From the comments on this post.
if it were made clear that in the event of a crisis the shareholders would be wiped out and the bondholders would take whatever loss was required, then why should anyone care what financial structure an institution chooses?
This approach could have been taken in 2008. Several economists argued that Citigroup could have been handed over to the bondholders. Why wasn’t this done? Here are some possible adverse consequences:
1. Depositors will hear “Citigroup is bankrupt” and rush to pull deposits out, even though they are safe.
2. Holders of bonds at other banks will sell those bonds in order to buy safer assets.
Of course, these concerns can always be raised about bank debt. If the government will never allow bank debtholders to take a loss, then in effect we have 100 percent government guarantees to bank debtholders. Russ Roberts has argued vociferously that this is in fact the regime we have been under, and the consequence is that banks have the incentive to maximize their debt financing.
It appears that the government cannot credibly commit to letting bank creditors bear some of the losses from an insolvency. If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity.
You write, It appears that the government cannot credibly commit to letting bank creditors bear some of the losses from an insolvency. If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity.
There are a lot of “troubling concepts” coming out the above statement. The government may or may not let creditors bear some of the losses of banking insolvency. The government in no way, and at no time, can, or will force banks to have adequate capital structure; do you care to invest money in a bank? Just ask capital investors in emerging market countries that question, countries like the Philippines, Indonesia, Chile, Peru, India, and Brazil if they would like to invest in banks.
Please consider that the economic and political paradigm of LIberalism beginning in May of 2013, and running to August 2013, has shifted to Authoritarianism, and as such traditional thinking simply does not apply.
Under the sovereignty of democracy, Crony Capitalism Militarism, European Socialism, and Greek Socialism Clientelism, flourished as the Speculative Leverage Investment Community gave seigniorage, that is moneyness, to Nation Investment, EFA, and Small Cap Nation Investment, IFSM, Global Industrial Production, all of which soared in value based schemes of credit and carry trade investing, such as Dollarization, POMO, and the EURJPY.
Jesus Christ operating at the helm of the Economy of God, Ephesians 1:10, enabled the bond vigilantes to rapidly call the Interest Rate on the US Ten Year Note, ^TNX, higher to 2.01% on May 21, 2013, which terminated Emerging Market Investment, EEM, Utility Stock Investment, XLU, and Real Estate Investment, IYR, such as REM, REZ, ROOF, and FNIO. And the further fast rise of the interest rate on August 13 2013, to 2.71%, constituted an “apocalyptic event” which terminated fiat money, in particular Major World Currencies, DBV, and Emerging Market Currencies. And the announcement of war on Saturday, August 24, 2013, quickly drove the Interest Rate even higher to 2.78%, terminating Nation Investment, EFA, Small Cap Nation Investment, IFSM, and Global Industrial Production, FXR.
The monetary policies of the world central banks has exahusted, and have finally crossed the rubicon of sound monetary policy, and have turned “money good” investments bad. The Global Government Bond Bubble burst in May 2013 through August 2013, as is seen in the YTD Google Finance Chart of World Treasury Bonds, BWX, together with Ten Year US Treasury Notes, TLT, Emerging Market Bonds, EMB, Nation Investment, EFA, and Emerging Market Investment, EEM.
With higher interest rates, the sovereignty of nation states is collapsing, and the sovereignty of regional governance is rising as foretold in bible prophecy of Revelation 13:1-4, and Daniel 2:25-45.
Authoritarianism is the new global economic and political paradigm, and it is fathered by Angela Merkel, who is engineering the Debt Servitude economy, under the soverignty of regional governance and totalitarian collectivism; she is quoted by the Telegraph saying in the Telegraph, Greece should never have been allowed in the euro, and puts the blame on former chancellor Gerhard Schroeder. Daily Europe reports An article in newspaper the Tagesspiegel on Monday argued that Greece must be given more help, either by writing off some of its debts or with a fresh bailout, Commentator Harald Schumman argued.
With the failure of Credit, AGG, Money, DBV, CEW, and Wealth, VT, Jesus Christ, acting in dispensation, that is the oversight of all things economic and political, Ephesians 1:10, has completed the old things of liberalism and is bringing forth the new things of authoritarianism.
New dynamos are in operation. The dynamos of corporate profit and global growth were based upon investment opportunities in sovereign nation states, are powering down; now the dynamos of regional security, stability and sustainability, are powering up, reflecting responsibilities to regional authority.
A new seigniorage, that is a new moneyness, is developing. The seigniorage of investment choice, is waining; and the seigniorage of diktat is gaining strength.
A new trust is emerging. Gone is trust in bankers, carry trade investing and credit, in particular Treasury debt, to increasing trust in statist nannycrats, totalitarian collectivism, public private partnerships and debt servitude.
A new religion will emerge. Liberalism featured religions and philosophies based upon the worship of one’s own will, eventually a mandatory one world religion consisting of emperor worship will emerge; yet for the elect, that is God’s chosen ones, a persecuted faith in Christ
Liebertarian Robert Wenzel posts on democracy’s clientelism. De Blasio close to 40% in New York City mayoral race. With 13 days until the primary election, Public Advocate Bill de Blasio has surged ahead of the Democratic pack in the New York City mayoral race with 36 percent of likely voters, close to the 40 percent threshold needed to avoid a runoff, according to a Quinnipiac University poll released today. As mayor, I will spend every waking moment fighting to bring opportunity to every New Yorker, with a plan to create jobs in all five boroughs; a dramatic expansion of affordable housing and accessible health care; increas-ing taxes on the wealthy to fund early childhood and after school programs; and building police community relations that keep everyone safer. I comment that such Bill de Blasion agenda is a rear view mirror vision back into the age of liberalism, and an anachronism in the age of authoritarianism.
Ron Paul writes in Ludwig von Mises Institute Private property is the essence of liberty. I comment that the desire to develop and use private property is simpy a mirage on the Authoritarian desert of the Real. Genuine freedom, comes from possessing the life of Christ, Colossians 3:3-4, and experiencing Christ as the all inclusive life experience, Colossians 3:11.
Ellen Brown writes The leveraged buyout of America and Cliff Kule blogs America is headed toward a feudalistic economy. I add that soon the banks, every one of America’s banks, the Nasdaq Community Banks, QABA, the Regional Banks, KRE, the Too Big To Fail Banks, RWW, and the US Regional Banks, such as PNC, HOMB, STI, which were lagely recapitalized by QE I’s TARP in 2009, where Distressed Investments, such as those traded in Fidelity’s Mutual Fund FAGIX, were traded out for money good US Treasuries, which were placed in Excess Reserves, will effectively nationalized and integrated into the US Federal Reserve, and be known as Government Banks, or Gov Banks, for short.
Admati et al. have emphasized that we must look at how banks are funded, rather than look at their investments. In a M&M world, debt vs equity doesn’t matter. But as you explain, if bank debt is guaranteed, then banks will be very highly leveraged, and taxpayers end up paying for (subsidizing) the excessive debt load (relative to equity financing).
I agree that changing the rules of the game in the middle of a crisis is a bad idea, but now that the crisis is over (waiting for the next one…), it would be a good time to tell banks the rules are changing. Instead we have Dodd-Frank… ::sigh::
Instead we have Dodd-Frank…
As the 5 year statute of limitations passes by, we’re hearing news stories about who should face prosecution for the financial crisis.
These two always leap to my mind first. Pity they don’t leap to reporters’ minds.
A response to my initial comment, received privately, said:
“I think the banks’ argument was slightly different. It went like this: ‘many of our non-depositor creditors are essentially overnight lenders through repos, etc. Those creditors can and will act just like depositors–if they get a whiff of trouble, they will head for the exits. We will then have to sell off the assets that those short-term credits are financing. That will create trading losses for us that, due to mark-to-market accounting, will cause other financial institutions to recognize losses. Which will lead their short-term creditors to run for the exits.’
“The story is not implausible. It’s just that we could never have gotten to that point had not everyone involved been fairly confident that the government would come along and ‘save’ any large financial institution that got into trouble (by injecting funds, by guaranteeing short-term creditors, by arranging a merger–all have been done in the past). And as we saw with Fannie and Freddie, once the market has that expectation, no amount of the government saying ‘no, we really aren’t going to step in this time’ is credible.
“It’s an enormous problem with no simple solution, other than for the government to call the banks’ bluff next time out. But that will cause a lot of short-term pain (that will be more than offset by long-term gains) and I see no evidence that any member of the political class has the stomach for it.”
” If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity. ”
Actually, it would seem that taxpayers have an interest in the banks themselves – that is, a direct financial interest equivalent to the cost or market value of providing this kind of insurance product.
Maybe the trick is that Banks can structure their debt-equity ratios any way they want, but all the funds for bonds are borrowed from the treasury at the equivalent government rate plus a small amount extra.
In a low-equity-ratio scenario, when the bank goes bad, the shareholders get wiped out, and the government owns the bank outright and can auction it off (similar to FDIC). I’m guessing this prospect would encourage higher equity ratios.
“in effect we have 100 percent government guarantees to bank debtholders.”
Holders of sub debt have taken losses in some cases, at least in Europe. Holders of senior have not.