“Society always stands as the loss-absorber of last resort” — TED
“There will always be a tail of financial risk that society must absorb” — David Murphy
[Note: TED deserves a more thorough response than I have time for right now, but David Murphy’s riff on TED’s latest post generated this brief reply — using time that really should have been devoted to one of my three deadlines. More to come, but maybe not for a week or so.]
Needless to say I can’t judge the truth of David Murphy’s statement about the future, but the historical evidence is clear: society as a whole has not always stood as the loss absorber of last resort for the financial system. (Asteroids, I hope we can all agree, belong to a different class of events). Our banking system was founded in an environment where the bankers absorbed the losses. Crises were costly, because bankers’ assets were wiped out.
(Note: in environments without lenders of last resort, society tended to bear more of the losses, after the bankers were wiped out because there was so much collateral damage — e.g. Venice 1300 – 1600. In a traditional environment with a lender of last resort, e.g. England 1763 – 1900 or so, the last resort lender has to fail before society bears a significant portion of the losses. Note that the Depression can be viewed as the failure of a last resort lender, since the Bank of England went off gold.)
Treating society, and not the bankers, as the financial system’s “loss absorber” is a new phenomenon, for which the seeds were laid in the reforms of the 1930s. The evidence lies in the facts: the Federal Reserve’s non-recourse loan supporting the purchase of Bear Stearns and the TARP legislation were unprecedented events in the nation’s history. We are treading new ground here – and the response of the financiers is to try to persuade us that society has “always” passed bills bailing out bankers. Nonsense.
I think that Mr. Murphy’s approach to “tail risk” illustrates the dangers of “putting financiers less on the hook.” The business of banking used to be about how one can lend without losing money, it used to be about how to turn ordinary commercial loans (and I mean whole loans) into safe assets. Banking was based on “the science of credit” (Thorton in 1801) and careful underwriting of short-term loans was the bread and butter of banking.
I am happy to acknowledge the theoretic possibility that putting financiers less on the hook is better for society, I just don’t see many facts that support the theory. The facts indicate that putting financiers “less on the hook” (starting in the 1930s with ever more support from the 1980s on ) and then forcing them to compete with each other (mostly after the 1980s growth of money market funds, commercial paper markets, repeal of Reg Q, etc.) induces them to issue loans without underwriting them – and to be unwilling to lend even to each other without collateral. How’s that supposed to be good for society?
I don’t get why arguing that requiring that financial tail risk be born by those who make the decisions determining how much financial tail risk society will have to bear constitutes a “knee-jerk response which is unlikely to lie on the efficient frontier.” Especially given the amount of money financiers manage to make while creating that excessive measure of tail risk. In economic terms, the standard description of such an argument is internalizing an externality – and it is very likely to bring society closer to the efficient frontier.
In short I agree with TED entirely when he writes:
the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects
It is precisely because the current allocation of financial losses is undermining our living standards — and gives every appearance of continuing to make them worse — that we need to reallocate financial risk to ensure that financial tail risk is correctly priced. The easiest way to do so is to make those who are in a position to price that risk, bear it. But I’m open to other suggestions.
Updated 2-7-12: “the” removed from title and replaced with “some.” See Sonic Charmer’s comment below.
Synthetic Assets 
I agree that banks themselves should bear more of, not socialize, their risk. My question to you is who needs convincing? Certainly it’s not surprising that many (not all) financiers are only too happy to make the self-serving argument that their losses should be socialized. But the important question is why do politicians go along with it? And why do (some) economists support such bailouts with their theories/fears about ‘systemic’ crises?
P.S. At some point could you elaborate on your distaste for banks posting collateral (before you had advocated a ‘prohibition’ on the ‘posting of’ collateral by large financial institutions). This is just my ignorance, because I’ve never encountered such a view, which seems to go against the grain of most conventional wisdom, which (post-Lehman) is hugely concerned about ‘instability’ due to how ‘interconnected’ financial actors all are, and the favored technocratic solutions mostly involve *requiring* collateral (or at least a shift to clearing houses – which amounts to the same thing) as a Good Thing(tm). For example I believe Dodd-Frank increases/hardens collateral requirements for derivative trades. New Basel capital rules will penalize counterparty risk more, which (I’m waving my hands here, but I think it’s essentially right) should ultimately end up with banks requiring more collateral from each other. Etc. Interested to hear your anti-collateral thoughts when you get a chance!
Best,
” and to be unwilling to lend even to each other without collateral.”
Not unwilling, the regulators have made unsecured lending very expensive by imposing capital charges on *undrawn* lines (which was not the case under basel I).
I think my point was that,whether or not there exists an explicit lender of last resort or not, society by definition bears financial loss in excess of financiers’ ability to absorb it, The question, I think we all agree, is where to draw the latter line.
I look forward to your more lengthy demolition of my post.
I have to agree that TED has a point. Society inevitably was always the loss-absorber of last resort. What has changed in this crisis is that loss-absorbing by the society has become the first resort, before wiping out equity and bondholders.
It may not have always been true. What about warlike societies from over a millennium ago?
What’s worse is that once you move from a system in which it is the financier’s job to prudently lend while avoiding losses to one where is is the financier’s job to maximize gains at all cost while pushing all risks into the long tail of the short-term probability distribution, then you are shifting risks from the long tail up to the fatter parts of the curve.
This is because the real tail risks are systemic. Once all financiers are aligned on this type of role, you guarantee that when one hits the tail risk that they all will. That means that the tail risk is not as “tail” as we might think (and some might argue).
Actually, society does not have to be the loss absorber for financial losses. Banks can still perform this function even with owners having limited liabilities.
As I discussed in a post, what to do with financial tail risk (http://tyillc.blogspot.com/2012/02/what-to-do-with-financial-tail-risk.html), banks are fully capable of absorbing all the losses from the financial excesses they created today and rebuilding their book earnings through future earnings and equity sales.
I realize that banks absorbing the losses today will not make either their stockholders or employees happy, but the employees made the decision to expose the bank to financial risk and the stockholders did not reign them in.
As a partial solution, why not expose the bank managers to unlimited liability? I realize that this might adversely select for managers with no caution, but at least the public would have a sense of justice that metaphorically the captain and crew went down with the ship.
This is essentially the position they held when the investment banks and exchanges were mutualized – in the days before they slipped under the limited veil of incorporation.
Is there a correct price for risk?