In my last post, I concluded that the presence of government subsidies – particularly guarantees explicit (deposit insurance) and implicit (Too-Big-To-Fail) – makes the political economy of financial institution regulation different from other areas of the regulatory state. In this post, I argue that these government subsidies and moreover, the underlying reason for government subsidies, contributes to the inherent instability of financial institution regulation.
The presence of government guarantees – explicit or implicit – creates strong incentives for financial firms to externalize the cost of their risk taking onto taxpayers. But there is more to government guarantees than moral hazard. Consider the following:
Market distortion: When the government subsidizes some financial firms but not others, it distorts the market. A lower cost of capital allows the subsidized firms to undercut their competition. This can drive competitors either out of business or, if risk is being mispriced because of an asset boom, into riskier market segments (a phenomena I explored in a symposium piece).
Cheaper debt and leverage: Government guarantees also make debt cheaper than equity. This supercharges the incentives of financial firms to increase leverage. Higher leverage of financial institutions, in turn, works to increase the effective supply of money. More money can fuel asset price bubbles and mask the mispricing of risk (phenomena explored by Margaret Blair in this paper, as well as by me in a forthcoming symposium piece in the Berkeley Business Law Journal.)
Cheaper debt and regulatory capital arbitrage: Cheaper debt also supercharges financial firm incentives to game regulatory capital requirements (something I am writing about in the context of the shadow banking system. See also Jones; Acharya & Schnabl; Acharya & Richardson.
Bailouts and correlated risk: Governments face pressure to bail out firms when their risk taking is highly correlated (because multiple firms will fail at the same time). On the flip side, this creates a strong incentive for financial firms to take on correlated risk. (See, e.g., Acharya et al.). Correlated risk taking reinforces the kind of herding that behavioral finance scholars have analyzed in the context of asset price bubbles.
So feedback loops abound. What to do, then, about government subsidies?
“Stop us before we bail out again”
1. Legal rules are by nature incomplete and, under pressure, firms and regulators will seek ways around rules.
2. It ain’t so easy for a sovereign to bind itself. In the end, what is the remedy and who will enforce it?
3. There is nothing to stop Congress from amending the law. Legislatures can’t entrench laws against amendments by future legislatures (although the government must honor contractual obligations – for a discussion of these issues, see U.S. v. Winstar)
True, Dodd-Frank’s prohibitions on bailouts and governments are not just pieces of paper. Law does constrain government behavior to a degree and can promote political accountability. However, we should not expect “law” to work like a wind-up toy that is self-executing without worrying about issues of interpretation, compliance, incentives, and the norms of government actors. I restrained myself at the conference from delivering a little legal koan: “the law will bind government officials, if they believe it binds them.”
As an aside: it strikes me that the legal academy has to do a much better job of educating economists, policy makers and the public about what is “law” and how it operates. We have to do this in an accessible manner and without undermining important norms of legal compliance. Financial reform proposals are replete with calls for more “automatic regulations” – whether to counter capture or political pressure to spike the economic punch when the party gets startin’. (For example, economists have proposed the very sensible policy of counter-cyclical capital buffers) But fetishizing automatic regulations can pervert financial regulation. Over-reliance on automatic regulation:
- Ignores the fact that regulators and lawmakers must interpret laws; and
- Discounts the likelihood or regulatory arbitrage or regulatory evasion.
In short, we need to have a much richer discussion of what the “law in action” means.
Letting it Burn: Confusing Bailouts with Other Externalities of Financial Institution Risk-Taking
What if restrictions on bailouts and government guarantees work too well? There is a rationale for government interventions like deposit insurance, lender-of-last resort, and bailouts. They are not just about “capture.” Financial institution failure can impose significant negative externalities (which is a fairly antiseptic description of the social costs of financial crises). Counterparty and market discipline don’t force firms to internalize all of these externalities. I respect the intellectual consistency and fervor of those who believe that bailouts and government interventions are the root of all financial regulatory problems. But I wouldn’t trust them in any position of responsibility.
Deposit insurance and bailouts aren’t the only ways governments distort markets when they act to avoid crises. Lender-of-last resort actions and even interest rates changes can create a type of moral hazard (see “Put, Greenspan”). It is a lot harder for central banks to calibrate liquidity responses to market seizures than armchair critics think.
So if some government subsidization of the financial firms is inevitable, it is critical that the government counter these subsidies -- whether by limiting firm risk-taking or charging firms for the subsidy. Absent attempts to counter subsidies, we are right back where this post started – moral hazard, distortion, cheap debt --> leverage and capital arbitrage.
But countering subsidies is not so easy:
- Subsidies are difficult to measure returning us to the problem of calibration. Consider the pricing of risk-based deposit insurance premia.
- Implicit subsidies are hard to identify with exact certainty and (as I noted in my earlier post) can become self-fulfilling prophecies.
- Subsidies are dynamic; their levels can change over time.
- Firms have every incentive to game any regulatory limitation that prevents them from externalizing cost onto taxpayers. They have every political incentive to convince regulators not to counter subsidies adequately.
Limiting Who Gets the Subsidy: the Political and Economic Dynamics of Competition
Regulators also must limit which firms receive the subsidy. But this too creates a host of challenges. Again the problem of calibration arises. Regulations that bite too hard or too soft on subsidized firms create the same market distortions discussed above. Less regulated and unsubsidized firms may gain if they can make investments that regulated firms cannot. Booming asset prices pressure regulated firms to evade regulatory restrictions or push for deregulation (phenomena I’ve looked at briefly before). Of course, when regulated firms push for deregulation, they are keen to keep subsidies, implicit and explicit.
Financial conglomerates have a natural incentive to transfer subsidies from more heavily regulated affiliates to less-regulated. These transfers are hard to detect, not to mention mind-numbingly technical (See Saule’s work on how the Federal Reserve chipped away at one statute that was designed to prevent a subsidy transfer from depository banks to non-bank affiliates)
If you’ve made it this far in the post, you are a hero! You have an amazing capacity to withstand a sustained dose of dense financial regulation talk. Let’s face it – you and I are special. Imagine that most law professors find this stuff less than scintillating. A prominent legal historian once congratulated me on studying financial markets given how dull the topic is. Thanks for that back-handed compliment, Larry!
The point of this interlude is not to flatter you (although you do look great – have you been working out?) It is to underscore a key problem with financial regulation: “technical issues” are really boring for most folks. And I am fond of saying that the boring issues are (A) where the bodies are buried and (B) where crises fester.
The Genie Won’t Go Back into the Bottle
The vision of turning back the clock to Glass-Steagall era “narrow banks” and neat divisions between categories of financial institutions is seductive. However, the genie won’t go easily back into that bottle. Many of the factors that led to the stability of financial institutions regulation from the 1940s to the 1970s are gone, perhaps forever:
- Bretton Woods is now just a hotel in New Hampshire;
- The important countries in international financial markets are no longer a cozy club and the U.S. no longer the unrivalled hegemon;
- The ability to move capital across borders means regulatory arbitrage has gone global baby -- and the alphabet soup of international organizations has done little to address this effectively;
- We were lucky in the 1970s when OPEC and the Bee Gees were the only economic shocks that threatened financial stability;
- If financial risk is here to stay, then demand for financial products to manage that risk won’t abate. The demand for products that “complete” capital markets conflicts with “narrow banking.”
Dynamic RegulationWhen I go to workshops, one typical reaction is that my views are “fatalistic.” Chalk it up to listening to too much Morrissey as a teenager.
But in honesty, arguing for the inherent instability of financial regulation is not arguing that regulators should just give up. Surrender is not an option. Instead, I agree with many of my co-panelists that the real challenge is ensuring that regulators continually adapt -- both to changes in financial markets and to the adaptation of financial markets to regulation. That means we need to ensure financial regulators have appropriate incentives and capacities. This is a tall order – but I’ll continue on this topic in a post tomorrow.