Quote of the day: On bank subsidies

By Matt Nolan 08/03/2013

Via this excellent review by John Cochrane, I decided to read “the banker’s new clothes“.  I’m only a small way in, but it already seem like a pretty good book, written for a non-technical type of audience.  Excellent.

My view has been that there is potentially some type of externality from bank’s actions (systemic risk stemming from asymmetric information and potentially linkages), and that there has been a implicit subsidy to  deal with this – and so the clearest solution would be to treat the lender of last resort function as enforced insurance … and make banks pay an insurance premium (*,*).

The book is taking a very similarish line, although it is focusing on capital ratios.  Essentially, banks become highly leveraged because debt is lower risk than capital funding when they go to borrow (as bondholders will get bailed out, but equity holders won’t) – so they appear to be pushing towards (as Cochrane is) much higher minimum capital ratios.  I would note that this is where the NZ Reserve Bank has been pushing regulation since prior to the crisis (to prove this I was looking for a paper I saw from 1999 … and ran into this bulletin from 1996!), and a number of measures have been introduced or are close.  By default I prefer price to quantity mechanisms, but I’m leaving myself open to be persuaded by the book.

In any case, the quote.  Here:

Subsidizing banks to borrow excessively and take on so much risk that the entire banking system is threatened is like subsidizing and encouraging companies to pollute when they have clean alternatives

On thing missing in the quote is the cost – we haven’t pinned down the true relative price for clean vs non-clean.  But adding a subsidy in the face of an externality is peverse, and is a good motivator for looking at the issue.