Well, when I\’m right I\’m right

From 1980 or so onward, however, that system gradually broke down, partly because of bank deregulation, but mainly because of the rise of “shadow banking”: institutions and practices — like financing long-term investments with overnight borrowing — that recreated the risks of old-fashioned banking but weren’t covered either by guarantees or by regulation. The result, by 2007, was a financial system as vulnerable to severe crisis as the system of 1930. And the crisis came.

Banking systems without deposit insurance are subject to runs. The modern banking system did not have deposit insurance on wholesale funding and as we found out, was subject to a run.

The solution to our problem is thus either having a system of deposit insurance for wholesale markets or….well, the only other alternative is to insist that there should be no wholesale funding.

And while I\’m well aware of things like moral hazard, not having wholesale funding looks like a much, much, more expensive proposition in the form of wealth not created.

Still, nice to have a Nobel Laureate on the liabilities tax side rather than the Robin Hood Tax side, isn\’t it?

5 thoughts on “Well, when I\’m right I\’m right”

  1. Surely the moral hazard can be dealt with by appropriate pricing of the deposit insurance? The problem with the current system is that the cost of government bailout (slightly higher taxes) is cheap to the people taking the direct risks (medium level commercial bankers, largely, not the Boards of Directors) compared to the potential bonuses.

    I suppose, if you take the public finances as a ‘commons’, it is really another aspect of that typical economic tragedy.

  2. Rather than insisting the poor tax payer gets fleeced why not not have higher capital requirements for banks that are higher risk?

    I starting to come around to the idea that banks shouldn’t have limited liability: banks becoming partnerships. That solves the moral hazard problem.

  3. “The solution to our problem is thus either having a system of deposit insurance for wholesale markets or….well, the only other alternative is to insist that there should be no wholesale funding.”

    It’s not so much a solution as a substitution of problems. You reduce the liquidity risk associated with bank runs, but at the expense of increasing credit risk. It’s moving the point of failure rather than irradicating it.

    If there is any hope of resolving the issue through regulation (which I’m still highly sceptical about), I think it’s more likely to come from tougher requirements on liquidity management and orderly wind-down plans than it is from deposit insurance.

  4. Kit: “Rather than insisting the poor tax payer gets fleeced why not not have higher capital requirements for banks that are higher risk?”

    There are (although that is subject to the problem of quantifying risk), but in the event of bank runs, they makes little difference. Capital requirements are a useful buffer against credit risk, as they allow the bank to absorb losses, but they’re generally useless when it comes to liquidity risk.

    If you haven’t got enough liquid assets to cover withdrawals as people demand them, it doesn’t really matter how much capital you’ve got.

  5. If you haven’t got enough liquid assets to cover withdrawals as people demand them, it doesn’t really matter how much capital you’ve got.

    Why not require the banks to hold a substantial percentage (e.g. 15-20%) of their liabilities in liquid assets, such as cash on deposit at the BoE or even actual cash, gold etc in their own vaults? The market value of a bank’s shares is a terrible thing to base capital requirements on, as the share price will be going down the toilet at the precise time this capital may be needed.

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