February 1, 2013

Bank Incentives

Blog friend EE has an article in National Review Online (well done, man!) on Reshaping Bank Incentives.

It's great in its own right, and it's EE. But what most grabbed me was that it solved a philosophical conundrum of mine. I gave Edward Conard's Unintended Consequences a five star Review Corner. And I'll stick by my lead paragraph: "Why didn't we nominate this Bain guy?"

Conard is a free market guy and smart as a whip. But Unintended Consequences advocates a huge role for the Fed and Treasury as lender of last resort. Without government playing JP Morgan's role, banks would have to devote too much capital to reserves, and growth would be stifled. Better to enjoy the benefits of liquidity -- and have Hank Paulson come in and mop things up after the party gets out of hand.

I know some ThreeSourcers are weeping in their cappuccinos over that last paragraph, but you have to accept the hossness of the source. It's a credible, Hamiltonian position, and Conard is no Karl Marx. He just accepts the Fed's maintaining guardrails. And I had no answer that was as sound economically as it was philosophically.

Until now. Hendrickson's "Double liability" strikes me as a free market answer to balance capital reserves with bank profits that facilitate growth. I wonder that you could not package the secondary assessments to shareholders as insurance and create a market for this risk (and trade derivatives off it, but I might be getting ahead of myself).

It is a thoughtful piece that contains a real solution and a free market solution to bank regulation.

Economics and Markets Posted by John Kranz at February 1, 2013 9:10 AM

I look forward to reading it in light of the story I heard on NPR this morning of the "too big to fail" Icelandic bank which did, indeed, fail. Iceland bailed out all depositors who vote in Iceland, but none from foreign lands. Other European states are stepping up to bail out the depositors who vote in their land. Who loses? Taxpayers. Who wins? Unclear. Still waiting for Jon Corzine to remember where he put those missing $billions.

Posted by: johngalt at February 1, 2013 3:36 PM

I still remember the day my mother explained depositor insurance to me as a young boy. "Even if the bank goes out of business, the government will make sure you get all of your money back." It seemed like a great reassurance to me at the time, but even then I did wonder where the government got the money to do this. More importantly though is the transference of risk that EE talks about. It's analogous to licensing a Fugu chef without first making him eat his own product. Someone may be harmed, even die, by his bad performance, but at least it won't be him. What's to worry about?

Posted by: johngalt at February 3, 2013 12:42 AM | What do you think? [2]