate them. That worsened in the current decade with the explosion of the house-asset derivative market, global in nature --- demanded by trillions of dollars of footloose capital from oil-rich countries and China (and Japanese yen-based, low-interest loans for investment and speculative purposes world-wide) --- that then entail a huge world-wide chain of creditor-debtors that was not only not transparent and accountable, but --- it seems --- left the creditors, whether based in concrete buildings with a name, or just a special vehicle instrument operating on the Internet, with an interest only in gaining fees and possible future gains while trying mightily to pass on all the risks.
....
And the response of the Bush-W appointees in Freddie Mac and the SEC and elsewhere, not to mention the Federal Reserve?
No need to regulate these genius-driven innovations. They were working to increase wealth globally, both tangibly (in house-purchases especially and rises in GDP) and on paper. And they were all self-regulating.
.....
5) So where are we?
What worked well in financial markets during the heyday of regulated financial markets --- roughly by the end of the 1930s until 1980 or so, when the institutions and their financial instruments and their credit-analysis and risk-management were fairly easy to track: that is, they were transparent and accountable --- started to rip apart under the pressures of financial innovations, one after another, on one side and the pressures on the other not to extend governmental regulations on the other. And when, to boot, there wasn't $70 trillion dollars worth of footloose capital in the world by 2006 --- a doubling of the cumulative $35 trillion that had taken centuries to accumulate around the world in capital eager to find good investment-returns (with low-risks entailed, it seemed) . . . a downside of globalizing trends that reflected tremendous imbalances around the globe.
....
Funny thing is, in the era of effectively regulated financial institutions, say 1945-1980, none of these erratic, half-loony balloons and busts occurred. And oddly, nobody worried about moral hazard thanks to a variety of governmental innovations in financial regulation and the floor set to bank depositors by FDIC.
.....
6) A conclusion?
The burden would seem to be on those, then, to show how --- on a cost/benefit basis --- the big financial innovations since 1980 or so, largely unregulated --- have had a benign overall effect on the US economy . . . or, for that matter, the global economy. Remember, on an "overall" basis. Not just pointing to this or that desirable effect, while ignoring the long-term costs, not to mention the recurring short-term financial shocks since the mid-1980s.
That is, whatever else might have dislocated the global economy after 1973, it was the combination of oil-shocks and misguided government policies (including central banks) that underpinned the dislocations . . . not financial institutions. These seemed, until the 1980s, to be doing fairly well what they should: allocate capital efficiently and manage risk properly. And for financial institutions to perform this role adequately again, they will have to be carefully regulated to keep pace with all the new financial innovations that have shot up and multiplied over the last three decades.
....
Michael Gordon, AKA, the buggy professor
Posted by: the buggy professor at Oct 30, 2008 6:28:47 PM
"The art of regulation is to keep banks from taking foolish actions"
This implies that either regulators can predict better than banks what actions will seem foolish in retrospect, or that banks know what actions will seem foolish in retrospect, but wish to undertake them anyhow, and must be restrained by the wise regulators.
I can imagine a variant of the second possibility, where there is some sort of Gresham's law of mortgages operating, forcing mortgage brokers to make worse loans than they would like. Some of the stories I've read recently seem to imply that mortgage brokers did think what they were doing was foolish, but that they had to continue making worse and worse loans or lose business to competitors with lower standards. So there was a merry race to the bottom. Then they ended up with a lot of the worst loans still in their inventory when demand suddenly dried up.
Am I arguing in favor of Tyler's 'increased wealth' hypothesis? The cute story above depends on an unexplained voracious and uncritical demand for securitized mortgages. How could demand be sustained during such a race to the bottom? Or maybe I've just accepted some folklore, and this story is false.
We could try to interpret the quote as 'regulators should force banks to tone down the risk.' But in the recent crisis, banks could have pointed to the AAA ratings of the securities they were holding until it was too late. Would a hypothetical regulator really have known when to put on the brakes? If such a regulator had indeed criticized the emperor's wardrobe, he would probably now be blamed for the subsequent crash, even if it was milder than the one we're actually experiencing. That is, unless he was so prescient as to have nipped the whole thing in the bud. (maybe 8 years ago? When?)
Posted by: Dave B at Oct 30, 2008 6:56:08 PM
Isn't the reason the crisis has been so broad basically due to the fact that financial systems were too efficient in spreading risk? It can be said that regulation works to increase robustness by isolatating risk through artificial barriers against efficiency.
Markets are often considered in evolutionary terms: the economy becomes collectively stronger when the ill-adapted perish.
While larger organisms are often more efficient, prosperous and robust during times of relative stability, the drawback is that it only takes a single bullet to the brain to kill even the cells in the toes. Smaller organisms are more evolutionarly agile and diverse, and better able to collectively withstand cataclysmic events.
As globalization continues, and the global markets become more connected and efficient, the world as a whole will become more able to protect itself from the usual smaller economic dangers, while ironically becoming even more exposed to the one crisis that dooms it all. The world is quickly becoming 'too large to fail', but who then will bail it out?
Posted by: crackpot joe at Oct 30, 2008 9:34:36 PM
Some have missed the point about banks' role in risk-sharing. Since banks are intermediaries, they channel funds from people who have more than enough money to make ends meet to those who temporarily don't have enough. This protects people from temporary shocks to income.
Posted by: Ricardo at Oct 30, 2008 10:47:32 PM
Ah, thanks Ricardo, that's clearer. Access to credit smooths out any bumps of year-to-year (or day-to-day) income uncertainty.
But what about planned large purchases, like a couple buying a house, or a small business owner investing in a tractor? Here debt is primarily a means of stretching out the time frame of a large purchase, right? Does this "time stretch" function fit under "risk sharing" in some way I don't get?
Posted by: mk at Oct 30, 2008 11:09:05 PM
Measuring the output of banks (just what do they do, and how do we measure it, how do we know if productivity has improved etc.) is a big deal and your input is encouraged. Bankers describe what they do as "managing risk" which does not fit well into conventional theory/measures. My view up to this point was that banks provide screening and monitoring services, and transactions services (like checking). The best papers I know of on this sub-topic are by Christina Wang and coauthors.
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