Simon Wren-Lewis and I may disagree on many things, but not on this.
Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.
Read the whole thing. Pointer from Mark Thoma
Corporate finance has a menu of financing options that reflect varying levels of risk — common stock; preferred stock; debt secured by specific assets; general debt; convertible — with returns and risk neatly calibrated. Furthermore, in corporate finance, it is known that the greater the leverage the greater the risk. If you are 3% equity financed, then a 3% loss wipes you out. After that, losses are distributed to the more senior financiers in accord with the bargains.
So why, in the endless discussions of banks, are the choices limited to “equity” and “debt”? And why is it assumed that there must be more equity because OF COURSE the bondholders will not be allowed to suffer a loss? (For the big banks during the crisis the stockholders were also bailed out, and so were the bonus babies.)
My understanding from people in the business is that during the crisis the banks maneuvered brilliantly to convince the government that it could not give the bondholders a haircut without also hitting the depositors. In fact, the structure of the financing system is such that that the bonded debt was issued by the holding companies while the deposits were owed by the banks, so the holding company bondholders could in fact have been shaved with touching the depositors.
It seems to me that If the system were restored to sanity, and 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?
Am I wrong? Am I missing something? I think the autopsies have shown that the “too big to fail” was a lie and the “too interconnected to fail” a myth, but I will take correction if appropriate.
Arnold, I would be interested in your thoughts on this issue.
Cheers,
Jim
Jim:
In your hypothetical, I don’t see how having the holding companies default on their bonds would help the banks. The bond holders have a claim against the assets of an equity holder in the bank, not against the bank’s assets. That means that, when the bank has has equity below what it is required to have, reducing the holding company’s bond obligations does not restore the bank’s balance sheet. The only way it does that is if the bank also owes the holding company and that debt is written down because the bond-holders get written down.
Am i missing something in your observation? (I realize this was not th emain point of your post.)
Max
I did not state my point well. At the time, the argument was made that failing to protect depositors would cause a crash (never mind the legal limits on deposit insurance) and that the depositors and the bondholders had equal claims. Ergo, there was no way to protect the depositors without also bailing out bondholders.
The point I meant to make was that some well informed people have told me that was not true — that the structure of the institutions allowed precisely this kind of discrimination, in which the bondholders took a haircut and the depositors did not.
I was not concerned with what would help the banks but with protecting the financial system and maintaining appropriate incentive structures. The banks as institutions would have survived, but with a different set of owners.