Tyler Cowen writes,

Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

Think of what AIG was doing when it was writing credit default swaps on mortgage securities. It was taking tail risk by writing out-of-the-money options. If you believe Gary Gorton, they were fine, except that in 2008 their counterparties demanded collateral that they did not have, not because the options were in the money but because the options were closer to being in the money.

Today, if you want to pick up the nickels that you can earn by taking tail risk, you need to put up more margin. What Tyler is suggesting is that this increases the demand for safe assets relative to what it was prior to 2008. So even if the real return on T-bills is negative, they are worth it for financial institutions who use them to meet margin requirements on trades that enable them to make a profit.

If the financial institution is helping the economy by taking the tail risk, then it’s all fine. But Tyler suggests that the financial institution is not helping the economy (AIG was an enabler of the housing bubble). In that case, we would be better off with less tail-risk taking, which in turn would reduce the demand for safe assets and lead to a better allocation of saving and investment.

Stricter bank regulation may or may not help. The effect of risk-based capital regulations was to increase the demand for AAA-rated securities, which in turn increased the demand for credit default swaps written by AIG. So that was a case in which stricter bank regulation actually created (apparent) profit opportunities in taking tail risk. If regulation still has that effect, then it will increase the fundamental distortion in financial markets.