Ricardo Caballero is once again proposing that the government insure private financial institutions against risk. His theory is that there are no solvency crises, only liquidity crises, and therefore public insurance is needed to support asset prices. (“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.”)
Caballero is opposed to the resolution of failed financial firms, because decisions made during the resolution would be based on panic prices and therefore error-prone. Thus resolution, he believes, would only fuel the panic.
I would like to know what Caballero thinks of the idea that whole debt structure (excluding deposits) of financial firms should be convertible in tiers. By insuring that banks have ample access to capital when they need it, a convertible debt structure guarantees that resolution will occur only when bank assets fall so low that they can’t even support the bank’s deposits. As long as Caballero’s theory that all crises are liquidity crises is correct, conversion into equity will be in the interests of bank creditors because they will earn spectacular gains as the economy recovers from the crisis that triggered the conversion. And if Caballero is wrong and there are solvency crises, then the policy insures that it is the creditors of the firm — instead of the government — that bear the cost of the crisis.