V.V. Chari and Christopher Phelan write,

the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe. Analyses of bailouts and moral hazard problems that focus exclusively on bank size are therefore misguided in our view, and the policy conclusion that limits on bank size can effectively solve moral hazard problems is unwarranted.

Pointer from James Pethokoukis. My argument against big banks is not that they are more prone to moral hazard. It is that they are better able to exploit political power to obtain regulatory leniency ex ante and bailouts ex post.

Samuel G. Hanson, Andrei Shleifer, Jeremy C. Stein, and Robert W. Vishny write,

the specialness of traditional banks comes from combining stable money creation on the liability side with assets that have relatively safe long-run cash flows but possibly volatile market values and limited liquidity. To make this business model work, banks limit their leverage, rely on deposit insurance, but also hold loans and securities that are relatively safe in the long run even if they are vulnerable to short-term price fluctuations.

…In a cross-section of types of financial intermediaries, intermediaries with stickier liabilities hold less liquid assets. Banks, in particular, appears as having extremely sticky liabilities as well as very illiquid assets…act as a bridge between households who want to put their money in a safe place they do not need to watch, and securities markets where even assets with relatively low fundamental risk can have volatile market prices.

My mantra is that the nonfinancial sector wants to hold riskless, short-term assets and to issue risky, long-term liabilities. The financial sector accommodates by doing the opposite. Government is tempted to back the financial sector with insurance and guarantees, and this in turn can cause the financial sector to become larger and riskier than it would be otherwise.

Gary Gorton and co-authors write,

banks will choose to create private money by investing in projects that are less risky and more opaque; opacity makes the cost of information acquisition higher. Note that the implied allocation of projects between banks and financial markets does not rely on any comparative advantage that banks have in evaluating and overseeing its assets.

I like the basic picture of financial intermediaries as holding information-rich assets and issuing low-information liabilities. This is similar to George Gilder channeling Arnold Kling.

I am not convinced that banks’ comparative advantage comes from corporate debt being more opaque than corporate equity. I suspect that what differentiates 20th-century banks from other financial intermediaries is their relationship to the government.

Marc Andreessen says,

The number of public companies in the US has dropped dramatically. And then correspondingly, growth companies go public much later. Microsoft went out at under $1 billion, Facebook went out at $80 billion. Gains from the growth accrue to the private investor, not the public investor.

Pointer from Tyler Cowen.

When you need a lot of physical capital to expand (think of a steel company 100 years ago), you have to offer a high return to public investors. When you can expand by adding more web servers, you might as well keep the company private. Going public does not mean raising funds for expansion. Instead, it just means converting some of your future profits into present cash, courtesy of public investors.

My point is that for information-intensive companies, the balance of power has shifted away from public investors, including large mutual funds, and toward private investors. It may have less to do with Sarbanes-Oxley or other factors that Andreessen cites. The service sector, which is growing as a share of the economy, may be inherently less dependent on outside capital than the goods-producing sector.

By the way, I always thought that Microsoft went public as a political defense strategy. In the absence of political threats, their optimal approach would have been to remain private. But having lots of shareholders gave more people a stake in their success, which helped to reduce the incentive for government predation against them.

Andreessen points out that the stock market has been flat for 15 years. But that takes as your starting point the late stage of the Internet Bubble.

The Internet companies told investors that they were raising money in order to survive without profits while they built up market share. The theory was that network effects and path-dependency were so powerful that once you established your brand you could basically generate profits at will.

We now know that a money-losing online pet store is just a money-losing online pet store, not a future exploiter of network effects and path dependency. To exploit network effects and path dependency, you have to be more like Facebook. But private investors had enough confidence in Facebook to take a large share of its value.

Furthermore, we are now in a world where mobile phones are the leading-edge platform. Who needs to raise hundreds of millions of dollars to create an app?

Noah Smith says that they do.

So in the equity market, shorts face huge disincentives, and longs don’t. That means over-optimistic longs get to set the price.

I am skeptical. Financial markets tend to find a way to work around barriers. For example, on alternative to shorting a stock is to buy a put option and write a call option.

Scott Sumner is suspicious.

Here is the evolution of labor compensation and corporate after-tax profits over the past 9 quarters:

Total labor compensation: $8315.3b. —-> $9049.5b. Up 8.8%

After-tax corporate profits: $1184.6b. —-> $1099.5b. Down 7.2%

…I know of no other data confirming that plunge. Stock prices are soaring. Corporations have been reporting very strong earnings. If someone can find non-government data supporting the claim that workers are far outperforming corporations in recent years, I’d love to see the evidence.

Robert Shiller tracks the data for the S&P 500. His earnings measure only goes through the end of 2013. From December 2011 to December 2013, he shows the S&P 500 up 45 %, dividends up 32 percent, and earnings up 15 percent. Since then, stock prices have gone up more than 5 percent, so if profits truly took a dive then the market is doing a great job of ignoring it.

We are going to see some upward revisions in Commerce Department data for corporate profits or some downward adjustment in stock prices. Personally, I expect to see some of both.

Jeremy Warner writes,

A simple transactional, online bank, where all deposits are placed as reserves with the central bank, making them completely safe, free of costly capital requirements, and immune to loss and panic, cries out to be invented.

Let’s assume that the main cost of the bank is upfront software development. It recovers that cost (and other expenses) with a monthly service charge to each customer.

Each customer will have a companion institution, call it a mutual fund, that pays a return on deposits. When you want to earn more interest, you shift money from the transactional bank to the mutual fund. When you want to have more money available for transactions, you shift it from the mutual fund to the transactional bank. As the cost of moving funds between institutions approaches zero, your average balance at the transactional bank will approach zero.

If they took away deposit insurance, would the system evolve toward this? If they keep deposit insurance, are you ensuring that the system cannot evolve toward this?

In any case, the safety of the transactional bank does not mean that risk goes away, or maturity mismatching goes away. It goes to other institutions, and I’m not convinced that those institutions won’t have a cozy relationship with the government.