Arnold Kling  

Divided on Financial Regulation

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In an interview, Ricardo Caballero says,


it's ludicrous to suggest that anticipation of support (a "bailout") in an extreme systemic event is one of the most significant sources of moral hazard.

Pointer from Mark Thoma. Caballero represents one end of a spectrum of thinking on financial regulation. That end, which includes Gary Gorton and Perry Mehrling, does not believe that government backstops create inevitable moral hazard. Instead, they argue that with proper regulation, government backstops can permit the financial system to satisfy people's desire for safe assets.

The opposite view is the one held by Nassim Taleb, Russ Roberts, Jeffrey Friedman, and myself. In our view, markets will find a way to load risk on to any government guarantor. Eventually, regulatory controls get gamed. The regulatory mechanism steers financial firms toward a common risk factor. When failure comes, it is catastrophic.

[UPDATE: Friedman emails me to say that he agrees with Caballero in that he does not think that bankers intentionally put their institutions at risk in order to take advantage of bailouts. Well, sure, nobody wants to fail. But sooner or later you choose the lowest cost financing. And when your debt is insured, debt finance is cheaper than equity finance, so you maximize leverage. And when regulators tell you that your leverage can be higher if you hold AAA-rated securities, you get AAA-rated securities without asking questions about how robust they really are. So the moral hazard may not seem blatant, but it is there in the background.]

I have been saying for quite some time that the goal of government should be to aim for a financial system that is easier to fix rather than one that is harder to break. I also believe that a large financial sector that provides a lot of "safe" assets (safe only because of a government guarantee) is not obviously better than a financial sector that is only as large as it can be using the tools of diversification and skill at managing risk. Sure, we all want to hold lots of safe assets and to issue risky liabilities, and the larger the financial sector, the more we can do that. The financial sector does the reverse.

But ultimately, the financial sector (including government) is not some separate entity. We as investors and taxpayers ultimately have the financial sector on our balance sheets. By creating the illusion that there are more safe assets in the economy than actually exist, we end up fooling ourselves.

I have a lot of respect for Caballero, Gorton, Mehrling, and some of the others who share their view. Still, as you can tell, there is a sharp divide on this issue.


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COMMENTS (9 to date)
PrometheeFeu writes:

I think the view that moral hazard was very high in the list of what caused the crisis may be overstated. I was just listening to an old econtalk podcast (I can't recall which one) where the guest mentioned that while the institution may live on, the management usually gets axed in a particularly humiliating way. (And sometimes even gets financially wiped out) I find this a convincing argument. I think what happened is that the bank managers were caught in the "it's the only game in town" problem. So they had to keep playing. Normally, creditors would have stopped the banks from acting so recklessly, but the creditors knew they would get bailed out. So the banks were able to keep playing with tax-payer insured money without any discipline. (I actually worked for a small investment advisor where we consciously depended upon a bailout if our money market fund picks went bad. The phrase "Bernanke put" was also quite frequently tossed around. So most definitely, some bailout expectations were acted upon.)

Yancey Ward writes:
But ultimately, the financial sector (including government) is not some separate entity. We as investors and taxpayers ultimately have the financial sector on our balance sheets.

That this doesn't seem to be understood by a lot of people that should know better is disturbing.

Methinks writes:

Given the amount of risk shifting over the past 100 years and my own direct experience with regulators and regulated firms, I'm team Kling.

Caballero is fantasizing. Those MIT guys should put down their calculators, step out of the ivory tower and meet a few of the people they're talking about from time to time.

roystgnr writes:

"Make things easier to fix, not harder to break" is common practice in engineering (redundant subsystems, leak-before-burst pressure vessels, circuit breakers and fuses, etc.). If it's not a universal philosophy in economics yet, then I suspect that's (ironically, in this context) because economists are more insulated from the effects of their theories.

Even the relevant engineering terms seem to get twisted by the wider culture. The word "failsafe" gets used to mean "safe from failing". No! It means "we know this design might fail, so we assumed it will fail and figured out how to make the process of failing as safe as possible." Has any political system been designed that way since the Federalist Papers?

magilson writes:

As an engineer, I couldn't possibly agree with roystgnr more. This makes so much sense to me that I feel like pinching myself when people speak as though they don't understand this.

Estupidante writes:

You are completely right - the effect of possibility of bailout is not on the managers or the institution itself, it is on the other institutions, who provide the necessary funds. Expectations (which are usually fulfiled) of bailout lead to weakening of market self-regulatory mechanism, much as deposit insurance leads to weakening of the same mechanism on part of depositors. The only sad story is that we always "fix" the problem by making the rule explicit and then we are forced to introduce regulation on activities of financial institutions. These rules are and will be always gamed, leading to another crisis.

R Richard Schweitzer writes:

Support via what source?

Through the coercive force of government to levy taxes ?

Same old tiresome query- is that a function of government?

Jeff Hallman writes:

You're right, Arnold. Unfortunately, since your post is in words, not equations, and doesn't feature a fully-worked-out DSGE model, no one in the profession cares. At least they haven't for the past thirty years.

rpl writes:
the guest mentioned that while the institution may live on, the management usually gets axed in a particularly humiliating way. (And sometimes even gets financially wiped out) I find this a convincing argument.
Really? I think it's complete hogwash. Many of the worst offenders in the financial collapse walked away with hundreds of millions of dollars in the bank. Sure, they're no longer billionaires, but when you have more money than you can spend, what does it matter? As for the humiliation of being fired, when severance packages run into the tens of millions of dollars, that sounds like Br'er Rabbit speaking. "Oh, punish me if you must, but whatever you do, please don't fire me and give me an 80 million dollar severance package!"
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