Tuesday, July 14, 2009

Further Thoughts on Shadow Banks

Posted on Rortybomb by Mike:

There has been some interesting feedback on the Shadow Bank interview: James Kwak, Noah Millman, Mark Thoma, Arnold Kling.

There are two additional points I want you to think about when it comes to the discussion of shadow banks, things I tried to get at in the interview.

Liquidity and Solvency

Banks, since long ago, have always had liquidity and solvency risks. This is the “bank run” problem you have heard about. Almost every banking problem can be described as a breakdown along these two lines. In the same way it is irresponsible to economics to discuss the economics of health care markets without discussing moral hazard or adverse selection and instead assume it is like the market for bread, it is irresponsible to talk about banks without these two special market failures in mind.

There was a lot of talk how the new capital markets banking system would regulate itself. I’ve read a lot about risks would be contained because of collateral posted, or that blue-blood CEOs would want to keep their reputations high. We have learned, and in retrospect it was naive to ever think otherwise, that none of that is going to be enough to hurdle these two problems.

Systematic Risks

There’s a quote from Robert Lucas about taming the business cycle from a few years ago that gets pulled out and laughed at. A statement I’ve been reflected on while thinking about all this is the following:

“I don’t see that the private market, in creating this wonderful array of derivatives, is creating any systemic risk. However, there is somebody around creating systemic risk: the government…Perhaps the biggest systemic risks that the government creates come from its debt guarantees”
- Fischer Black, 1995

I take a deep breath before saying this, but my man Fischer is wrong – AIGFP created systemic risk out of nothing by mispricing CDS contracts over a few year period. Systemic risk is the risk that effects us all, the risk we can’t diversify or innovate our investments away. It’s the risk that hits my boring index fund of stocks that I want to use to retire.

How do they do that? By underpricing CDS contracts – charge 2 or 15 bp on some accounts – they encourage people on the other end to take on more risk thinking they are insured, when they are not. This chains through the system to the point where it hits my boring index fund.

This point is really important, so I’m going to harp on it. Think if you got fire insurance on your home cheap, really cheap, but the fire insurance firm has no intention of paying it out. Since you feel more secure, you smoke in bed and leave oily rags around the furnace and use the smoke alarm batteries for the remote, and sure enough your house catches on fire. You aren’t going to get paid, but that’s a your problem at that point – however now your house is on fire, and your neighbors houses are catching on fire. Other fire insurance companies, not capitalized to handle this sudden wave of fires, start going bankrupt. This metaphor may seem a bit much, but that’s what happens in financial firms.

There’s a lot of talk about derivatives being great because Caterpillar wants to buy them over the counter or terrible because Warren Buffet says they are WMDs for geeks. That’s not the point – certain ones are dangerous and need to be regulated because they can create risks that impacts everyone, systemic risk, regardless of whether or not they own any derivative products.

I’m not sure what the best way to go about this. As the commenters mention, like access to the Fed window, having the government be the insurer of last resort would require that everyone is committed to it, and trade off regulation for that privilege. It would also have to mean, like what happens to boring banks, banks would have to be collapsed via FDIC if they messed up – we don’t have a safety net and bailouts.

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