Arnold Kling  

Is Bank Regulation This Easy?

Some Questions About Governmen... Ed Leamer on "Pure" Economics...

Amar Bhide writes,

governments should fully guarantee all bank deposits ­ and impose much tighter restrictions on risk-taking by banks.

I emailed him to say that I thought that this assumed that regulators would know when banks are taking risks. I am not sure this is true. He replied that we managed not to have bank failures for two decades. Here is my response:

When we have a period of no bank failures, that could be because banks aren't making bets. Or it could be because their bets are working. It is hard to tell the difference until after the fact. If you had asked regulators as late as 2006, they would have told you that the banks weren't making bets. Instead, new, better methods of risk management were in play. What we know now is that the bets they were making had been working because house prices kept going up.

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COMMENTS (9 to date)
Becky Hargrove writes:

And in fact, their bets could have been reasonable risk - up to a point as you said. The problem was, too many people piled on to what had been a way to come out ahead, in an environment where not enough options existed to do so. That is one reason why it's hard to predict the degree of risk. No one can predict how many people will want to ultimately use that instrument in the timeframe it can achieve its best result. Surely there is a correlation somewhere between the rapid rise in gain in such instruments, and the other options that still exist for monetary gain.

George Selgin writes:

Mr. Bhide's observation that there were few bank failures during the first decades of FDIC insurance is correct; but he fails to note that the "tight restrictions" that played perhaps the most crucial part in that outcome were regulations (including reg Q) restricting interest payments on bank deposits, which themselves ultimately proved unsustainable as inflation rates rose and as banking became a global business. Nor does he seem aware of how other "tight restrictions," such as those that limited branch banking prior to the 1990s, were a potent cause of US banks' previous vulnerability to failure. Indeed, deposit insurance was in essence a substitute for branch banking, which is to say a means for artificially sustaining an inherently weak but politically influential unit banking structure despite the public's loss of confidence in that structure.

Ironically, now that we have nationwide branching, our banking system suffers from a new affliction, to wit: bankers' excessive risk taking, itself a consequence of the moral hazard created by both explicit and implicit deposit guarantees.

In short, coming up with sound solutions to the problem of bank failures requires looking beyond a few decades of past U.S. experience. It requires looking into the more remote past, and also looking into the experiences of other nations. In the latter regard, it is essential to recognize that the U.S. was, during most of those decades of low bank failures, the only nation with national deposit insurance (Canada was next, in the late 60s.) Yet other nations (Canada among them) also experienced low bank failure rates. That they did so suggests that there are ways to protect depositors against loss that don't let the moral hazard genie out of the bottle.

Kevin Dick writes:

As you have said many times before, one has to look at where the policy puts the incentive to apply human creativity.

In Bhide's case, the incentive is to be creative in finding risky bets that circumvent the government restrictions. Then the bank gets the higher returns with someone else bearing the risk.

Costard writes:

George - +1.

Currency history is a malleable thing, but it's still pretty cheeky for Amar to clam that the greenback was introduced to stabilize a decentralized system, when in fact it was the actions of Lincoln's government that had destabilized it. Demand notes (proto-greenbacks) were introduced in 1861 (not 1863), redeemable in specie. It was understood that the government would have to suspend redemption because of this, so everyone attempted exchange for metal before this happened - which in fact it did, 4 months later. Thus the cardinal sin of the gold standard: it did not allow unfunded wars...

M. Ricks writes:

Agreed that a two-decade period with few depository failures isn't necessarily evidence of the success of depository regulation. Nevertheless, I wonder whether we should be so quick to conclude that prudential regulation and supervision of depository institutions is practically hopeless (if I'm interpreting the post correctly).

The pertinent question seems to be whether the Fed/OCC/FDIC can do a satisfactory job over time with implementing and enforcing portfolio limitations (including underwriting standards), diversification requirements, and capital requirements on the depository sector, in order to limit losses to the deposit insurance fund. Satisfactory doesn't mean perfect.

For what it's worth, the deposit insurance fund is currently in the black, after having gone into the red for a time during the crisis. Of course, that could change again (depending on how Europe plays out, among other things). Still, barring another major downward spiral, we won't need a taxpayer bailout of the deposit insurance system in this crisis. That seems like a good thing, although maybe I'm setting the bar too low ...

Separately, thanks (belatedly) for citing my article the other day in this post. I don't usually regard myself as having an "Austrian" perspective, but I'm not complaining.

Jim writes:

Costard +1

It is difficult to argue that the Fed stabilized anything; even Romer argues that. But it did allow the government to pile up incredible debt. But Krugman says that doesn't matter. Except macro assumes the system is stable and free of exogenous shocks. But we just had one and it is debt driven. And demographically, we won't be able to pay the debt rollover. So now we're back to finance again, because macro can't deal with a destabilized system.

Mark Pitts writes:

Mr. Bhide ignores the questions of HOW governments could possibly guarantee such deposits. Anyone familiar with the predicament of Southern European governments knows that such guarantees are not possible. Afterall, it is the governments' other guarantees (ie, bonds) that are endangering deposits.

Tom West writes:

George Selgin comments about Canada make it clear that culture matters.

Americans are the world's primary innovators and risk-takers. This has made them the world's wealthiest nation, but it is axiomatic that this will on occasion lead them to the occasional massive setback, after all, it's not innovation if it can't fail.

The world praises Canada's bank system now, but it's pretty clear that if the world banking system hadn't imploded when it did, Canada's banks would have been relegated to a footnote of history, bought or rendered insignificant because they refused to be on the cutting edge.

david stinson writes:

@Tom West

" Americans are the world's primary innovators and risk-takers. "

Three points:

1) Perhaps that is in part an artefact of the moral hazard in the financial system that has existed for the last 100 years. Moral hazard skews the risk-return tradeoff for those who finance innovation.

2) I am not sure that I would characterize those who seek the protection of being backstopped by others as "risk takers". It strikes me that the extent of moral hazard in the banking system is the product of risk avoidance or risk shifting.

3) Where the "cutting edge" of banking is enabled by moral hazard, you don't want to be there.

4) If it is indeed true that Americans are more naturally risk-taking, that is an argument for maintaining market discipline against excessive risk taking, not undermining it through moral hazard.

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