Arnold Kling  

Banks, Private Benefits, and Social Benefits

Some Further Comments on Blind... How Bad Was Moral Relativism?...

Samuel Hanson, Anil K. Kashyap, and Jeremy C. Stein write,

If significant increases in capital ratios have only small consequences for the rates that banks charge their customers, why do banks generally feel compelled to operate in such a highly-leveraged fashion, in spite of the obvious risks this poses? And why do they deploy armies of lobbyists to fight against increases in their capital requirements? By way of contrast, it should be noted that non-financial firms tend to operate with much less leverage than financial firms, and indeed often appear willing to forego the tax (or other) benefits of debt finance altogether.

They proceed to argue that when one financial intermediary competes with another, the ability to use high leverage makes a large difference in market share and profits, even though it makes only a small difference in the ultimate cost to the the users of the intermediary's services. The ability to achieve high leverage creates private competitive benefits that far exceed the social benefits.

Thanks to Simon Johnson for the pointer.

This strikes me as correct and also very important. Some implications.

1. Financialization of the economy (growth in financial intermediaries relative to nonfinancial firms) will generate a lot of private benefits, supported by intense lobbying, but very little social benefit. (In fact, when you take into account the tail risk that this creates, it is a huge social cost.)

2. Re-read Why We Have Freddie and Fannie in light of this thinking. Fannie and Freddie became as large as they did precisely because they had lower capital requirements than competing firms.

3. For that matter, re-read Not What They Had in Mind. You can appreciate why I put capital requirements at the heart of the narrative.

4. This analysis may affect one's view of the value of the financial bailouts. I think that the authors would take the view that extremely rapid de-leveraging causes harm, by driving risk spreads above their long-run equilibrium values. But if the model is that the private benefits of leverage are enormous relative to the social benefits, then perhaps we would be better off today if more of the highly-leveraged institutions had failed. It is possible that the damage to risk spreads would have been short-lived, and that by now we would be enjoying the benefits of more efficient deployment of savings.

Comments and Sharing

COMMENTS (7 to date)
Philo writes:

High leverage will be widespread only in the presence of government guarantees. Moral hazard is the root of our bailout-sickness.

kebko writes:

I agree with Philo. I don't know anybody who reviewed the leverage position of their bank before they decided to deposit their savings there. That should seem really bizarre to us. If FDIC & all the other regulations controlling the banking sector remain in place, it will be a race to the highest allowable leverage position, just like it has been. If we had free banking, unregulated & without social deposit insurance, the banks would be much less leveraged....because reasonable people would insist on it.

Kevin Driscoll writes:


I agree as a matter of principle, but there is a policy issue I have been wrestling with.

Using Kling's distinction, if individuals had model-based expectations then as soon "free banking" goes into effect, depositors will change their behavior. They will immediately flee highly-leveraged banks for safer ones (if they prefer security over returns).

However, if individuals have habit-based expectations (and in these daily and local matters, I think they do) then they will continue to keep their money in their previous bank until they lose it. In fact, I think a lot of people will lose their money by depositing in unsafe institutions.

This leads me to 2 questions:

1. Although we believe that the equilibrium situation of free banking is better than the equilibrium situation of regulated banking, how can we be sure that the losses and damages incurred during the non-equilibrium transition from regulated banking to free banking don't destroy the benefits/prevent them from being realized during my lifetime?

2. Suppose that the benefits will be realized rather quickly, how do we get people to vote for a situation in which they will lose their money?

Philo writes:

@ Kevin Driscoll:

Why do you limit the benefits to those realized "during my lifetime"? Why not "forever"? (By the way, I have no idea how much longer you are going to live.)

"[H]ow do we get people to vote for [ending deposit insurance]?" Probably, we don't. Probably, we're stuck with deposit insurance.

Kevin Driscoll writes:

I didn't make the benefits go out to 'forever' because then the non-equilibrium situations don't matter. That is, the transient part of the solution dies out. I already stipulated that the steady state solution (the free banking equilibrium) was better off than the regulated one so if I made benefits go out to infinity then the answer would be obvious. EVENTUALLY, the benefits will outweigh the costs, all other things being equal (I think economists say ceteris non paribus or something like that).

However, as a matter of policy, the farther into the future I look, the more uncertain I am, so I chose to discount future benefits AFTER my lifetime to 0. 2 reasons come to mind,
1. they don't much matter to me because I'll be dead
2. it is impossible to predict the state of anything for a period of time longer than my lifetime (often it is impossible to predict for periods shorter than that, but certainly nothing longer, at least not when it comes to economic or political variables)

It's not a hard deadline, but it seemed like a reasonable estimate of the time in which the costs would have to be recouped in order for me to say it's a sound decision.

I know getting people to vote to end deposit insurance is nearly impossible but it seems more likely (if only infinitesimally so) to happen if we have a plan.

(also, Philo, I like your name. I hate David Hume, but only because I can't answer his questions well.)

Vincent Poncet writes:

In latest BIS annual report, it provide statistics on return on assets, return on equity and leverage from several sectors.

Banks and non-bank financials have a low return on assets compared to other sectors, even before the current financial mess.
On 2001-2007, banks have a ROA of 0.7, non-bank financials have 1.0 and non-financials have 3.4.
At the end, financials have a return on equity at par with non-financials, but at the cost of leverage about 4 to 6 times higher.

Anybody know why ROA is so low in financial sector ?

kebko writes:

@kevin driscoll

I think you're talking about a transitional issue. To the extent that it would need to be handled carefully, I agree that the current federal government (speaking broadly, not just the current administration) would be unlikely to set up a coherent transition.
There are many current markets, even in finance, where people have savings outside of the regulated banking industry & those areas aren't overwhelmed by dysfunction & disaster. It seems like it would be very easy to establish a pecking order that put depositors high enough on the creditors list that even in worst case scenarios, losses would be unlikely. But, even given that, there is every reason to believe that deposit insurance could be provided privately. In fact, it isn't that hard to imagine every bank advertising their new private deposit insurance the day after FDIC was nullified. And, the behavior required to keep those insurance premiums low would replace the supposed necessity to have a few thousand pages of regulatory oversight.

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