Further Thoughts on Shadow Banks

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There has been some interesting feedback on the Shadow Bank interview: James Kwak, Noah Millman, Mark Thoma, Arnold Kling.

There are two additional points I want you to think about when it comes to the discussion of shadow banks, things I tried to get at in the interview.

Liquidity and Solvency

Banks, since long ago, have always had liquidity and solvency risks. This is the “bank run” problem you have heard about. Almost every banking problem can be described as a breakdown along these two lines. In the same way it is irresponsible to economics to discuss the economics of health care markets without discussing moral hazard or adverse selection and instead assume it is like the market for bread, it is irresponsible to talk about banks without these two special market failures in mind.

There was a lot of talk how the new capital markets banking system would regulate itself. I’ve read a lot about risks would be contained because of collateral posted, or that blue-blood CEOs would want to keep their reputations high. We have learned, and in retrospect it was naive to ever think otherwise, that none of that is going to be enough to hurdle these two problems.

Systematic Risks

There’s a quote from Robert Lucas about taming the business cycle from a few years ago that gets pulled out and laughed at. A statement I’ve been reflected on while thinking about all this is the following:

“I don’t see that the private market, in creating this wonderful array of derivatives, is creating any systemic risk. However, there is somebody around creating systemic risk: the government…Perhaps the biggest systemic risks that the government creates come from its debt guarantees”
– Fischer Black, 1995

I take a deep breath before saying this, but my man Fischer is wrong – AIGFP created systemic risk out of nothing by mispricing CDS contracts over a few year period. Systemic risk is the risk that effects us all, the risk we can’t diversify or innovate our investments away. It’s the risk that hits my boring index fund of stocks that I want to use to retire.

How do they do that? By underpricing CDS contracts – charge 2 or 15 bp on some accounts – they encourage people on the other end to take on more risk thinking they are insured, when they are not. This chains through the system to the point where it hits my boring index fund.

This point is really important, so I’m going to harp on it. Think if you got fire insurance on your home cheap, really cheap, but the fire insurance firm has no intention of paying it out. Since you feel more secure, you smoke in bed and leave oily rags around the furnace and use the smoke alarm batteries for the remote, and sure enough your house catches on fire. You aren’t going to get paid, but that’s a your problem at that point – however now your house is on fire, and your neighbors houses are catching on fire. Other fire insurance companies, not capitalized to handle this sudden wave of fires, start going bankrupt. This metaphor may seem a bit much, but that’s what happens in financial firms.

There’s a lot of talk about derivatives being great because Caterpillar wants to buy them over the counter or terrible because Warren Buffet says they are WMDs for geeks. That’s not the point – certain ones are dangerous and need to be regulated because they can create risks that impacts everyone, systemic risk, regardless of whether or not they own any derivative products.

I’m not sure what the best way to go about this. As the commenters mention, like access to the Fed window, having the government be the insurer of last resort would require that everyone is committed to it, and trade off regulation for that privilege. It would also have to mean, like what happens to boring banks, banks would have to be collapsed via FDIC if they messed up – we don’t have a safety net and bailouts.

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5 Responses to Further Thoughts on Shadow Banks

  1. Here’s where I got hung up with your interview with Mehrling, when he says:

    “I suppose it is true that we could get back to the banking system of the 1950s. But let’s remember where that banking system came from. It came from a Great Depression and a World War. Hopefully we won’t need to go down that road. Hopefully we can find a way to fix the system we have now.”

    The system we have now required Henry Paulson, Treasury Secretary, to come before Congress last fall and say that if nearly a trillion dollars were not handed over to Wall Street, there would be no economy on Monday. He wasn’t talking about the failure of a particular sector within finance or the savings and loan industry or a particular company.

    He was talking about the economy.

    That’s an exceptional crisis.

    (And we all know now that with the various federal bailout and recovery programs, the price tag to help Wall Street fix itself is well into the trillions – at a time when capital investment is desperately needed to create jobs in America.)

    So I am struggling with the idea that we need, for whatever reason, to let the shadow banking system continue unregulated, with just a higher premium to be paid out to insure the bets.

    I’m not an economist – but we’re not talking about the uneducated masses who smoke in bed surrounded by oily rags, feeling protected by the cheap insurance they got from the fly-by-night company.

    We’re talking about extremely well compensated CEOs, educated at the finest universities, who’ve surrounded themselves with some of the smartest people in the country, who thought that buying cheap insurance would protect them from a massive flameout caused when extraordinarily risky investments went up in smoke.

    They didn’t put the work in to examine what they were buying. They instead fueled a boom based on an assumption – that giving people loans they couldn’t afford was not a a bad judgment call because housing prices would rise skyward forever.

    Huh?

    That’s an equation that simply does not add up. These people are supposedly too smart for this kind of failure.

    Yes, insurance on these bets needs to cost significantly more. But given the many failures that led us to this point, what it looks like to me is that systemic greed must also be regulated – or we’ll travel down this path again and again, especially when the very brightest minds in business understand that no matter what they do, they’ll get a massive federal bailout – and their bonuses – should their decisions result in failure.

  2. Pingback: The Big Externality «  Modeled Behavior

  3. Not the Mike You're Looking For says:

    I don’t think Black was 100% wrong–at least not in this instance.

    While the government did not provide direct guarantees, I think it still was complicit. Regulators allowed banks to count the fake insurance in calculating their reserve requirements. Complying with the reserve requirements was a condition of protection by the FDIC and therefore provided indirect insurance.

    In a more global sense, however, he is wrong. There were plenty of banking panics prior to the introduction of deposit insurance, and investment banks managed to screw things up without any government guarantees.

    Come to think of it, though, there is one last consideration. Limited liability is a government guarantee of sorts. But I don’t think even Black would be willing to go that far.

  4. Chris says:

    ISTM that part of the problem is that people who bought insurance from AIG to cover event X thought that they had eliminated (for themselves) the risk of event X, when in fact they merely replaced it with the risk of [event X happens and AIG is insolvent]. Similar remarks on counterparty-insolvency risk apply to all types of derivative risk-slicing, I think. Solvency risk isn’t just for bank depositors – anyone who has or might have someone else owe them money in *any* way, including insurance policy holders and even the victims of torts, bear the risk of being unable to collect what they are owed. Only lenders routinely think about it. (As a society, we don’t *want* depositors to think about it, hence the FDIC.) And anyone who thinks they have hedged a risk by dealing with someone else is still exposed to the collapse of that hedge if the counterparty becomes insolvent.

    Given the amount of insurance on similar events AIG was handing out, anyone who actually looked at the question ought to have realized that P(AIG is insolvent|covered event X happened) is significantly nonzero. The tail risk can’t be borne by AIG because the presence of the tail event renders AIG insolvent – its business model was based on betting against the tail event (which wins steadily right up until it blows up horribly, the kind of business model that could only be adopted by a madman or a limited liability corporation), disguised as betting against the individual subevents and pretending to believe they are uncorrelated in all possible scenarios. (Talking about the tail risk is negative-thinking defeatism, and worse, it’s bad for business.)

    The bailout is likely to worsen this kind of behavior going forward – if the government is going to cover AIG’s counterparties when AIG is insolvent, then counterparties have no reason to price in, or even acknowledge, their risk of being unable to collect from AIG due to insolvency.

  5. q says:

    i left a long response at kling’s site. if it is against your policy to post copy and paste responses, go ahead and delete mine:

    i don’t know whether it is worth the time to bother criticizing this sort of thing as it is completely unworkable politically. but to point out the obvious and indisputable:

    — there would be no way to estimate the premium for this insurance, and near a crisis any estimate of the premium would be so dear that it would become prohibitively expensive leading to a breakdown in market liquidity, which is exactly what it tries to address. the only way it works is if the insurance stays uneconomically cheap during a crisis, which begs the question: why not wait until a crisis occurs to offer it? well, we did, and we are, in a way.

    — most financial crises stem from currency rate problems (ie borrow estonian, pay back euro) and the fed can only print dollars

    — money paid to the fed from banks and holding companies as premium would be destroyed or used to fund federal operations — because the fed is charged with maintaining monetary levels it would want to create that money elsewhere in the system to keep growth where they want it. so it couldn’t be seen as as ‘savings’ to be applied during a disaster.

    — payouts during a crisis would depend on political conditions anyway. this is analogous to the social security ‘trust fund’.

    — the real problem is that this would cause the government / financial system to decide on its crisis actions long in advance of an actual crisis and without knowing the nature of the crisis or prevailing politics at the time of the crisis. in the present crisis, losses in US banks are going to be about $1-$1.5T — what if the losses were going to be $10T? in that case you might just let the system crash and deal with the wreckage later.

    etc.

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