It’s my impression that this experiment is precisely what was tried in 2008. Regulators across the world engaged in policies of regulatory forebearance – finding ways to protect banks from writing down too many of their assets, protecting them from taking off balance sheet vehicles on balance sheet and possibly even encouraging banks to not to disclose material information to shareholders. One of the consequences of regulatory forebearance is a general suspicion that many of the largest banks are in fact insolvent -- i.e. that at least during the last quarter of 2008, the US was operating a "capital-less" financial system.
Despite the general suspicion that we now have a "capital less" financial system, government insurance of large chunks of the financial system has meant that stock and credit markets are showing few signs of fear that systemic collapse is imminent (now in late January). On the other hand, after three months of extraordinary government intervention, the prices of many assets are not recovering. So one question is: What is the evidence that these are "panic" prices, and shouldn't we consider the possibility that assets are simply being fairly marked?
Ricardo Caballero argues that the problem is that the government insurance being offered to the financial system is not sufficiently comprehensive: The government needs to become the explicit insurer for generalised panic-risk (which can also be called systemic risk, or macroeconomic risk). There are two questions that his essays do not address: Is a policy of systemic risk insurance feasible for any government? Are the moral hazard consequences of the systemic risk insurance policy so damaging that the policy's costs exceed its benefits?
My own view is that it is precisely because the financial community perceived the government as a provider of systemic risk insurance that we find ourselves in a crisis of this magnitude. This view is based on a belief that it is precisely the risk of general financial instability that causes financial institutions to make investment decisions that are conservative enough to protect the stability of the system. In other words, I believe that the fundamental flaw that developed in our financial system was the view that: "Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty." and that the government should provide insurance for all financial institutions against uncertainty or systemic risk.
The Federal Reserve under Alan Greenspan encouraged this view. The actions of Gerald Corrigan, president of the New York Fed, in 1987 were a watershed. The stock market crashed, the investment banks were caught unprepared and were unable to meet margin calls on their bank loans. The banks were unwilling to offer unsecured credit and bankruptcy for at least one investment bank and possibly all of them loomed. The Federal Reserve apparently decided that the investment banks were, like Continental Illinois in 1984, "too big to fail". Corrigan convinced the bankers to extend unsecured loans to the investment banks. The investment banks were saved and for the first time in history the Fed used its authority as lender of last resort to the commercial banking system to support investment banks.
It did not pass unnoticed that the Federal Reserve succeeded in rescuing the investment banks in 1987, only because moral suasion was effective. In 1991, section 473 of FDICIA, the law that revised bank regulation after the savings and loan crisis, relaxed the collateral criteria of the Federal Reserve Act's emergency lending clause -- and the Congressional debate indicates that the purpose of this change was to benefit securities firms (see page 5 here). Thus there was legislative support for the expansion of the "too big to fail" doctrine to the investment banks.
1998 was another watershed. Long Term Capital Management was a hedge fund with assets of more than $125 billion. These assets were supported by less than $5 billion in equity -- LTCM owed the financial system more than $120 billion. When bankruptcy loomed for LTCM, it also put some investment banks at risk. It became clear that the policy that investment banks were "too big to fail," also meant that certain hedge funds were "too big to fail." Just as in 1987, the Federal Reserve put pressure on Long Term Capital Management's counterparties to prevent the firm's failure. The banks put together a rescue package for LTCM, but it escaped no one's notice that, if the banks had failed, the Federal Reserve had the legal authority under FDICIA to lend directly to LTCM itself.
Thus, by the end of 1998 the Federal Reserve had made it clear that its job was not just to support commercial banks through a financial crisis, but also to support investment banks and financial markets. This extension of the "too big to fail" safety net to large securities firms almost certainly lowered their borrowing costs relative to a market rate. As Brad Setser put it after the Lehman crisis:
Much of the infrastructure of modern finance in effect rested on an expectation of a government backstop for the creditors of large financial institutions – a backstop that allowed a broad set of institutions to borrow short-term at low rates despite holding large quantities opaque and hard to value assets on their balance sheets.
That observation has a number of implications, not the least that the leverage – and resulting capacity for outsized profits — of some parts of the financial sector was made possible by the expectation that the government would protect the key creditors of the financial system from losses.
Lehman’s default shattered this implicit guarantee.
Coincident with the establishment of this government guarantee was the exponential growth of private debt in the United States.
Prof. Caballero is taking the position that this implicit guarantee needs to be extended, so that all financial institutions are protected from uncertainty and systemic risk. He apparently hopes that financial regulation can offset the propensity of such a system to be overleveraged. I suspect that only draconian regulatory measures could possibly keep an insured financial system stable. It would certainly represent a huge change from the historical experience of the British and American financial systems.
It has long been understood that a firm's first defense against uncertainty in financial markets is to be well-capitalized. One reason to require firms to handle uncertainty on their own is precisely to encourage them to be well-capitalized and to promote systemic stability by reducing the degree of leverage in the system. There are those who claim that this is inefficient, but that is necessarily a matter of definition -- a system which is efficiently capitalized from a long run perspective will appear to be over-capitalized if measures are taken over a short horizon during which the uncertainty is not realized.
When the concept of a lender of last resort was born (see Thornton 1801 and Bagehot 1873), the lender of last resort (that is, the Bank of England) was a private institution. And one of the reasons Bagehot wrote Lombard Street was to make the point that a system of last resort lending is inherently fragile -- that uncertainty always lingers somewhere over the horizon. First Bagehot quotes Ricardo:
'On extraordinary occasions, a general panic may seize the country, ... against such panic banks have no security on any system.' The [lenders of last resort] may last a little longer than the others; but if apprehension pass a certain bound, they must perish too.
Bagehot considers any credit system that relies on a last resort lender to be frail -- something that is to be protected and cherished, because once it is broken up, it will take generations to develop anew.
Credit is a power which may grow, but cannot be constructed. Those who live under a great and firm system of credit must consider that if they break up that one they will never see another, for it will take years upon years to make a successor to it. ... [W]e should look at the rest of our banking system, and try to reduce the demands on the Bank [of England] as much as we can. The central machinery being inevitably frail, we should carefully and as much as possible diminish the strain upon it.
Professor Caballero is proposing a model completely at odds with that of the traditional model of last resort lending. He claims that there is a source of security for the banking and financial system -- the credit of the government. Perhaps Prof. Caballero understands finance better than Bagehot, but just in case he is wrong, my question is: What is plan B? If Bagehot is correct and government provided systemic insurance may have as a consequence the destruction of the credit of the government rather than saving the credit of the financial system, what does Prof. Caballero propose that we do next?
In my opinion all policy makers need to understand one thing: The complete collapse of Western financial infrastructure, including the credit of American and European governments is possible. Every decision needs to be made with an understanding that the financial system is fragile: the credit of our governments should be treated as a precious resource -- to be used, yes, but to be used with prudence and a view towards conservation.
If Prof. Caballero had proposed carefully scrutinizing the different classes of assets to select which ones merited government insurance and which need to be written down to zero, I would find his argument far more convincing. Instead he writes:
With some dismay, I read that an enormous amount of time is being spent discussing what should be the price of the insurance and the first-loss threshold. It seems to me that given the extreme severity of the crisis and the asymmetries involved in failing in one or the other direction in each of these issues, the answers are rather obvious: The price of the insurance should be very low – say risk-neutral pricing plus 20 or 50 basis points of markup; and the first-loss threshold should be sufficiently low that no new capital will need to be raised in the short run if a loss arises.
The difference between his view and mine is simple: he only sees a possibility of collapse if the government does too little. I, however, also see a possibility of collapse if the government does too much.
Update 1-29-09: I've just read (the introduction of) Rethinking Capital Regulation by Kashyap, Rajan and Stein. They have a reasonable proposal for systemic risk insurance, though I'm not sure it would work in practice. First, their proposal is prospective, a solution for the future, not a resolution of the present. Second, their insurance is fully funded.
The only problem with the idea that I can see is that their insurance policies have a specific term at which point the insurer has the option of refusing to renew the policy. I would expect the policies to disappear just when they are needed. Perhaps as the authors argue 5 year overlapping policies would help solve this problem -- but I wouldn't be surprised if market perspicacity makes the insurance much less effective than would be desirable.
Could rising insurance premiums help trigger a crisis?
Update 2-10-09: Professors at NYU Stern also view the too big to fail guarantees as an important cause of the crisis.
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