Taxing banks does not tame them

During the last financial crisis, it was quite obvious that at least some banks were taking excessive risks. What do economists usually advocate when it comes to discouraging particular behaviors? Taxes. And that is popular as the foolishness of banks has imposed costs on the taxpayers. Thus, some countries such as Germany, the UK and the Netherlands have imposed taxes on banks. Did that work?

Not really, tell us Michael Devereux, Niels Johannesen and John Vella. They look back at the experience in various European countries and conclude that while this taxation on borrowed funds indeed reduced borrowed funds, and therefore loans, it turns out that it also increased the riskiness of the funding. These are two bads. First, loans actually encourage the economy. Second the risk has increased is of course counter-productive. Even worse, it is the safest banks that reduced most borrowing the the unsafest ones that took on additional risk. How could this happen? As there were fewer borrowed funds, and hence relatively more own assets, regulations allowed banks to modify their risk-weighted portfolio. In other words, regulation that was invariant to the introduction of the taxes made things worse.

Self-delusion in Basel II

The Second Basel Accord was put in place to more effectively prevent bank failures. The first one imposed some rather rigid rules that where not taking into account the true risk exposure of the banks, which obviously varies according to the particular activities of the bank and overall economic conditions. Basel II is more flexible in that it allows banks to used their risk models and scenarios to determine how much capital they need to secure. The goal is to have sufficient capital in 99.9% of cases of unexpected losses, or a failure once every 1000 years. That is pretty safe.

Except it is not. The first exhibit is of course what happened during the last recession. The second is a paper by Ilkka Kiema and Esa Jokivuolle that shows that in fact only a fraction of the regulatory capital needs to be loss absorbing capital. Indeed, half can be subordinated debt and thus not available when needed. According to the authors, this means that the true risk of bank failure is every 20 to 100 years. Not very reassuring, and Basel III does not seem to really address this.

Insider bank runs

Bank runs occur when depositors believe a bank is insolvent. They rush to withdraw their deposits before everyone else as funds dry up. Who is first in the queue at the wicket? When such panics break out, they must originate somewhere, whether justified or not. In particular, somebody must have had some privileged information that there is a problem with this bank. I doubt bank runs start as the bank releases its latest numbers and everybody is surprised.

Rajkamal Iyer, Manju Puri and Nicholas Ryan got access to the deposit withdrawal logs from a bank that has been subject to two runs. The last one is particularly informative, as a regulatory audit found the bank insolvent, and despite this information being private the bank run ensued. It is then no surprise to see bank employees as the first ones to withdraw their funds, followed by depositors with uninsured funds, who are the most vulnerable and may have been tipped off by some employees. Insider information appears unavoidable and leaks to the public. It appears difficult to avoid a run when a bank is indeed insolvent, unless it comes as a sudden development over the week-end. As a policy maker, this means that you better make sure banks never become insolvent, or you end up always insuring the bad risks, those that do not have insider information.

A hesitant government may have good aspects

If you look at economic and especially fiscal policy in the US and in Europe these days, it can be characterized as hesitant. And this despite large challenges, or maybe because of these challenges as more is at stake and political forces dig in. It is widely regarded that a hesitant government is welfare worsening, but a case could be made for it to be welfare improving in situations where a the government lacks a necessary commitment device.

Jaromir Nosal and Guillermo Ordoñez discuss such a situation, namely bank bailouts. Quite obviously, the first best policy is to never allow bailouts, but once an opportunity arises, the government is much tempted to still use a bailout. This time-inconsistent policy translates into more risk-taking by banks, and more bailouts opportunities ensue. But if the government is hesitant, either because the information is not clear or because of internal or political constraints, then it does not authorize bailouts as easily, and banks behave better. Hesitating (or filibustering) acts like a commitment device. And this is good, in some situations.

Imagine Chinese growth rates without misallocations

China has been growing at a very rapid pace, and many have studied how this has happened and why. Yet, when you look at the economy now, it is still remarkably inefficient, especially with a financial sector that is very far from potential. In particular, the state-controlled banks do not provide loans for the best investment opportunities, but rather disproportionately to state-owned enterprises, which obviously are not as productive as the private sector.

Robert Cull, Wei Li, Bo Sun and Lixin Colin Xu use a survey of manufacturing firms that the World Bank conducted in China in 2005 to document what determines the firm;s financial constraints. To no one's surprise, state-owned enterprises have a big advantage. But among them, those who have CEOs that are well connected with the government or the Party have is even markedly easier. This points of course to the massive misallocations within China that people are still complaining about. Imagine how much richer China could be with a better allocation of its financial resources.

But of course, one can argue that China is growing like crazy because it is transitioning from even worse misallocations, where there weren't even private savings to sustain a more productive manufacturing sector. This argument has been made, among others, by Zheng Song, Kjetil Storesletten and Fabrizio Zilibotti. Not only is China growing through rapid investment in more productive technologies, it is doing so while getting more efficient in distributing financing. And seeing how inefficient it is, there is a lot of potential growth for many more years.

Banking for those unwilling to bank

While we worry about the unbanked population that faces significant costs for trivial transactions, there is also a not insignificant share of the population that is unwilling to have bank accounts for religious reasons. Islam and some strands of Christianity forbid the use of interest. Islamic banking has emerged in response and is offering deposit accounts that do not provide interest, but shares in the bank's profits. If this becomes more commonplace this could have important implications for how we think about banking, regulation and systemic risk in this sector.

Cagri Kumru and Saran Sarntisart show that if such a sizable population exists, then it is welfare improving to have an alternative banking system in place. It seems kind of obvious that it would be a loss to society not to capture these savings for growth-enhancing loans. The paper also shows that this alternative banking sector would emerge endogenously. The market forces are thus doing the right thing. What we need to be careful about is how to adjust the regulatory framework to not mess things up unnecessarily. And I see no reason why we should resist the emergence of such a banking sector.

Banking crises and income inequality

With the Occupy X movement, discussion about the unequal distribution of income has flared up. At the same time, we are still not over the banking crisis. Several people have linked the two, saying that the large banking sector has lead to more income inequality and that the rich have benefited form the crisis at the expense of the poor. We probably do not yet the data to corroborate any of this, but we have data that allow to look at income inequality through other banking crises.

This is what Luca Agnello and Ricardo Sousa set out to do with a panel dataset from OECD and non-OECD countries. They find some regularities: there is a run-up of income inequality before the crisis hits especially in non-OECD countries; it declines fast thereafter, especially in OECD countries; better access to credit reduces income inequality; and the size of government has no impact on income inequality. The estimates of the paper are rather crude, there is just a lag on the Gini coefficient. I am sure one can tease out more interesting dynamics with a structural vector auto-regression. But the results are still interesting as is.

State-owned banks in the US?

Many countries have state operated banks that support local development or other objectives that deviate somewhat from those of usual for-profit banks. No such institution exists in the US except for the Bank of North Dakota.

Yolanda Kodrzycki and Tal Elmatad study the Bank of North Dakota in the perspective of the feasibility of a similar bank in Massachusetts. They find that the BND is not a typical bank. While it favors local development, it rarely does so directly, but rather by helping local banks. It thus encourages a network of small and local banks, something that does not quite seem efficient to me. The BND was, however, not particularly useful in periods of crisis, like the agricultural crisis of the 1980s, because it also had financing difficulties. All in all, the bank of North Dakota is very different from state banks abroad, which offer all customer services like private banks and thus help regulate through competition some the excesses of private banking. The BND looks much more like existing development corporation that exist in most if not all US states. If Massachusetts just wants to em ulate North Dakota, it does not seem worth the large cost of the initial bond issue, especially in the current economics context.

Cross-border banking and financial stability

Should banks be allowed to do business across borders? The answer is not obvious. For one, it is beneficial that they have the opportunity to better diversify their risks, but they can do this without having to open branches in other states or countries. The counterpart is that doing business elsewhere increases opportunities for adverse shocks. Finally, regulatory competition in an international banking market leads to a large systemic risk.

Dirk Schoenmark and Wolf Wagner try to sort this out in the case of Europe and come to the conclusion that it depends. They argue that Germany and the UK are well diversified and thus can sustain cross-border banking, even though there appears to be overexposure to the US, as exemplified by the large negative consequences in Europe of the recent crisis in the US. For the countries on the fringes of Europe, though, there seems to be very poor diversification. Indeed, these economies seem to be very dependent on a few large foreign banks, and consequences could be dire if they run into difficulties or decide to pull out.

This analysis is entirely based on asset shares and thus diversification. This neglects a major advantage of foreign banks: they bring lending capital that would otherwise not be available. The case for cross-border banking is thus understated in this paper.

You want to restrict bankers' pay

There has been and there still is much outrage about the large bonus payments bankers get. What the public does not understand is that bonus pay is a very large part of total pay, and it is so to encourage bankers to perform really well. And they certainly put in the hours. For example, bonus pay has been criticized because there is most often no "malus," but given that base pay is relatively low, this should capture it. The main criticism is aimed at the disparity of these bonus payments with respect to the average pay of a worker. This is, however, not something that should be regulated at the level of bonus pay, but through redistribution with income taxes. In this regard, whether it is regular pay or bonus pay makes no difference. So, should then bonus pay in banking be left unregulated?

John Thanassoulis does not think so. He argues that as bank compete for top bankers and try to shift the risk on them, they end up paying them too much and all in bonuses. This is optimal for the bank as it lowers its costs right when things get critical. But as a consequence, the bank gets too much into risky activities, as competition for bankers drives bonuses up higher than socially optimal, especially if there is a contagion risk of default for other banks. So you want a regulator to limit bonuses, but in a flexible way, or the benefit of having bonuses in the first place gets eroded. Indeed, it is the top brass that sets the bank level risk, whereas other employees all the way down to secretaries (who also get bonuses) are less influential, even collectively, on the aggregate risk. Thus the idea is not to cap bonuses individually, but at the bank level as a proportion of the balance sheet (which is what matters in terms of default). The pay structure would then presumably be readjusted by the bank, relying more on bonuses where it matters the most. Taxing bonuses has no risk impact, though, except for reducing bankers' pay.

Another possibility could be the dynamic incentive accounts I mentioned before.

How good is it to have a stable banking sector?

You know the feeling, it is only once you lost something that you realize how much you cared about it. Nowadays that we are affected by instability in the banking sector, we realize how good it was to have stable banks. How could we quantify this?

There is ample research on the impact of banking crises, but it treats data in a black or white fashion: either you are in a crisis or you are not. Pierre Monnin and Terhi Jokipii, however, use a continuous measure, the probability that banks would fail, in 18 OECD countries. Their panel VAR indicates clearly that bank instability leads to lower real GDP growth, more volatility of growth, and over-prediction of future growth. Looking at the numbers, the impact is not large, though: a one standard deviation shock to output increase the bank failure measure by 11% of its standard deviation, while it is 7% the other way around. While statistically significant, this does not strike me as economically significant. And one should not interpret too much these results, as VARs are only good to describe the data, but not good for understanding behavior and policy.

Of course, for such an exercise, details are also very important. For example, how do you measure the probability of default of a banking sector? Monnin and Jokinii model it as the probability that the whole banking sector would exercise an option to renege its debts. Why not use the Z-Score, which is available for individual banks and already widely used, and work from there? How sensitive are the results to the many choices the VAR econometrician has? There is always danger of data mining here, so having some theory to guide choices would be good.

On the cost of financial crises

Are financial crises costly? To answer this question, one should not look at the cost of a bailout, a drop in GDP or missing tax revenue, but at what people care about: consumption. In this regard, the current crisis is too young to be analyzed, but other ones are available. Two recent papers look at this for Japan and Norway.

Yasuyuki Sawada, Kazumitsu Nawata, Masako Ii and Mark Lee use panel data from Japan that spans over the 1997 banking crisis and estimate Euler equation that allow for credit constraints. While in normal times, 7.82% of households are credit constraint, this increases only to 8.44% during the credit crunch. In other words, the ability for households to smooth out consumption was only negligibly affected.

Eilev Jansen studies Norway, but prefers a VAR approach linking current wealth and income to consumption, which appears to work better than Euler equation approaches for the recent years. But again, the impact of the crisis on consumption is negligible: the elasticity of equity income on consumption is 2%.

Thus, the impact on consumption seems to be minimal. So why again are we seeing these huge interventions?

Repo runs

The recent financial crisis saw bank runs of a new kind. Instead of depositors running banks, banks were running each other. I do not think anybody had foreseen that such a thing could happen, and there was little theory to help policy. Now we have at least two.

One is by Harald Uhlig. The second is by Antoine Martin, David Skeie and Ernst-Ludwig von Thadden. In both cases, it is about maturity mismatches, a core issue in bank runs: banks invest in longer maturities than their liabilities. In this case, banks hold assets as guarantees, but they have difficulties selling them quickly when in need of liquidity. Of course, if this happens at more than one bank, this has also an impact on asset prices, thus making it even more difficult to raise the required liquidity. The first paper emphasizes that risk aversion is crucial here to explain the discounts on the assets. The second paper highlights how cash-in-the-market pricing can precipitate a run. In both cases, it makes sense for a governmental authority to buy those assets at prices above market, and in both cases the government should be able to make a profit from this operation. Let's whether this will be the case in reality.

Why are bad mortgages not renegociated?

As everybody is well aware of, there are plenty of delinquent mortgages in the United States. It is also quite obvious that a home loses substantial value as soon as it is foreclosed, because of homeowner neglect and the fact that it needs to be sold rapidly. Then, why do banks not renegotiate mortgage terms to keep foreclosures from happening. It seems to be in the best interest of banks.

Manuel Adelino, Kristopher Gerardi and Paul Willen wondered about this as well and and a hard look at the data. Specifically, they analyze detailed data on mortgages from Lender Processing Services (LPS). They first reject the standard explanation: whether a mortgage has been securitized or not has no impact on renegotiation.

It turns out that the risk of default after a renegotiation of terms is very high. After all this is why there was renegotiation in the first place. Given the cost of finding new terms, banks simply do not find it worth the trouble. This is similar to the adverse selection problem in insurance. Also, those homeowners who are temporarily in difficulty and will get back on their feet will escape default anyway, and new terms would not change anything.

Optimal deposit insurance

With the current financial crisis, the question of the optimality of bank deposit insurance has flared up again. Figuring out how much deposit insurance should cover is not an obvious exercise. Indeed, one has to think this as a game between bank managers, who want to take advantage of moral hazard through excessive risk taking, bank owners, looking maximize bank value, depositors, who decide whether to run and withdraw funds, and regulators, who want to prevents crises, but also want to liquidate banks that should be liquidated.

Michael Manz develops a nice and rich model that attack the problem from the perspective of global games. This has the advantage of resolving the issue of multiple equilibria in the standard bank run models. Among the many results, several stand out. If the bank risk is exogenous, coverage should not be high as it prevents necessary and efficient runs. Also, liquidity requirements are a good substitute to deposit insurance. Finally, coverage should not increase in the event a financial crisis hits. The reason is that the financial risk increases with the scope of deposit insurance because, if I understand right, while higher coverage protects better deposits in banks of systemic importance, it leads to more moral hazard in others and then increases the likelihood of a run on all banks. The only way out is to discriminate coverage by bank, which is a completely different regulatory game.

Regulation and the financial crisis

Various people have argued that the current crisis has been the result of a lock of regulatory oversight, that basically allowed banks to do silly things. I fail to be convinced about this argument for the simple fact that the only financial entities that have run into trouble were regulated ones, and the unregulated hedge funds, while obviously facing losses, are still in business without outside help. But it is still worthwhile thinking whether regulation is at an optimal level.

Joshua Aizenman provides a rather intuitive model of banking regulation: regulation reduces the risk of a crisis, but the perceived lower risk reduces support for regulation. Thus, one would always have under-regulation and even no regulation after sufficiently long, crisis free spell. This under-regulation is exacerbated by the fact that the public typically does not observe (or understand) the regulator's efforts. Of course, there is over-regulation immediately following a crisis, especially if it is very costly. Bayesian updating will do that to you. How to prevent these issues? Essentially the same way one prevents the inflation bias of a central bank: independence, transparency and predefined goals.

That said, and I mentioned it above, under-regulation may not necessarily be the trigger of the current crisis. What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market...

The IMF mission to the US: embarrassment or normal procedure?

One of the roles of the IMF is to make assessments of economic policies in member countries and forcing them to adopt sounder ones. The important word here is "forcing." Many governments are in fact grateful for this, as it allows to enforce good, but unpopular policy using the IMF as a scapegoat.

In principle, any member country could be subject to such scrutiny. Unfortunately, there is considerable politicking in the IMF, and in particular rich countries manage to impose upon others prescriptions they would adopt themselves. They can get away with it due to current structure of the IMF. We reported before on the need for this structure to be reformed.

In turns out the US will be scrutinized soon within a Financial Sector Assessment Program (FSAP), i.e., a complete analysis of the financial sector. Market participants and government agencies will be required to hand over confidential documents. This is no different than what is done elsewhere, but the uproar is certain to appear.

One could view this as a sign that finally rich economies are coming under the same scrutiny as the poorer ones. Not quite. Indeed, this mission had been on the radar for a long time, but the Bush Administration vehemently opposed it for seven years, but finally gave in on the condition that the report be issued after the handover to the next administration. By then, everyone in charge will be out of office, but one: Ben Bernanke.

Face it: banks are illiquid

What is the role of a bank? It takes deposits and lends them to borrowers, typically on business loans or mortgages. The latter have rather long maturities, deposits can be withdrawn at any time. In other words, bank perform a maturity transformation. Doing so, they take the constant risk of not being able to satisfy sudden withdrawals from deposits. Hence the help of central banks as lenders of last resort.

What this means is that no bank is liquid enough to satisfy the withdrawals of all deposits. In fact, if any bank would be able to do so, it would lose money, as it is paying interest on deposits that just sit idle in the vault. Thus any bank risks being subject to a run.

If Senator Charles Shumer reads this, I hope he will come to realize the situation and send letters about every bank in the US, or even every bank in the world, stating that the bank cannot honor deposits. Because this is true, and has always been true.

The Fed was wrong, and knows it

The Fed has done lately a few moves that were out of the ordinary lately, and has been heavily criticized for it. It seems to start acknowledging now that it was wrong. Bernanke is dropping hints that interest rates will go up sooner than later due inflationary pressures. But the biggest head turner was the episode with Bear Stearns.

Now, Richmond Fed president Jeffrey Lacker acknowledges in a speech that bailing out Bear Stearn is counterproductive, as it has radically changed the expectations of the financial sector. You do not need to be a genius to figure that out, as much of banking theory is centered exactly on this concept and its related moral hazard issues, but it is nice to see an official concede he messed up.

This is the perfect opportunity to undo the damage. Acknowledge now big time that it was a mistake, and find some way for the Fed to commit itself not to do this in the future. For example by having some heads roll.

Grameen America

Grameen Bank of Bangladesh, champion of micro-credit without collateral to the poor, has opened two branches in the United States, one in New York, the other in Dallas. Again, it targets the very poor: small credit, no collateral, 15% interest. Grameen is not allowed to collect deposits on American soil. So imagine that: Bangladesh is actually financing loans in the US...