By Karl Smith
The Fed minutes from 2007 reveal that members of the Federal Open Market Committee began to struggle to find a middle ground between action that was internationalist enough to ward off a systemic financial collapse on the one hand, and laissez-faire enough to avoid moral hazard on the other.
However, it occurs to me that the tension between the two may not be as obvious as it first seems. To motivate the rest of this post consider this quote that Bill McBride brought up recently:
A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him. -- John Maynard Keynes, Consequences to the Banks of a Collapse in Money Values, 1931
The key insight here is that systemic collapse brings about its own form of moral hazard as the safe thing to do is not to try to find smart ways of accessing risk, but to make sure that when the crisis comes your bank fails in the typical way. Ultimately, I think it’s the externality of uncertainty which makes it rational to engage in a presumptive blame game, rather than invest time and energy into figuring out how to avoid collapse in the first place.
So, what can we do? Paradoxically, I think massive blanket bailouts would reduce moral hazard.
Imagine a system like this. The Fed makes a guarantee (at this point we’ll assume away concerns about credibility) that if the Kansas City Financial Stress Index crosses two then all outstanding credit liabilities issued by financial offices with the United States (or some other suitably broad definition) are secured by the U.S. government.
Here is the Kansas City Financial Stress Index over time:
Here is the index over the current crisis:
So, we are suggesting that if things got about as bad as they did in and around the collapse of Lehman then an automatic guarantee is tripped. You can think of this as a type of slaughter rule. Once things pass a certain point the refs stop the game.
How could this be a good idea?
Well, one there is the direct effect that it guarantees that aggressive action will be taken to save the financial system regardless of how the FOMC views the situation analytically and emotionally. This alone gives a degree of support to the financial sector that could prevent a global crisis such as the one went through.
More importantly, it also lets participants know that things can’t get but so bad, and thus we avoid the self-fulfilling prophecy where panic about a possible crisis brings about an actual crisis. However, there is more. It radically changes the risk management incentives for bankers and not necessarily in the ways that one would expect.
First, if the guarantee is tripped credit losses from lending within the financial sector stop. However, credit losses from lending outside of the sector don’t. So for example, banks or other institutions which were exposed to subprime lending would still see their capital base depleted and their shareholders wiped out. Second, while creditors are insured against a systemic collapse they are not insured against a partial collapse. That is, if things go badly but not so badly that there is a full scale panic, you can still loose money.
This implies that a creditors primary concern is not the absolute safety of a bond or other credit instrument, but its relative safety. The worse thing that could happen to you is that your borrower goes under but the entire system avoids collapse.
So, what you want to know is not "Is this bond safe?" but "Is this bond safer than the other guy's bond?" This means that inventing ways to declare an ever greater numbers of bonds AAA, for example, has diminishing returns. Since everyone is now graded on curve, grade inflation doesn’t help.
Third, and perhaps most importantly, it means that a bond issuer can’t simply rely on a model showing her bonds are safe. She has to show that they are safer. Which means that its in her interest to point out the flaws in other people’s bonds. Right now, the opposite is true as you don’t want a potential investor thinking too much about strange ways in which risk models could go wrong. A bond issuer wants to promote the idea that the general environment is safe.
However, now because of the slaughter rule, it is completely in your interest as a bond issuer to trash other people’s bonds and explain how they are morons who haven’t accounted for X or Y. Incentivizing bankers to scrutinize each other’s risk management is the key element I wanted to bring in because it creates a more traditional type of competition. Rather than it being in an credit issuers interest to promote a general feeling of security, its in an issuers interest to emphasize why they are particularly secure.
Now, the obvious concern here is that it would also be in the interest of all bankers to try to correlate the default probabilities of their credit instruments so that they all default together and thus trigger the guarantee. I believe this roughly analogous to the classic problem of collusion where it would be in the interest of all producers to reduce output in unison and thus raise the market price. So, I think similar broad conclusions likely apply.
For example, with a large number of financial intermediaries it seems unlikely that they could nudge themselves into tacit risk collusion. That's because the incentive to defect is would be strong unless you were sure that enough firms had already tacitly colluded that they could trip the slaughter rule themselves.
On the other hand, a very large player might be able to push some sort of Stackelberg-esque solution where she makes it blatantly obvious the conditions under which she will suffer massive failure and likely trip the slaughter rule. Then other firms rush to hide under her cover.
Now, clearly this entire slaughter rule concept is highly unlikely to be adopted for a host of reasons. But, its interesting and I think it may be worth teasing apart.