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Have a lousy Christmas, with a note on banking regulation.

Some people are offended if you say "happy holidays" and others are offended if you say "merry Christmas." Some people are offended if you are offended by one greeting or another, and some people are offended by efforts to explain why some people are offended when other people are offended by one greeting or the other. Makes one's head spin. So let's change the subject.

Megan McArdle disagrees with "a very common" point I made in an earlier post: that banking regulation is necessary because of moral hazard that results from deposit insurance (both formal FDIC insurance and the informal insurance where authorities end up compensating creditors not covered by the FDIC program). Yes, it's a very common point, but it turns out to be wrong, she says:

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.

The problem with this example is that in the real world the bus driver has a continuous range of options as to how much care to take. Suppose, for example, that he slept badly the night before and knows that he will not be able to drive very attentively. He may well decide to drive even though he would not if he fully internalized the risk of harm to the passengers. We have all done this, and all kinds of laws and regulations, with the tort system as an overall backstop, attempt to deter people from acting in this way. McArdle continues:

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.

In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets. If I win the lottery, I pay you back; if I don't, I dissolve the bank and you go to the government for your funds. I wouldn't bother to hide my investment strategy from you; you wouldn't care because you would be paid in any event. I would set up hundreds of banks and give the managers a salary that they would receive if and only if they collect deposits and use them to buy lottery tickets; otherwise, they are fired. (Corporate law junkies will point out that the government will pierce the corporate veil and go after my lottery winnings, but in the real world, with thousands of shareholders and not-lottery but still risky investment schemes that unfold over decades during which dividends are paid and the money spent, that's not so easy.) McArdle continues:

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.

This can't be true. In the nineteenth century, elaborate efforts were made to keep track of bank risk. Merchants discounted bank notes after consulting books that compiled risk estimates. The notes of larger and more stable banks were discounted less. Since people often made payments with bank notes, they must have had a sense of how risky different banks were, and taken the risk into account when making deposits, to say nothing of common memory about which banks have stayed in business and for how long. Today, people don't pay attention to bank risk because of deposit insurance; but people certainly think about risk when they make uninsured investments, for example, when they buy stocks or corporate bonds or, for that matter, stereos and personal computers. She concludes:

The reason that deposit 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.

The argument here seems to be that we should distinguish the perverse incentives of depositors and of bankers. Depositors have a perverse incentive to ignore the riskiness of a bank; ironically, the government does little to counter this incentive aside from capping the insurance payout (and not very credibly). One could imagine a different system where the government tried to regulate depositors the way insurance companies normally regulate insured parties—by demanding that the insured bear some of the risk with a copayment or deductible and take other actions to minimize the potential loss.

Instead, the government goes after the banker. This would be like an insurance company trying to regulate the activity of people who impose risks on insured parties rather than on the insured parties themselves. Imagine that I have health insurance and the insurance company tries to shut down the local polluter so as to minimize its expected insurance costs. Our system of banking regulation resembles this approach.

But moral hazard is the right term. Economists use the term moral hazard to refer to the perverse incentives that arise when a principal pays an agent to act in a certain way that benefits the principal where the agent would rather act differently, but cannot observe the agent's action, so the agent acts in a way that ends up hurting the principal relative to a baseline of optimal behavior. There are various ways of mitigating moral hazard: one is to share risks, but another is to confine the agent's choice set. That is what government banking regulation does. It reduces moral hazard by depriving insured depositors of the option of investing in a risky bank, which would presumably offer a high interest rate or other advantages.

traveler496:
Eric,
In the 6th paragraph which begins "In a world without bank insurance but with regulation,...", did you mean "In a world with bank insurance but without regulation,..."?
12.27.2008 7:25pm
SupremacyClaus (mail) (www):
Need an explanation.

Had a loan from 4 years ago, at 5.75%, for a jumbo amount. Wished to refinance. The rate is 6.25% today, on an amount not a jumbo loan anymore. The loan and the refinance would have full documentation, and not a single payment was ever missed.

Let's say, 4 years ago, the money cost the bank 3%. That was a fair markup. If money costs the bank 0.5% today, and the government sent it $bils, what gives?

The loan officer could not explain the high interest rate.
12.27.2008 8:20pm
walter:

Instead, the government goes after the banker. This would be like an insurance company trying to regulate the activity of people who impose risks on insured parties rather than on the insured parties themselves. Imagine that I have health insurance and the insurance company tries to shut down the local polluter so as to minimize its expected insurance costs. Our system of banking regulation resembles this approach.


For the insurance company to go after the local polluter doesn't sound like such a bad idea. They are trying to remove a single large risk factor, which might actually happen. Rather than trying to make a small change to the habits of a large number of people (long, costly and differcult).
12.27.2008 8:46pm
Jay Levitt (mail) (www):
McArdle writes: "Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either."

You counter that with mentions of elaborate efforts to determine that risk, and how depositors must have had a sense of the risk, and how today investors surely must think about risk.

Even if all three were true, it wouldn't contradict her assertion: that most depositors are not capable of determining the risk.

PS, re the title: And up YOUR menorah too, buddy! Make THIS out of clay. Etc.
12.27.2008 8:47pm
Anderson (mail):
The Obvious: 1.
McArdle: 0.

(Series 7,982 - 0.)
12.27.2008 9:21pm
Dede:
Good points, but there are some other facets to the equation.

The capital markets created by banks have important benefits to society. Even if banks are sound, a run on a sound bank can result in the last guy losing out -- hence the run on the bank in the first place.

While yes, some can judge the risk appropriately, they also know that they could be wrong. Why risk being sorry -- go get your money out at the earliest hint of rumor of trouble. Rumors then become an effective way to attack your competition.

Ratings change... which means there is some lag time from when a good rating was given, and the bad rating replaces it. Who wants to be caught in that lag period? More pressure to create a run.

Imagine a system with less moral hazard: The depositor, rather than the bank, pays the premium for the deposit insurance. The insurer sets the premium based on objective criteria relative to the risk based on the bank's capital risks.

And then who reinsures the insurer? And who insures that reinsurer? You are back to AIG, systemic failure, and the government being in the picture.

You also then put the burden on the depositor to check and follow the solvency of the insurance chain. Where does it stop?

Pure libertarianism is a disaster, as is pure capitalism, pure democracy, or pure anything else. Government backed deposit insurance, with variable premiums based on the bank's risk level, paid by the bank, is not such a affront to me, and I'm a pretty strong libertarian at heart. Choosing to participate in commercial activity in this limited way is not much different than choosing to fund the necessary (limited) functions of government by taxing capital gains, income, or exports rather than taxing consumption.

I am often in a position to try to explain to a layperson why appellate courts are less concerned with "justice" than with "consistency" as justice impacts a single person, but consistency is more important, as without it the legal system would be unworkable. Finality, with a statute of limitations and procedural hurdles, is a benefit at the expense of "justice." There is nothing special about a person the day before their 18th birthday, versus the day after... but without that bright-line test, there would be endless litigation over whether the person was or was not competent to enter the contract or undertake whatever act is being challenged. Can you imagine a law that set the drinking age at "when the person is mature enough to handle alcohol?" It ain't perfect, but it is a bright-line test that makes things work much better overall.
12.27.2008 9:31pm
frankcross (mail):
I'm with you up to claims about depositors ability to monitor risk. I would have thought that recent experiences with Moody's and other evaluators of credit risk would amply give the lie to the effectiveness of these private intermediaries. Without insurance, people would certainly think about bank risk. But there ability to accurately measure it is in some question.
12.27.2008 9:33pm
Alexia:

In a world with bank insurance but without regulation [corrected, thx to traveler456], I would start up a Posner bank, ask you for a deposit, and then use your money to buy lottery tickets.


It's mind-boggling to see how far some people can go to defend a failed system. "Our HUGE government controlled monopolistic banking system didn't work! Let's make the gargantuan book of rules even bigger!!!"

The bank's insurance shouldn't be government insurance. The brokerages carry private insurance on my deposits over and above the amounts that the government provides. Why does the government provide insurance at all?

If the government was out of the insurance game, I could choose to put my money into a bank that made loans to poor people, or I could choose to put my money in a bank that only loaned money to people with absolutely perfect credit ratings.

You seriously think that the people insuring said banks wouldn't put limitations on the type of investments they could make?

This whole concept of the "public/private" partnership always fails, because it leaves evolves into a "government/private" partnership, leaving nobody to actually act in the interest of the end user.
12.27.2008 10:13pm
Harry Eagar (mail):
If you think that in the 19th c., depositors were more careful to assess risk and were able to do so, I have 2 words for you: Jay Cooke.

And if the hazard of operating a partnership bank was not enough to inspire caution in bankers, I can't imagine what would, but as the examples of Cooke, Barings and many others proves that it was not enough.
12.27.2008 10:13pm
Alexia:

McArdle writes: "Most depositors are not capable of determining whether a bank is faulty or sound, and they weren't in 1830, either."


But apparently most bankers and government regulators aren't able to figure it out either. In fact, it seems to be a secondary concern.

Send the issue back to the individual states.
12.27.2008 10:17pm
Bruce McCullough (mail):
McArdle continues:

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.
--------------

McArdle is wrong. The banks signalled their stability and profitability by building large edifices. A fly-by-night bank would set up office in a rented building -- would-be depositors would pass by this bank and place their money in the bank with the large, secure building. There is a scholarly literature on this.
12.27.2008 10:26pm
Jim at FSU (mail):
So we're still playing the original shell game are we? Under one of these shells is the secret to profitably investing your money without knowing what the hell you are doing. The trick, of course, is that there is no such secret.

Giving your money to strangers always involves risk. The question, as always, is who gets to bear it and at what cost to the risk-taker? If the answers are "someone else gets to bear it" and "at no cost to the risk-taker" bend over America, here it comes again.

Separately, regulations don't fix the problems of the uninformed consumer or the dishonest money-handler because regulators don't have a magical ability to detect cooked books or hidden swindles. It only forces swindlers to observe certain forms that our experts have deemed to be "trustworthy." At best, you could argue that a high regulatory barrier to entry keeps out all but the wealthiest and most determined crooks.

Madoff is a great example- he made billions of dollars disappear over many decades despite plenty of oversight assuring that he obeyed all the regulations. Yet he was only caught when he confessed his crimes.

Unfortunately the "logical alternative" to trusting large and possibly corrupt or mismanaged institutions may not be remotely feasible- instead of performing research and investing wisely on their own, people would probably hide it under mattresses, loan it to entrepreneurial relatives or engage in various other pre-20th century investment models such as using the money to start businesses and buy equipment. When I say is that way, it almost sounds like a good idea.
12.27.2008 11:32pm
Merry New Year:
Did anyone else enjoy the introductory graf as thoroughly as I did. Very amusing. Posner is fast becoming one of my favorite Conspirators.
12.28.2008 1:06am
Harry Eagar (mail):
Jim, please read the news. Madoff was not regulated until late in the game, and only partially even then.

It would appear -- I await further revelations -- that when he finally came under regulation, he was put at the bottom of the pile because he was understood to have been a successful businessman for so long. Had he been a newcomer with no apparent record, he might have gotten a closer look sooner. But presumably most of the thefts had already occurred by then.

There is a problem with this reconstruction. I don't know how long a Ponzi scheme can run, but 17 years is stretching it. Something else, as yet unknown, was going on with Madoff.

Anyhow, anybody who knows the history of 19th c. finance, when government regulation was minimal to non-existent, knows that McArdle is just making stuff up.
12.28.2008 1:45am
Anon and anon:
[everyone] ... knows that McArdle is just making stuff up.

As ever!
12.28.2008 7:48am
markm (mail):
"I don't know how long a Ponzi scheme can run"

41 years and still running.
12.28.2008 8:18am
PersonFromPorlock:
The trick, I think, is to make the public calm and the bankers nervous. So why not write the law so that specified officers of any bank accepting government deposit insurance are responsible (along with the bank corporation, of course) for any loss to depositors? If the bank goes broke the depositors are paid off and, say, the CEO and Chairman of the Board are pauperized: Let them worry about keeping the bank afloat.

This wouldn't work to frustrate a deliberately fraudulent bank where every 'specified' officer was in on the scheme and set to flee the country, of course, but a ponderous enterprise like that would be (a) rare and (b) vulnerable to exposure, for instance by rewarding lesser plotters for ratting their fellows out.
12.28.2008 9:05am
PersonFromPorlock:

Let them worry about keeping the bank afloat.

I should have added: "and let them 'regulate' it as they see fit." Sorry, some mornings two cups of coffee aren't enough.
12.28.2008 9:15am
Bad (mail) (www):
I find it decidedly messed up that I'd spent more time on holiday greetings than on this subject, which is way way more important. I think the reason is that at least I'm pretty sure there's a right answer to the holiday greeting issue (i.e., stop being annoyed at random well wishes in any form or phrasing) whereas on this subject, I'm really not sure at all what the right answer is.

In economics, the truly important academic questions really come down to a matter of degree: the optimal situation is always a balance, and the very difficult question is where exactly that balance should be. There's such a thing as too little of any given regulation, and such a thing as too much. A layperson can easily sound principled and authoritative by declaring that there shouldn't be any regulation, or alternatively that there should be as much as possible. But the reality is that the real question demands a heck of a lot of knowledge about how markets actually work, figuring out exactly how much makes sense, and that's a question laypeople generally can't answer with any degree of knowledge or expertise. Economists may not be able to agree or be certain either. But at least they have a hell of a lot more of the relevant information at their fingertips and in their models than the vast majority of people that try to weigh in on these topics. Most of these discussions sound like people who know next to nothing about biochemistry trying to weigh in on how much of an enzyme we need to add in order to produce maximum yield of a certain compound.

Oh, and Social Security is not a Ponzi scheme in any meaningful sense. For good or for bad, it's a simple wealth transfer scheme. Whether or not its long term solvent or not is a very different matter, and is based on your estimation of the longterm projections of both population and GDP.
12.28.2008 9:28am
Anderson (mail):
The trick, I think, is to make the public calm and the bankers nervous.

Which makes it interesting that Paulson has pursued precisely the opposite approach.
12.28.2008 10:32am
PersonFromPorlock:


Which makes it interesting that Paulson has pursued precisely the opposite approach.

Well, that's Capitolism for you.
12.28.2008 11:23am
Fub:
Dede wrote at 12.27.2008 9:31pm:
Imagine a system with less moral hazard: The depositor, rather than the bank, pays the premium for the deposit insurance. The insurer sets the premium based on objective criteria relative to the risk based on the bank's capital risks.
As a general proposition I think that questions of who pays for what are premised on a false assumption. Ultimately the depositor pays the premium for deposit insurance, either through taxes, through reduced interest on deposits or fees on deposits or transactions, through inflation, or through some other mechanism. But the money always comes from the customer, and never from the business entity or from some magic government money mill.

A more certain way to reduce these particular moral hazards in banking would be to make all corporate board members and officers of a banks, and all government regulatory officers, subject to harsh criminal prosecution if a bank fails. It may not be a very economically productive way to run a banking system, and it would create new moral hazards. But it would reduce the particular moral hazards under discussion here.
12.28.2008 12:00pm
Anderson (mail):
Ultimately the depositor pays the premium for deposit insurance

No; the depositor, his neighbors, and the rest of the taxpayers -- they pay the premium.

I don't favor criminal prosecution of bank leaders -- it seems a bit silly (what crime?) and economically unsound -- but the idea of having them financially on the hook, as advanced upthread, seems to have more merit.

It is pretty obvious to the lay voter that a system where leading your company to bankruptcy results in your being only a multimillionaire, rather than a gazillionaire, is not a system whose principals are going to seriously worry about the success or failure of what they're doing.

If we're going to believe in market incentives, then let's not discard that belief when it comes to the profits and responsibilities of the guys running the banks.
12.28.2008 12:17pm
Bruce:
Some people are offended if you say "happy holidays" and others are offended if you say "merry Christmas."

Happy Christmas, then.
12.28.2008 1:49pm
Fub:
Anderson wrote at 12.28.2008 12:17pm:
No; the depositor, his neighbors, and the rest of the taxpayers -- they pay the premium.
True. Somebody will pay, and it won't necessarily be the depositor or the banker.
I don't favor criminal prosecution of bank leaders -- it seems a bit silly (what crime?) and economically unsound -- but the idea of having them financially on the hook, as advanced upthread, seems to have more merit.
Agreed there also. Just pointing out criminal sanctions (legislatures are pretty good at makng up crimes) could be effective means to eliminate particular moral hazards, though not necessarily optimal or even useful means to produce a solid banking system.
12.28.2008 1:57pm
Harry Eagar (mail):
Making the bank officers responsible would be a return, more or less, to partnership banking. It doesn't work to keep bankers prudent. Look up Jay Cooke.

There's a transaction cost to determining whether a bank (or other business) is solvent. If it were up to each depossitor, we wouldn't have banks, or, if we did, only the wealthiest 0.1% could afford banking services, like in 1850.

It's the old problem of the fireproof hotel. Most any traveler would pay a premium to stay in a fireproof hotel, but how does he tell? Capitalism assures us that profit maximization leads the rational hotelier to paint FIREPROOF HOTEL on the side of his building (as they used to do, look at pictures of American cities 75 years ago)but not to actually fireproof it.

There might be other ways to set up banks, but there is no questionb that deposit insurance is a supercheap way to manage. It makes sense for the underwriter (the national government now although there were state deposit insurors in the '20s) to mind the store. G. Bush explicitly believes in not minding the store. The outcome was predictable. I predicted it.
12.28.2008 8:56pm
gb (mail):
McArdle's point seems almost absurd on its face. Are many depositors not able to judge the risk of their deposits? Sure, I'd say most can't. But so what? Most people can't judge the reliability of a car by looking under the hood. Thats why we have Consumer Reports and other sources of information. With FDIC insurance, there is less incentive, and thus less of a market for, rating deposit risk. There is also less incentive for banks to make their books more public (and publicly digestible). In the free banking era in Scotland, I'm told some bank owners personally guaranteed deposits with their own personal savings (i.e., no limited liability). I don't think this would happen under insured deposits.

Obviously ratings are imperfect with cars or banks, but that doesn't mean its not worthwhile to try. We don't care about ultimate efficiency, but efficiency at the margin: does spending X on investigating deposit risk yield returns > X?

Given two banks with similar competitiveness, you only need a fraction of educated depositors to favor one over the other for it to succeed while the other fails.
12.29.2008 12:57am
gb (mail):
Sorry for the double post, but I forgot to mention the institutional effects of deposit insurance: people are less likely to try other forms of banking which may have less systemic risk (partnership banking? credit unions? something else?).

When applicable, the laws of economics don't take a back seat to specifics: socializing the costs of people's decisions just doesn't produce good outcomes. Because of transaction costs, it may not be worthwhile to make sure all costs are privatized (i.e., it may not be worthwhile to sue suicidal bus drivers), but the FDIC does have a positive cost, and it turns private losses into social losses.
12.29.2008 1:06am
Dan Weber (www):
Harry Eagar said:
There is a problem with this reconstruction. I don't know how long a Ponzi scheme can run, but 17 years is stretching it. Something else, as yet unknown, was going on with Madoff.
I think the bull market was going on. It's easy to Ponzi 9% returns into 14% returns when everyone flocks to you because of your 14% returns.

Recessions uncover what auditors cannot.
12.29.2008 12:31pm
Harry Eagar (mail):
Maybe. But Madoff wasn't being audited. If he had been, probably it would have been uncovered.

Most of Wall Street was being run like a bucket shop at the time, so Madoff's scheme didn't particularly stick out. Had the rest of the financial community been even averagely honest and prudent, I suspect Madoff would have looked like such an outlier that people would have paid attention to him.

As we now know, various insiders did notice, went to news reporters (from the maligned MSM), who pointed at Madoff, but no one seemed to care.

So much for the wisdom of markets.
12.29.2008 3:29pm

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