Friday, June 4, 2010

Two Fed Presidents and Financial Externalties

You can find an interesting contrast between a policy paper written by Narayana Kocherlakota, Minneapolis Fed President, and a speech by Jeff Lacker, the Richmond Fed President. Narayana thinks that the financial sector is fraught with externalities. For example:
It is important to distinguish my notion of a risk externality from two other types of externalities that are mentioned in discussions of bank regulation. One of these is a systemic externality. The failure of a given Bank X may affect the profitability of many other firms in the economy even though Bank X has no direct contracts with those firms. In this sense, any decision by Bank X that increases its probability of failure has a systemic implication, because it also increases the expected losses by the entire financial—and indeed economic—system.2

My notion of a risk externality is also distinct from what might be termed a fire sale externality. During financial crises, many financial institutions may have to sell assets or collateral at the same time. These simultaneous sales will put downward pressures on the assets’ prices. A given financial institution will not internalize the impact of its sales on the price of other institutions’ assets.
According to Kocherlakota, then, there are three important externalities, a risk externality (the primary focus of his paper), a systemic externality, and a fire sale externality. Now, let's turn to Lacker, who says:
First, I am skeptical of the characterization of systemic risk as an externality that leads market participants to undervalue or ignore risks. Those spillovers are usually ascribed to the interconnectedness that is said to be more prevalent among financial firms. But those interconnections are all the result of mutually agreed-upon contracts. Creditors have voluntarily chosen their counterparties, and they have no inherent reason to neglect the implied exposure to their counterparties' counterparties. Similarly, financial asset owners have voluntarily agreed to a range of potential returns, and they have no inherent reason to neglect any particular possibilities. Interconnectedness, by itself, is not a market failure.

Skepticism is also warranted, I believe, regarding the systemic consequences of an individual firm's failure, no matter how interconnected. Arguments that one firm's failure can spark costly runs at other firms rely on the logic of panics as self-fulfilling prophecies. While this logic is correct as far as it goes, it provides an unsatisfactory guide for policymakers, because it does not provide a means for determining whether creditors are justified in pulling away from other firms. After all, news that one firm has failed can be genuinely informative about fundamental prospects at other firms with similar exposures.

I do think there is a fundamental deficiency in the way our financial markets have performed. And you could describe this deficiency as an externality that leads both to the overexposure to risks in the financial system and to contagious reactions of markets to problems at one institution. But this externality is the product of government policy — namely, the provision of government protection to creditors through an ambiguous, implicit financial safety net. The widespread belief that some financial firms are too big or too "systemically important" to fail and their creditors will benefit from government support increases those firms' appetite for risk. In this setting, allowing a firm to fail creates contagion by forcing market participants to adjust their beliefs about the extent of future government protection.
Obviously, Lacker has a very different view of the world.

Now, since Kocherlakota sees the financial crisis as in part an externality problem, this gets him thinking about how we can use standard Pigouvian taxation to solve the problem. There's nothing new about that of course. For example, some of the IMF's taxation proposals (see my piece here) have that flavor.

Kocherlakota's idea is the following. Large financial institutions understand that they are too big to fail, and that they will inevitably be bailed out in a crisis. We would like to prevent these large financial institutions from taking on a level of risk that is in excess of what is socially optimal. However, monitoring what these financial institutions are up to is difficult and costly. Why not let the market help this solution along, much like a cap-and-trade arrangement for a pollution externality? Kocherlakota proposes a solution, somewhat reminiscent of Charlie Calomiris's subordinated debt proposal (see here), described as follows:
Here’s what I have in mind. Suppose that, for every relevant financial institution, the government issues a “rescue bond.” The rescue bond pays a variable coupon equal to 1/1,000 of the transfers actually made from the taxpayer to the financial institution or its stakeholders. (I pick 1/1,000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero. However, just like the financial institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In theory, or in a perfectly functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the financial institution’s stakeholders. Thus, the government should charge the financial institution a tax equal to 1,000 times the price of the bond.
Well, that seems appealing, but doomed to failure I think. As I discussed here, a key problem in the financial crisis was that assets were not correctly priced. If we can't price mortgage-backed securities, we do not have the ability to price rescue bonds correctly either. Further, the approach appears to warrant that the payoffs on the rescue bonds should include all of the benefits that financial institutions receive from the government. How do we account for the effects of monetary policy on asset prices, which could benefit banks and other financial intermediaries? What about the benefits from access to the discount window? Conclusion: There is no cheap fix here - you just have to bear the pain of figuring out how to correctly regulate the financial institutions. But if Canadians can do it right, we can too. I like this quote from Lacker's speech:
A compelling alternative premise, one that I personally believe is most likely to emerge as the consensus assessment among future scholars, is that the incentives created by the financial safety net were the chief cause of the financial crisis. Richmond Fed economists have conservatively estimated that in 1999, 18 percent of the U.S. financial sector was covered, or believed to be covered, by the implicit safety net.5 Another 27 percent received explicit protection such as deposit insurance, meaning that a total of 45 percent of financial sector liabilities benefited from explicit or implicit government safety net support. The implicit coverage was accounted for almost entirely by the housing government sponsored entities (GSEs) and several large commercial banks — all of which were important players in the build-up of risks related to housing finance over the last decade.

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