Simple Logic is Enough

Filed Under (Finance, U.S. Fiscal Policy) by Don Fullerton on Jun 15, 2012

Despite being in a Department of Finance, my own background and research is in economics and public policy (hence the “Center for Business and Public Policy” in our department).  I don’t claim expertise in finance, per se.   On the other hand, it seems that both sides of the JP Morgan debate are using discussion of the Volcker Rule and their other financial expertise to obscure the basic logic of government bank regulation.  It is a basic logic of incentives, which does not require expertise in finance!

JP Morgan wants to make money; we can hardly blame them for that.  In economics generally, we let companies try to make money, as they have the expertise in their own line of business to determine the risk-reward tradeoff.  If they lose money, then they lose money.  They might even be able to buy various kinds of insurance – that’s between the company and their insurer.  A person or company with insurance might have incentive to undertake riskier activities, since any gains are retained, while losses go to the insurer.  But the insurance company might enter the deal willingly, to charge premiums, especially if it can require the company or person to limit some of their riskier activities.  Your auto insurance has co-insurance and deductibles, to make you pay at least part of a loss and to restore some of your incentive for precaution.  

But when a bank becomes “too big to fail”, the U.S. government is thrown into the role of insurer, without being able to collect premiums, co-insurance, or deductibles.  It is not a “deal” between the bank and their insurer, because the government has no choice.  Because of financial contagion, a single major bank failure could bring down the whole system and cause horrific recession.

Given that the bank’s biggest losses must be covered by their insurer (the U.S. government), the bank has more incentive to undertake even riskier activities: they get any profits, and they don’t suffer the worst losses.   Any private insurer would require the bank to limit their riskiest activities, in order to be willing to sell that insurance.  But the government is the insurer by default, with no private “deal” allowing the government to require limits on the riskiest activities in order to be willing to offer that insurance.

To be sure, the bank still must be careful about some risks, as many different kinds of losses would reduce their profits without requiring government bailout.  The recent JP Morgan case did not create danger of bankruptcy or bailout, because their $2 billion loss on that one operation only offset part of their positive profits!  But any bank that is “too big to fail” has less incentive to avoid the really big losses that could cause bankruptcy, because that would require the government to bail them out.

The government could pass laws and regulations to limit the banks’ riskiest activities, and that is the purpose of the much discussed Volcker Rule.  I will leave the discussion of the details to the experts in finance.  For example, the Volcker Rule may or may not be the best way to regulate banks.  The effects depend a lot on the rule’s design, implementation, and enforcement!  Maybe some other rule or incentive-management would be better.  I will leave those details to the experts.  Instead, the point here is just the simple logic that the government is not a private insurer who would require limitations on risky activity to be willing to sell insurance.  The government must provide insurance, so they must have some kind of regulation to limit banks’ risky activities: higher capitalization requirement, Volcker rule, or other regulations.   

I did in fact talk to some of the finance department’s experts, like Jeff Brown and George Pennacchi.  George notes that “the incentive to take big risks declines as a bank finances itself with more shareholders’ equity (capital), and in JPMorgan’s defense they are one of the most highly capitalized banks, which helped them survive the crisis.”  He adds that “If banks carry government deposit insurance, whether explicit or implicit due to Too-Big-to-Fail, then the government should limit their activities to protect taxpayers from losses.”  Moreover, “it is noteworthy that, prior to the establishment of deposit insurance in 1933, banks had much greater capital (financing via shareholders’ equity) and made much less risky loans. … Indeed, there are several recent “narrow bank” proposals to greatly limit the activities of banks that issue insured deposits.”  He has a review of the topic on his website (forthcoming in the Annual Review of Financial Economics).

The bottom line is that in a private deal between a bank and its insurance company, the bank would have to agree to limit risky activity in exchange for being able to buy this insurance.  With government as insurer, they get the insurance regardless.  So just look at their incentives!  The banks have incentive to make money, and so they have incentive to take more risks since they can keep any profits and not cover the biggest losses.  AND they have incentive to lobby Congress to avoid government regulations.  We switch from a private market “deal” to the world of politics!  If they can get Congress to limit regulation of banks, they can make riskier investments, make more money, and not have to cover the biggest losses.

So just think about those incentives, next time you hear a bank executive use the jargon of financial expertise to make the case against “unfair interference by government regulators into the private market”.