Notes from the Vault

Larry D. Wall
April 2013

Columbia University Professor Charles Calomiris presented an interesting but in many ways depressing paper coauthored with Stanford's Stephen Haber on financial system stability. The Atlanta Fed's Center for Financial Innovation and Stability cosponsored this year's conference, titled Maintaining Financial Stability: Holding a Tiger by the Tail. Calomiris argued that the structure and stability of the banking system is the result of a series of bargains between banks and governments that operate "according to the logic of politics and not the logic of efficiency." Taken to its logical extreme, Calomiris's discussion suggests that anyone working on proposals to enhance financial stability is mostly wasting his or her time—the stability of a financial system is largely determined by political negotiations in which those outside the political process are unlikely to play a substantial role. I will present a somewhat less bleak picture, arguing that at least some unstable systems will create brief opportunities for reforms that could have lasting effects.

Calomiris and Haber thesis
The Calomiris and Haber thesis begins with the proposition that banking—and more generally financial—systems are the outcome of implicit partnerships between the government and private actors. The government supplies banks with the legal framework needed to protect various suppliers of funds from expropriation by others. In return, governments typically expect banks to take certain actions in support of the government's political objectives. The resulting financial system is based on a series of bargains as mentioned above.

Calomiris and Haber use this framework to understand the deals that have been reached in various countries over time. As decisions are driven by political considerations, some countries reach bargains that are supportive of financial stability while others reach deals that produce frequent instability. For example, in the United States the joint efforts of unit bankers and agrarian populists resulted in a highly fragmented, under-diversified banking system that went through a number of crises in the 19th and 20th centuries.

Credit guarantee programs in the United States
While the contemporary bargaining game affects the U.S. financial system in a variety of ways, arguably the current favorite mechanism for directing financial resources is explicit and implicit government guarantees. Calomiris and Haber point to the creation of the Federal Deposit Insurance Corporation (FDIC) as being intended to support the populist unit banking system. Some other examples of entities created to influence credit allocation include Fannie Mae, Freddie Mac, Federal Housing Administration, Small Business Administration, various student loan programs, and Farm Credit System.

Credit guarantees appear to be an efficient mechanism in political bargaining terms. Borrowers obtain an immediate benefit in the form of more and lower-cost credit. However, the government does not immediately recognize their full cost in its budget, according to MIT Professor Deborah Lucas. These credit guarantee programs are often inefficient, with a substantial part of the benefit accruing to lenders and those related to the borrowers' use of funds (such as cheaper home mortgages resulting in higher prices for existing homeowners and more business for real estate agents). However, while the spillover of gains may be economically inefficient, it likely adds to the political appeal of the guarantee by expanding the supporting coalition.

The one vulnerability of credit guarantee programs is that their value to borrowers is linked to their eventual cost to taxpayers. Government credit guarantees are valuable to lenders precisely because there will be occasional periods where many borrowers will default and the taxpayers will have to make good on the guarantee. Moreover, the value of the guarantee increases with the amount of risk being taken. The result is that credit guarantee may have long periods of no losses, but these are likely to be punctuated by occasional periods of very high losses to taxpayers. When taxpayers suffer losses, there is usually political pressure to adopt a bargain that is friendlier to taxpayers.

Preparing to seize the moment
When taxpayer funds are needed, those who had not previously benefited from the guarantee often demand changes to reduce taxpayer risk exposure. Congress frequently responds to these demands by passing reform legislation and then claims the problem is solved. Unfortunately, the political economy discussed by Calomiris and Haber suggests that the problem will never be permanently solved. However, some solutions are likely to prove more effective over longer periods of time than others. The key is for analysts to identify solutions and craft them into workable proposals to be advanced when the next blowup refocuses congressional interest.

A common response to recent large losses in a credit guarantee program is to identify the specific mistakes that were made in the past and mandate new regulations to prevent a repetition. An example is the so-called Volcker Rule, which is intended to limit banks' exposure to speculation in financial markets. While such efforts have some value, they are likely to fall far short of being a solution for at least three reasons. First, those that benefit from the guarantee will seek to have the legislation and implementing regulations written in a way that imposes minimal limits on their behavior. Second, after the regulations are adopted, those who would be constrained by them look for methods that comply with the letter of the regulations but violate their spirit. Third, the beneficiaries will seek and likely find new ways of increasing the value of the credit guarantee.

Another common response is to expand supervisory discretionary power to address emerging methods of increasing the value of the credit guarantee. This response may also be helpful but is unlikely to solve the problem. Supervisors are at an information disadvantage in terms of understanding the latest developments in detail. With supervisory pay scales set to government limits, many of the best supervisors are likely to move to higher-paying industry jobs. Moreover, supervisors are part of the political system that created the problem and have their own sets of conflicting incentives. As a result, many times the losses leading to congressional action arose in part because supervisors failed to use their discretionary powers fully.

Two policy analysts, George Benston and George Kaufman, attempted to develop a way of backstopping other supervisory and regulatory systems with a fail-safe mechanism. The idea behind their proposal was that supervisors could exercise discretion while a bank remains healthy, but that this discretion would be taken away as the bank's capital level fell through a series of trigger points. Congress ultimately passed a version of their plan, called prompt corrective action (PCA), in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). However, as a review paper by Bentson and others points out, PCA trigger points are based on accounting values rather than the economic values advocated by Benston and Kaufman. As a result, many banks avoided triggering PCA during the recent financial crisis by refusing to recognize losses until shortly before they failed.

Options currently being discussed
Given the demonstrated inadequacy of relying solely on stricter supervision and regulation, policy analysts have suggested a number of alternatives to reduce expected losses from credit guarantee programs, especially those related to deposit insurance.

An obvious solution to an expensive credit guarantee program is to repeal it. However, total repeal is likely to prove difficult in practice as the beneficiaries of the program would fight to maintain some guarantees. For example, the collapse and bailout of Fannie Mae and Freddie Mac would seem to provide an opportunity to reduce the federal government's exposure to residential real estate. However, W. Scott Frame's, Lawrence J. White's, and my survey of outstanding reform proposals found that almost all of them call for continuing government guarantees similar to those provided by the two housing government-sponsored enterprises.

If the guarantee cannot be eliminated, perhaps its expected cost can be reduced to near zero, especially if the guarantee is of a bank's or other financial corporation's liabilities. One such approach seeks to put the firms into resolution while their losses are small. In a companion piece on the conference proceedings in macroblog, Paula Tkac and I will review some of the difficulties in adopting a credible resolution regime for the largest financial firms.

Another way to almost eliminate the value of guarantees of corporate debt issued is to immunize the firm from failure. Two variations on this approach have been advocated for banks. The first proposal is to create "safe banks" by making a bank's portfolio very low risk, such as limiting the bank to holding only short-term Treasury and possibly other highly rated obligations. The other approach is to require them to maintain capital at levels that would all but prevent their failure. Anat Admati, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer advocate raising equity capital to levels that would reduce the risk of failure to near zero. A potential problem with these proposals is that they may drive risk into other parts of the financial system that will be viewed as systemically important in some future crisis.

An alternative to very high equity capital ratios, proposed by University of Florida Professor Mark Flannery, is that large banks issue bonds that would be convertible into equity (contingent convertibles or CoCos) if the bank's capital ratio, measured in market value terms, falls below a prespecified level. Flannery's proposal avoids the concern that very high required equity levels will drive activity into less regulated intermediaries. However, it raises a new set of concerns about whether and how the supervisory use of market prices would change the way these prices are set in financial markets.

Finally, some proposals start with the proposition that one important reason for the buildup in taxpayer exposure is that it is too costly for taxpayers and other interested parties to understand fully the growing risk in credit guarantee programs. These proposals, which might be called monitored supervision and regulation, seek to provide such information to encourage earlier action by Congress and the prudential supervisors.

Williams College Professor Gerard Caprio's presentation at the Financial Markets Conference and his coauthored book support the creation of a "sentinel" of the financial system that would monitor and evaluate bank supervisors from the perspective of the public. Boston College's Edward Kane proposes that banks estimate and report the value of their government guarantee. In an earlier working paper, I recommended that the macroprudential supervisor establish regular reviews of major financial markets (such as the market for residential mortgage-backed securities) to identify weakening of underwriting standards and other flaws that would pose a systemic risk. A concern with these approaches is whether identifying the existence and potential magnitudes of taxpayer exposure would be sufficient to induce supervisory and/or congressional action. Or would those benefiting from credit guarantees be able to deflect action by downplaying these "hypothetical concerns"—until, that is, the concerns are no longer hypothetical?

Calomiris and Haber provide considerable evidence that the efficiency and stability of financial systems are largely the result of bargains struck by market participants and key players in the political system. If their analysis is taken to its logical conclusion, it implies that while analysts can develop proposals to reduce financial system risk, the proposals are unlikely fundamentally to change these political bargains. I argue that this bleak interpretation of Calomiris and Haber somewhat overstates the problem, as the political system is open to risk reducing forms after taxpayers have taken significant losses. But solid proposals must be established to take advantage of these fleeting opportunities.

Larry D. Wall is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail