Incentives Matter: Bank Regulatory Edition

Tyler Cowen explains why he doesn't think we are going to get the banking system that either left or right dream of:  one where bankers and their creditors take a bath when there's a crisis, and the incentives for risk-taking are properly aligned.  Read the whole thing, but for me here's the critical paragraph:

Let's say a no-bailout policy was credible, as indeed it was in the 19th century (there were no bailout facilities). What does the equilibrium look like? Is there less long-term lending to banks and more short-term lending? Would that make banks more or less stable? Few people think this is a positive development for countries. Would banks be more subject to "capital flight" risk?

We also could expect greater mutualization of banks, as was the case before deposit insurance, and we could expect experimentation with corporate forms other than limited liability. My view is this is what would be required to limit excess bank risk-taking. Yet I believe that, for better or worse, it it is politically impossible. In a nutshell,big government needs big finance (or much higher taxes).

One reason that bailouts are so politically popular (not in rhetoric, but in their practice and in their effects) is that they make financial crises less common but, when they come, more severe because more leverage has built up. That change in the structure of returns is usually a political winner, call it "Ticking Time Bomb."

As you see in Ireland, a government which is running a primary deficit (i.e., it is partially financing its day-today-activities with borrowing, not just borrowing to pay interest on old loans) has great trouble telling the creditors of the banking sector to go to hell.  If they do, any resulting panic will raise the government's borrowing costs too.  

All very well to point to 1933, but by the time the serious bank resolutions began, more than a third of all the banks in the country had already failed, as in, taking peoples' life savings down with them, something we won't tolerate today. And the government's budget deficit was a dainty 3.5% of GDP.  If you favor massive stimulus, I think you sort of implicitly favor being nice to the people who lend us the money.  Those people would have become cranky and vaporish if we had decided not to guarantee the money they had already lent, on the belief that the US government ultimately stood behind it.  

Moreover, "toughness" is emotionally satisfying hard to formulate into good long-term policy.  It's customary to celebrate the low-risk era of banking that followed the Glass-Steagall era, thanks to laws like Regulation Q, which controlled interest rates, and other regulations that restricted diversification.  These regulations ultimately resulted in the Savings and Loan Crisis.  Do not be so sure that you can design a tough regulation that won't have similarly expensive side effects down the road.  As with a lot of the "risk management" engineering at places like Lehman, this regulatory strategy actually just pushed a lot of the risk into an area (inflation) where people didn't expect much volatility.

As for private regulation, done by shareholders and creditors who do not expect to be bailed out, I have long been skeptical.  It is not possible for even the most astute investor or depositor to measure all the exposures in a bank's trading book or loan portfolio--not just because the trading book has to be confidential, but because there's so much counterparty risk.  If the other banks, or the homeowners, to whom the bank has lent money, take on more risk, the bank's risk goes up even if its lending stays conservative.  The major shareholders and depositors of the banks in Youngstown, Ohio during the late twenties were prominent local businessmen with deep knowledge of business conditions, and ample skin in the game. Nonetheless, the banks all shut down.