Waldman on Financial Intermediation
Read the whole thing. I am proud that he claims to have been inspired by my Future of Macroeconomics post, but he obviously has been thinking about this stuff for quite some time.
Fundamentally, the value intermediaries can add by diversifying over investments and liquidity requirements is very modest, and ought to be acknowledged as such.
I think that intermediaries add value in other ways. One is by evaluating risks. I do not have time to learn how to evaluate oil drilling projects. Instead, I invest in a oil company.
Another way intermediaries add value is by monitoring the behavior of risk-takers. How do I know that the entrepreneur is not keeping a hopeless business going so that he can collect a salary? How do I know that the entrepreneur is not keeping secret a tremendous success, taking most of the payout for himself and cheating me as an investor? I pay the intermediary to monitor the entrepreneur. This “delegated monitoring” idea comes from Doug Diamond.
So how does the financial sector seem to offer risk-free assets against risky projects? I think “constructive ambiguity” is the right phrase. The government provides subsidies in the form of literally priceless deposit and liquidity backstops, but those are explicitly limited. Banks work to diligently to increase both the level of insurance and degree to which assets are perceived to be insured by becoming so large that social costs of a bank default on even notionally risky assets are thought to exceed the costs to government of paying out on insurance policies to which it never agreed. Even a very careful observer cannot tell a priori whether many assets offered are genuinely riskless or not, that is to what degree the risk-free status of bank assets is due to subsidy, and to what degree to subterfuge. But there is an ingenious tinkerbell aspect to the risk status of bank assets: If, with a bit of subterfuge, risky assets can be sold as riskless assets, then the social costs of default rise, since asset holders will not have privately managed the risk that the asset might fail. The increase in social costs created by a mischaracterization of a risky asset as riskless, however, alters the likelihood that an asset will be de facto insured. There is a game theoretic equilibrium, that works to the advantage of intermediaries and their customers on both sides of the funding stream, whereby banks offer assets in large quantities as though they are risk-free, and investors accept and treat those assets as risk-free, and by believing together in what is formally not true, they create costs to the sovereign so [sic?] larger if it is not true that if the sovereign makes it true. This is an equilibrium, a predictable outcome, not an aberration. And it does happen all the time.
What I think he is saying is that intermediaries take advantage of the fact that governments hate to see financial collapse. Even without explicit government insurance, intermediaries will try to pretend to be low-risk, taking the view that if they fail the government will bail them out. With explicit insurance, however, intermediaries have another option, which is to try to fool the regulators into believing that they are staying within risk boundaries, when in fact they are taking risks at taxpayers’ expense.
So what is the best institutional design? Waldman lists a number of possibilities. His fourth one is:
Prefer equity to debt arrangements. All business risks must eventually be borne by investors. Debt financing concentrates enterprise risk among equity holders, and enables debt-holders to manage their investment risk less carefully. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
That seems to me to be on the right track. But there is much to chew on in his entire post.
Mar 13 2009 at 10:40am
You have talked about criminalizing excessive risk-taking by bank executives as one way to stop FDIC-backed banks from arbitraging their government insurance.
Waldman talks about equity investments as another kind of check.
Are you and Waldman thinking that all banks with government-insured accounts will be privately held banks, where the equity and management will be linked? Or are you indifferent about that as long as you have cowed the executives?
If you are thinking that banks will be privately held, that’s a lot of private equity money!
Maybe something like a Lloyds ‘names’ model could work, limited to management. But that’s even more farfetched than your suggestions. What capable executives would join these companies? You take huge risks, like an entrepeneur, but the huge risk is not trying to creating a new product but trying to prevent the china from falling off the cabinet.
Also, based on the Buffet CNBC transcripts, you seem like the anti-Buffet. You could probably do a great article disagreeing with him.
Mar 13 2009 at 11:35am
Like many others, Waldman does a wonderful job of describing an existing phenomena from an unusual and fairly rigorous perspective – then errs in delineating ‘remedies’ for what he considers flaws in the phenomena. For instance, he completely lost me with his first “what is to be done” suggestion:
“Eliminate the “constructive ambiguity” that permits private sector actors to offer apparently risk-free, instantaneously redeemable securities.”
I’m left wondering if he’s including every central bank on the planet in his “private sector actors” list – or even public sector actors, for that matter – and their offerings of “apparently risk-free instantaneously redeemable securities” such as currency.
Mar 13 2009 at 1:17pm
Instead of trying to limit the risk that a bank takes why not limit the return that it can make, say by taxing everything above some level.
This makes the assumption that there is no free luch. Any excess returns earned by the bank are done so by taking more risk and that is why the return is larger.
How would banks compete in this set up? By striving to minimize risk instead of maximize return. Since all institutions would get pretty much the same return on assets, the institution that minimized its risk to get that return would get the highest market valuation.
An alternative to this would to be to create capital requirement not based on modeled risk but on return. The higher the return the more capital that would need to be set aside.
Mar 13 2009 at 4:08pm
Do you still believe the 21st century GDP growth projections that you discussed over here :
Are you still expecting that level of growth in the 2020s, 30s, and 40s? If not, do you have new projections?
Mar 13 2009 at 10:29pm
Arnold, what do you think of Antonio Fatas’ Macroeconomic imbalances, http://fatasmihov.blogspot.com/2009/03/macroeconomic-imbalances-and-current.html
Mar 14 2009 at 5:53pm
I don’t think any of these players even thought about moral hazard, or whether or not Uncle would bail their companies out.
I think they just fudged the spreadsheets in order to underbid the competition on whatever derivative they were trying to sell. As a result they crowded out the honest players and won a bunch of money. And the chicks were free.
The problem is apparently that the government has no intention of going after these swindlers. Because they definitely knew their assumptions were too optimistic. And so did their bosses right up the board of directors. It’s real tough to forego billions of dollars in bonuses when all you need to do is fudge a variable here and there.
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