Tuesday, March 26, 2013

The Other Shoe Drops

Fresh from the unusual (whether it turns out well or not, it certainly was handled differently) crisis in Cyprus, there’s this from the current head of the Eurozone:

If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?' …

If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders. …

"We should aim at a situation where we will never need to even consider direct recapitalisation," …

"If we have even more instruments in terms of bail-in and how far we can go on bail-in, the need for direct recap will become smaller and smaller."

So, here we go again: uninsured depositors are on the hook for a Cyprus-style bail-in in other Eurozone countries too. Watch out if you live in Spain, Ireland or Italy.

Note that he doesn’t say they’ll take money from insured depositors. That’s a lark. Here’s what everyone’s going to do now. If you have 200K in an account, only 100K of which is covered by a deposit guarantee, then you’ll split it into 2 accounts of 100K which are both guaranteed. The only reason people haven’t done this before is inconvenience. So, it’s reasonable to conclude that by the time the next crisis hits, there will only be insured deposits to call on for a bail-in.

On one level, the Eurozone’s position isn’t a horrible policy. These banks that are in trouble get this way by offering high rates of return to depositors. They get those high rates of return by making risky investments with the depositors money. High risk means you lose sometimes, but deposit insurance means you don’t have to worry about that. It’s heads-I-win, tails-you-lose. Getting depositors on the hook is just changing the tails-you-lose part to tails-I-lose.

The problem that the Eurozone has is that it has invited countries into this single overarching monetary system, with lender-of-last-resort power. But it hasn’t integrated their regulatory systems quite as well. And it’s opened up borders to financial transactions. So the customer in, say, Austria, can deposit their money in Spain’s heads-I-win-tails-you-lose bank, or in Finland’s heads-I-win-tails-I-lose bank. We shouldn’t be surprised that they choose the Spanish bank.

Hold that thought. Back to the current head of the Eurozone, who also said this:

Macro-economic adjustment programmes are tailor-made to the situation of the country concerned and no models or templates are used …

This is really bad.

Kydland and Prescott were awarded a Nobel Prize for their work in the 1970’s that government’s get themselves into trouble when they use their own discretion rather than some fixed rule to determine policy responses. This problem is known as time inconsistency.

It goes like this. There’s a game between the public (like, say, a bank) and the government. The bank knows that if it screws up, the government will bail it out. This encourages it to incur more risk. No surprise there. But Kydland and Prescott noted that it can be optimal for a government to 1) say truthfully that it won’t bail out the bank before there is a need to, and then 2) change their mind when the bail out is needed. Now here’s the kicker: the optimal response of a bank is then to incur the risk and force the government to do exactly this.

Think about that for a minute: it’s saying that the outcome of optimal choices is for banks to take on too much risk and government to back them up. The world would be a better place if this didn’t happen; which makes this a form of prisoners’ dilemma.

The solution to this is some sort of binding rule on government behavior that makes # 2 impossible. Say, a rule that says the government can never bail out anyone.

Thirty-five years after Kydland and Prescott’s publication, and ten years after they were recognized for it with a Nobel Prize … the head of the Eurozone doesn’t get it yet.

But, more generally, the whole Eurozone doesn’t get it either. The inconsistency between having a unified monetary system and a non-unified regulatory system is also a rules vs. discretion problem. The Eurozone has some rules for admittance (it came out last year that Greece lied left and right to get in), but is still harboring the illusion that bank regulation and deposit guarantees can be handled at the state level. They haven’t admitted to themselves yet that this doesn’t work.

I am not claiming this is easy or fun for taxpayers and policymakers in the better regulated economies. We can and do have the potential for the same sort of problems in the U.S. But, we have recognized through trial and error the benefits of a more centralized regulatory system. Think about it: you might shop for a cheaper financial firm on the internet, and when you find one it’s more than likely because they have reduced brick-and-mortar costs … not because of the particular state they happen to be headquartered in. In the Eurozone, it’s the other way around.

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