A thought provoked by Crisis Economics

An idea provoked by Crisis Economics

I'm reading a book called Crisis Economics by Nouriel Roubini and and Stephen Mimh. It's about the Econonmic Crisis and the bailout. So far, it's unimpressive and tends anti-capitalist and anti-Austrian. But it gave me an idea.

The motivating problem

In the subchapter "Moral Hazard" (page 68 ff) they describe why the why various participants in the world of finance had no incentive to do the right thing. First the Principal-Agent Problem, then the moral hazard experienced by shareholders, who were happy to gamble with mostly other people's money. Finally they say (page 70):

In theory, one final firewall exists to keep moral hazard in check: the people who lend money to banks and other financial firms. If any party has a strong incentive to monitor banks, they do. After all, they stand to lose their shirts if the bank does something stupid. Unfortunately, this is another example of the law of unintended consequences. Fund lent to most ordinary banks come in the form of deposits. However, most deposits are subject to deposit insurance. So even if a bank recklessly gambles with depositors' money, the depositors can sleep well at night knowinhg that deposit insurance will make them whole.That remvoes any incentive for them to take actions that might punish the bank for its bad decisions.

In other words (this is me talking now), FDIC is concealing a price signal. Had this signal existed and discomfited depositors, the problem would have been essentially self-correcting. But FDIC is also needed to prevent bank runs. It got me thinking, is there any way to have that price signal and yet mostly have protection against bank runs?

The idea

And then I thought, we need a real market signal. And it can't come from the bank, because the case in which it must pay, bank failure, is exactly the case in which it can't pay. That leaves just two interested parties: depositors (in aggregate) and insurers.

So instead of FDIC, let private insurers compete. They would bid the lowest rate they're willing to charge to insure a given bank's deposits, for instance "%0.56 per year". Winner gets cash flow at that rate and the obligation to make deposits good if the bank fails. The bank in question is not a party to this auction, and does not set the terms.

ISTM there's no need for them to negotiate directly with individual depositors - that'd be impractical and the situation would be dominated by depositors' individual lack of information and negotiating skill.

The relation between bank and depositors would almost sort itself out as long as depositors aren't locked into long-term arrangements. Of course banks will pass the cost on to depositors. Depositors presumably go elsewhere if terms are too unfavorable.

The rate information will make its way to depositors as a matter of course. Nevertheless, since their use of this information is the whole point of this exercise, it probably should be made public and brought to each depositor's attention, though most will ignore it.

Some issues

Regress: The moral hazard of insurers defaulting

It risks creating a new moral hazard: Insurers that can't actually bear the potential losses. They might be speculators hoping that lightning won't strike on their watch, or their fate might be tied to that bank, so that if the bank fails, so do they.

How are we to know which insurers can actually bear the potential losses? Better, how can we know it without a bureaucracy deciding it?

We appear to have just moved the problem from the bank to the insurer. So let's re-apply the same solution there: let insurance in turn require coverage against defaulting, on basically the same terms. The cash flow to the second insurer comes from the first insurer's cut, the cost is not (directly) borne by the depositor.

Presumably for unreliable would-be insurers, their own coverage takes so large a cut of their profits that they can't effectively compete in the bidding. For reliable insurers, presumably the situation is the reverse, so they can make a profit. Since there is this dimunition in rates, we can be sure that an infinite regress of meta^N-insurers does not result in an infinite rate. Instead for a dimunition R, the overall rate is about:

1/((1/R)-1)

So we can simply let it regress to extinction.

That solves half the problem. But we still might be looking at a circular situation. A bank might (openly or otherwise) be its own insurer and meta-insurer and meta²-insurer etc.

So we'd like to predictively know whether a bank and its insurer are truly independent. Prediction markets may help us. For each bank and insurer, there would be a prediction market on whether the insurer survives a bank collapse. It pays "No" if both default, "Yes" if the bank defaults but the insurer doesn't, and is not resolved if the bank does not fail. This gives us a probability of double-failure; a figure between 0.0 and 1.0. Call it p(!F_2|F1)

Now calculate the total coverage required, assuming a single insurer, as:

`total deposits' / p(!F_2|F_1)

In other words, the bank is required to have coverage up to the total amount of deposits, but the amount of coverage from a given insurer only "counts" as:

`face value of coverage' * p(!F_2|F_1)

Similarly, for a meta-insurer, have a prediction market on whether it survives default by both bank and insurer.

Making these markets would add some overhead, but not neccessarily much, since at any instant it's required once over the bank's entire holdings.

No signal until very late

Another worry is that the rates may not reflect the actual situation until very late. Insurers who are aware of a developing problem at a bank might think that they can pull out in time.

The problem is that the contract may have less latency than the situation. So let's add a time rule. Say a formerly successful bidder who is now outbid retains a continually diminishing fraction of the insurance contract for some time. Ie, still gets a fraction of the deposits per unit time, and still has to provide coverage uniformly for that fraction of total deposits. That time interval is a free parameter in this proposal.

Then the situation is sensitive to the exact time at which the bank fails.

Collusion keeping the little guy out

Having arranged all this, we wouldn't like to see it become the sole preserve of a de facto cartel with captured regulatory agencies keeping others out.

This is apparently at odds with our need to keep lightweight insurers out. But fortunately my solution to the lightweight insurers does not rely on bureaucracy. Of course nothing will keep regulators from regulating, but there's little in this proposal that requires them to do so.