Tuesday, 17 November 2009
How should governments respond to sudden failure of the financial system? This column says that it is neither credible nor desirable to refuse to assist the private sector in financial crises. It makes the case for massive provision of credible public insurance and guarantees to financial transactions and balance sheets - a financial defibrillator to respond to sudden financial arrest.
"Sudden cardiac arrest (SCA) is a condition in which the heart suddenly and unexpectedly stops beating. When this happens, blood stops flowing to the brain and other vital organs…. SCA usually causes death if it's not treated within minutes…."
- US National Institute of Health
There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as a sudden cardiac arrest (SCA). By analogy, I refer to its financial counterpart as a sudden financial arrest (SFA).
When an economy enters an episode of SFA, panic takes over, trust breaks down, and investors and creditors withdraw from their normal financial transactions. These reactions trigger a chain of events and perverse feedback-loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis. In this article I draw on the parallels between SCA and SFA to characterise the latter and to argue that a pragmatic policy framework to address SFA requires a much larger component of systemic insurance than most policymakers and politicians currently support.
Risk Factors and Preventive Medicine
An important risk factor behind SCA is coronary artery disease, and the front line for its prevention is a healthy lifestyle. However, the medical profession is keenly aware that people make poor choices regardless of warnings and that even those who do adopt a healthy lifestyle and have no known risk conditions may still experience a fatal SCA episode. The pragmatic response to these facts of life is to complement preventive healthy lifestyle guidelines and advise with an effective protocol to prevent death once SCA takes place. The main (and perhaps only) option to treat SCA once triggered is the use of a defibrillator. Moreover, the window of time for this treatment to be effective is very narrow, just a few minutes, making it crucial to have defibrillators readily available in as many places as is economically feasible.
Need for a Financial Defibrillator and Fuzzy Moral Hazard Reasoning
Unfortunately, the pragmatic approach followed by the medical profession in reducing the risk of death associated with SCA contrasts sharply with the stubborn reluctance to supplement the financial equivalent of policies reducing coronary artery disease-risk (mostly regulatory requirements) with an effective financial defibrillator mechanism. The main antidote to SFA is massive provision of credible public insurance and guarantees to financial transactions and balance sheets. In this analogy, these are the financial equivalent of a defibrillator.
The main dogma behind the great resistance in the policy world to institutionalise a public insurance provision is a fuzzy moral hazard argument: If the financial defibrillator were to be implanted in an economy, the argument goes, banks and their creditors would abandon all forms of healthy financial lifestyle and would thus dramatically increase the chances of an SFA episode.
This moral hazard perspective is the equivalent of discouraging the placement of defibrillators in public places because of the concern that, upon seeing them, people would have a sudden urge to consume cheeseburgers, since they would realise that their chances of surviving an SCA had risen as a result of the ready access to defibrillators.
But actual behaviour is not so forward-looking and rational. People indeed consume more cheeseburgers than they should, but this is more or less independent of whether defibrillators are visible or not. Surely, there is a need for advocating healthy habits, but no one in their right mind would propose doing so by making all available defibrillators inaccessible. Such policy would be both ineffective as an incentive mechanism and a human tragedy when an episode of SCA occurs.
By the same token, and with very few exceptions (Fannie and Freddie?), financial institutions and investors in bullish mode make portfolio decisions that are driven by dreams of exorbitant returns, not by distant marginal subsidies built into financial defibrillators. Nothing is further from these investors' minds than the possibility of (financial) death, and hence they could not ascribe meaningful value to an aid which, in their mind, is meant for someone else. This is simply the other side of the risk-compression and undervaluation during the boom phase. Logical coherence dictates that if one believes in this undervaluation, then one must also believe in the near-irrelevance of anticipated subsidies during distress for private actions during the boom.
Of course, once the crisis sets in, insurance acquires great value and leads to more risk-taking and speculative capital injections into the financial system, but by then this is mostly desirable since the main economy-wide problem during a financial panic is too little, not too much, risk-taking. The last thing we need at this time is for creditors to panic and shortsellers to feast, as they suddenly realise that financial institutions can indeed fail from self-fulfilling runs, fires sales, and liquidity dry-ups, for which there is no counteracting policy framework in place aside from ill-timed "market discipline" or high-risk surgery. Indeed, attempting to "resolve" a large and interconnected institution in the middle of a panic, when asset prices are uninformative and hence "resolution" decisions are largely arbitrary, carries the serious risk of adding fuel to the fire (panic).
What to Do when SFA Occurs
In any event, when SFA does take place, it becomes immediately apparent to pragmatic policymakers that there is no other choice than to provide massive support to distressed institutions and markets, but since the channels to do so are not readily available, precious time and resources are wasted groping for a mid-crisis response (recall the many flip-flops during the early stages of the TARP implementation). If one is of the view (which I am not) that hubris plays only a small role during the boom and instead it is all about incentive problems due to anticipated subsidies during distress, then one must believe that savvy bankers and their creditors anticipate intervention anyway. Hence the incentive benefit of not having financial defibrillators readily available does not derive from the absence of a well designed ex ante policy framework but from the real risk that improvised ex post interventions may fail to be deployed in time to prevent death from SFA. This logic seems contrived at best as the foundation for a policy framework that does not include readily available financial defibrillators.
SFAs will Continue to Occur Regardless of Regulation
In summary, it is a fact of life, and of cognitive distortions, financial complexity, and innovation in particular, that SFA episodes will continue to happen regardless of how much regulatory creativity policymakers may muster. The absence of a financial defibrillator is a very weak incentive mechanism during the boom phase and a potential economic tragedy during a financial crisis. We need a more pragmatic approach to SFA than the current monovision coronary-artery-disease-style, hope-for-the-best, approach. We need to endow the policy framework with powerful financial defibrillators.
Modern economies already count on one such device in the lender of last resort facility housed at the central bank, but this has clearly proven to be insufficient during the recent crisis. I discuss three supplements to this facility:
-Self insurance, which is where policymakers' instinct lies. In the current context this is reflected in a call for higher capital adequacy ratios, especially for systemically important financial institutions.
-Contingent capital injections, which is where most academics' instinct lies. The basic idea is to reduce the costs associated with holding capital when is not needed. Proposals primarily differ on whether the contingency depends on bank-specific or systemic events, and on whether the source of capital is external to the distressed bank or internal (as in the debt-convertibility proposals).
-Contingent insurance injections, which is the most cost effective mechanism for the panic component of SFA. The basic idea is that the enormous distortion in perceived probabilities of a catastrophe during panics can be put to good use since economic agents greatly overvalue public insurance and guarantees. Providing these can be as effective as capital injections in dealing with the panic at a fraction of the expected cost (when assessed at reasonable rather than panic-driven probabilities of a catastrophe).
In practice, there are good reasons to have in place some of each of these types of mechanisms. For normal shocks, it is probably easiest to have banks self- and cross-insure. For large shocks, there is always a fundamental component, which is probably best addressed immediately with contingent capital (private at first and in extreme events, public). However, the large panic component of an SFA episode requires large amounts of guarantees, which would be too costly and potentially counterproductive (if they add to the fear of large dilutions) to achieve through capital injections. For this component, a contingent-insurance policy is the appropriate response.
One particularly flexible form of a contingent insurance program is the Tradable Insurance Credits proposed in Caballero and Kurlat (2009a). These act as contingent (on systemic events) CDS to protect banks' assets against spikes in uncertainty. They are a (nearly) automatic, pre-paid, and mandated mechanism to ring-fence assets whose price is severely affected by SFA, as it was done ex post in the US for some Citibank and Bank of America assets and was offered more broadly in the UK.2
The International Dimension
The international dimension of SFA adds its own ingredients. I focus on the problem for emerging markets which has a close parallel with the issues faced by the financial sector within developed economies.
For emerging markets, it is often the case that the sovereign itself becomes entangled in the crisis as the main shortage is one of international rather than (just) domestic liquidity. Most policymakers in emerging economies are acutely aware of this danger, which is one of the main reasons they accumulate large amounts of international reserves. However, large accumulations of reserves are the equivalent to self-insurance for domestic banks - they are costly insurance facilities. For this reason, many of us have advocated the use of external insurance arrangements, and the IMF has spent a significant amount of time attempting to design the right contingent credit line facility.
In the full paper from which this column is drawn, I propose a system akin to the Tradable Insurance Credits but aimed at supporting the value of emerging market new and legacy emerging debt during global SFA episodes. I refer to these instruments as E-TICs and envision them as being controlled by the IMF rather than by the US or other developed economies' governments.3
Editor's note: This column is drawn from Ricardo Caballero's Mundell-Fleming Lecture, delivered at the Tenth Jacques Polak Annual Research Conference, IMF, 5-6 November 2009.
Footnotes
1 One way to get a sense of how much the market values the "too big to fail" insurance provided by the government is to compare the cost of funding for small and large banks. Baker and McArthur (2009) compare the average costs of funding for banks with more than $100 billion in assets to the average costs for banks with less than $100 billion. They find that between the first quarter of 2000 and the fourth quarter of 2007, the large banks' costs were 0.29 percentage points lower than the small banks, averaging across time. Between fourth quarter 2008 and second quarter 2009, the spread increased to 0.78 percentage points. Clearly, there are many reasons why larger and smaller banks can have different costs of funding: different types of assets, different amounts of leverage, and so on. Baker and McArthur (2009) take the difference between these spreads, 0.78 minus 0.29, as a crude upper-bound on the subsidy associated with the solidification of the "too big to fail" policy after Lehman's collapse. I would suggest an alternative interpretation: During boom times, the "too big to fail" insurance was there but of little importance, while during the crisis, it became much more important and probably a source of stability.
2 It turns out that the Bank of America deal was never signed, but the perception that it had been was enough to contain the panic. The UK system was less successful in terms of the takers than it would have been socially optimal because it was voluntary and very expensive. Both aspects would be improved by the Tradable Insurance Credits framework.
3 For developed economies, the international liquidity shortage problem is much less significant and it was appropriately dealt with the swap arrangements between major central banks. These should remain in place, at least on a contingent (to SFA) basis. A more delicate problem for these countries stems from the high degree of cross-borders interconnectedness of their financial institutions and the potential arbitrage and free riding issues that may emerge from differences in the type of financial defibrillators available. This raises international coordination issues which I don't develop in this paper but that obviously need to be addressed.
References
Baker, Dean and Travis McArthur (2009), "The Value of the "Too Big to Fail' Big Bank Subsidy." Center for Economic Policy and Research Issue Brief. September.
Caballero, Ricardo J. and Pablo Kurlat (2009), "The "Surprising" Origin and Nature of Financial Crises: A Macroeconomic Policy Proposal." Prepared for the Jackson Hole Symposium on Financial Stability and Macroeconomic Policy, August.
Ricardo Caballero © voxEU.org
