How Regulation Subsidizes Big Finance

By Brink Lindsey and Steven M. Teles of ProMarket. Excerpt:

"But instead of correcting any market failures that leads to excessive risk taking, regulatory policy actually makes matters worse. Specifically, the government’s efforts to reduce the harm caused when financial firms fail ends up subsidizing the heavy reliance on debt that makes firm failure more likely.

The main explicit subsidies consist of (1) the Federal Reserve System’s discount window, established in 1913, through which the Fed can act as a “lender of last resort” and supply emergency liquidity to distressed banks; and (2) federal deposit insurance, first instituted in 1933, through which covered depositors are held harmless in the event of a bank failure. Both these policies are justified on the grounds of preventing and containing bank runs—a particularly serious problem in the United States because historical limits on branch banking rendered US banks underdiversified and consequently crisis-prone.

Yet even as they reduced the risks of contagion and financial meltdown, these policies simultaneously reduced the risks of high leverage. Access to the discount window made banks less vulnerable to liquidity shocks and thus made it safer for them to borrow more. Deposit insurance, because it has never been priced in an actuarially sound manner, acts to subsidize heavy reliance on deposits to fund banking operations. Insured depositors are rationally indifferent to the financial soundness of the banks they patronize, as they will get their money no matter what. Accordingly, they do not demand higher interest rates from undercapitalized banks to compensate them for the risk of insolvency. It is no surprise, then, that the creation of a formal safety net for banks led to higher levels of indebtedness.

In addition to these explicit subsidies, an implicit subsidy created by a string of ad hoc bailouts has further incentivized financial institutions to ramp up their leverage. Continental Illinois in 1984, the Latin American debt crisis of the 1980s, the peso crisis of 1994, the Asian financial crisis of 1997-1998, Long Term Capital Management in 1998, and of course the financial crisis of 2007-2009—again and again the US government has intervened with emergency assistance to prop up American financial institutions deemed too big or too important to fail. This implicit safety net has extended far beyond the traditional banks covered by deposit insurance to include investment banks, the government-sponsored enterprises Fannie Mae and Freddie Mac, hedge funds, money market mutual funds, and insurance companies. As a result, creditors of those financial institutions have been spared the consequences of their misplaced trust. Given the expectation that bailouts will again be forthcoming the next time a crisis hits, the riskiness of lending to highly leveraged institutions is much lower than it otherwise would be—and thus the interest rates that those institutions pay to their nominally uninsured creditors are kept artificially low.

The perverse incentives created by deposit insurance and bailouts are known as “moral hazard”—an expression that comes from the insurance industry to describe the reduced motivation to guard against risks that have been insured against. How moral hazard operates in the financial sector, though, is widely misunderstood. The common picture is that, if moral hazard is present, it must mean that financial sector executives are consciously making business decisions with an attitude of “heads I win, tails you lose.” In other words, they deliberately make investments they know are risky because they understand that they will make big profits if the investments pay off—and if they don’t, well that’s the government’s problem.

It’s clear enough that such thinking is fairly uncommon. Yes, when a financial institution is already insolvent or close to it, executives may try “hail Mary” investments because they face no downside risk—their equity stakes have already been wiped out so they are effectively making one-way bets. Such behavior was seen during the savings-and-loan crisis, as “regulatory forbearance” allowed thrifts with negative net worth to stay in business and attempt to recoup their losses with increasingly desperate gambles. This is precisely the pattern of behavior that Charles Keating notoriously engaged in back in the 1980s, and which the “Keating Five” senators helped to protect.

In the recent housing bubble, though, many of the most disastrous decisions were made by people with plenty to lose. Huge fortunes and sky-high incomes were on the line, and few could be complacent about the prospect of losing them. Far from seeing themselves as reckless, the unwitting architects of the financial crisis were highly confident that they were managing risks expertly and were shocked when the facts proved otherwise. Accordingly, it would seem that moral hazard wasn’t a major factor in explaining what went wrong.

But in fact moral hazard was absolutely central to the story, and it is at the heart of why the financial sector remains a disaster waiting to happen. The main effect of moral hazard, though, isn’t on the incentives facing the executives of financial institutions. Rather, the main effect is on depositors and other creditors. Because their risk of loss has been artificially reduced by the formal and informal safety net created by government, they do not respond as normal market actors would to the heightened risk of insolvency created by extreme leverage. Because they do not bear the risk, they do not demand higher interest rates to compensate for that risk. Financial institutions can keep piling up more and more debt without market consequences, with the result that those institutions and the financial system as a whole grow increasingly fragile and disaster-prone. Sooner or later, a relatively minor reversal of fortune will suffice to spell catastrophe because almost all margin for error has been eliminated.

The system as currently constituted is especially vulnerable to insidious, slow-fuse risks lurking in the tails of probability distributions. The economist Tyler Cowen has characterized the problem as a strategy of “going short on volatility”—in other words, “betting against big, unexpected moves in market prices.” This strategy can appear to work well for many years, as by definition the contingencies being bet against are rare events. During these good times investors earn above average returns, amped up by leverage. Complacency sets in, as backward-looking risk management systems assure everyone that all is well. These systems, for all their mathematical sophistication, rest on a highly dubious and dangerous proposition—namely, that just because something never occurred in the relatively recent past for which data are available, it will never happen in the future. Eventually, though, a blue moon or a black swan appears in the sky, and all those highly leveraged bets now generate losses big enough to threaten the whole system with collapse."