Sunday, September 28, 2008

Moral hazard in banking

Banking as we know it is an industry largely made possible by regulation and deposit protection. There are unregulated savings schemes around, like FairPak, and unregulated borrowing, like from loan sharks. But with or without such protection, there is always a danger in having somebody else look after your money. Bankers and bank shareholders can profit from risk taking, but their losses are limited to their own stakes in the bank. This is moral hazard. The hazard is minimized if shareholders are left with nothing after a bailout, as they should be, but it is still there.

So the regulatory framework we have would seem to reflect the view that the sort of banking industry we have is worth having, that confidence in banks is worth protecting, and that depositors should be largely protected from the bad luck of a bank failure.

Clearly not everybody agrees. Some view banking as parasitical on the real economy, that without debt and credit we would all be better off. Banking, in this view should be essentially nationalised, so that the profits from credit creation goes to the public purse and so that investment favours public goods.

Others argue that the problem here is that the banking system is effectively already too much like a nationalised industry, with private banks merely agents of a state-controlled currency. Thus lighter regulation, private currencies, and banks being allowed to fail, are the answers. If depositors had more cause to care about the soundness of their banks, they would seek out and reward truly sound banks.

Both these camps are cheering the present crisis and pointing out how this proves that they were right all along. And in some small ways they are right.

Banking is parasitical in the sense that it does need to be bailed out from time to time. In the long run, it is therefore a subsidised industry, and seen in this light, public anger at overpaid failing bankers is entirely justified. Insisting that none of the bailout money goes on dividends or bonuses rather misses the point - the bailout money is socialising the loss. The profits mostly occur in another part of the cycle. I would favour an insurance pool paid into by the banks to fund the next bailout whenever that might occur. It would be in the banks interest that this fund is not called upon, and this might hopefully encourage them to engage constructively with regulators to help minimise systemic risks.

The other camp is right that interdependence of the banks and the central banks does give the system the characteristic of a monolithic monpolistic bank to which there is no alternative. Some risks are pooled rather than avoided, so instead of frequent bank failures hurting only a few, we have rare systemic threats that affect us all. But I, for one, would have even less confidence in an unregulated bank or a private currency, and I suspect only the real enthusiasts for those things would disagree. The moral hazard, of being able to profit from risks taken with the money of others, is just as great, or greater, in an unregulated bank as in a regulated one.

It may be dull, and we have overdone it lately, but credit is important. It makes all sorts of choices possible, and only some of them are unwise. And the banking system does a decent job of offering credit, better, certainly, than many state banks around the world have done - they tend to end up bullied by politicians into propping up failing state industries, and failing themselves. Better certainly than loan sharks, who we would be more beholden to if legal credit was greatly restricted. Better than LETS schemes, which are generally failures for reasons too many to go into here. The best alternative is perhaps the Building Society, and yet when many of them converted into banks, it hardly made much difference to their customers, except that they could suddenly get current accounts.

So it is important to maintain a banking system not unlike the one we have. The challenge is to do that while minimising moral hazard and the risks of failure, bailouts, and what amounts in the long run to a public subsidy to overpaid failures. Less regulation won't do this. More regulation won't necessarily do it either, and can increase risks. We need smarter regulation. Perhaps we need to revisit the reserve requirements abolished by Thatcher. But the details of this smarter regulation are beyond my competence. 

I have one last possibly unworkable suggestion: that bank bonuses and dividends in future should be staged over, say, 10 years, the balance being held in a fund. If a bank fails, then it has a fund of effectively 5 years worth of bonuses and dividends which can be used to meet its obligations, those responsible for that failure paying a greater price than they would otherwise do. But banks could still pay as much as they like for success. Ideally banks would do this voluntarily, to show that they have the right incentives in place to be more reponsible with other people's money.

3 comments:

Anonymous said...

"Perhaps we need to revisit the reserve requirements abolished by Thatcher."

Ah - glad you raised her - she has some responsibility for this mess


"I have one last possibly unworkable suggestion: that bank bonuses and dividends in future should be staged over, say, 10 years, the balance being held in a fund. If a bank fails, then it has a fund of effectively 5 years worth of bonuses and dividends which can be used to meet its obligations, those responsible for that failure paying a greater price than they would otherwise do. But banks could still pay as much as they like for success."

But who defines 'success'?

"Ideally banks would do this voluntarily, to show that they have the right incentives in place to be more reponsible with other people's money."

Excuse me while I fall about laughing.

thomas said...

Some form of modified reserve system is definitely the way this situation is going to play out, and I wonder about the ideas you have for the precise form.

The panic of 1907 lead ultimately to the creation of the Federal Reserve in 1913, but that was a national crisis. Today we have an international crisis, so would that suggest an international reserve will be created (potentially under the auspices of the IMF or World Bank) to enable intervention on a global scale?

I gather this is one of the directions Brown was moving when he was in NY last week, but handing unaccountable powers to undemocratic UN-mandated authorities proved a sticking point which I guess is unsellable to the US public. Nevertheless it seems like a logical step in the development of an integrated world government.

Globalisation, huh?

Joe Otten said...

An international crisis merits an international solution? I'm not convinced. Why should we pool the socialising of loss? Are any international institutions actually good enough for the job? Able to command the funding they are due, and democratically legitimate?

I have some sympathy for the republican suggestion of a league of democracies. Not so much as an alternative to the UN, but perhaps more like a global version of what the EU has meant to much of eastern Europe, entrenching democracy and the rule of law in countries that wanted to join, but could otherwise have ended up like Belarus or Russia. Clearly any such initiative must be handled diplomatically.

I don't have any precise suggestions for bank regulation reform. I can see some problems with some governments guaranteeing all deposits and others not doing so, and yet we are so far from getting banking regulation right, that trying to unify it globally, now, seems even more frightening.

It worries me that the old ideological battle: more regulation versus less, is dominating this debate. As a rule, ideology is rarely very useful when you need to find the smart answer to something.