Rethinking Subsidized Finance

Includes: AIG, BAC, C
by: Steve Waldman

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won't speak for CR, but some of us would disagree with JH's presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH's plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers' put option and its "vega" — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry's quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It's as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

As even Paul McCulley, the PIMCO dude, acknowledges

it has always been somewhat of an oxymoron, at least to me, to think of banks as strictly private sector enterprises. To be sure, they have private shareholders. And, yes, those shareholders get all the upside of the net interest margin intrinsic to the alchemy of maturity and risk transformation. But the whole enterprise itself depends on the governmental safety nets.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms' reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we'd like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.

In thinking this through, I don't think we should give much deference to traditional banking, on the theory that we know it works. On the contrary, we know that it does not work. Banking crises are not aberrations. They are infrequent but regular occurrences almost everywhere there are banks. I challenge readers to make the case that banking, in its long centuries, has ever been a profitable industry, net of the costs it extracts from governments, counterparties, and investors during its low frequency, high amplitude breakdowns. Banking is lucrative for bankers, and during quiescent periods it has served a useful role in financial intermediation. But in aggregate, has banking ever been a successful industry for capital providers? A "healthy" banking system is arguably just a bubble, worth investing in only if you're smart enough or lucky enough to get out before the crash, or if you expect to be bailed out after the fall.

If banks were our only option, we might think of them like airlines — we've never figured out how to run the things profitably, but we do want commercial air travel, so we find ways to cover their losses. But at least with airlines, the costs are relatively modest, and we constantly experiment in hopes of hitting on a sustainable business model. Despite being catastrophically broken, the core structure of banking has been fixed in an amber of incumbency and regulation since the Pleistocene era. It's long past time to try something else.