Category / Bank Run
Mitigating Moral Hazard February 21, 2008 at 11:16 pm
Willem Buiter has a typically intelligent post on Northern Rock. He ends, as one might expect, with a discussion of moral hazard:
Future Northern Rocks will be encouraged to fund themselves recklessly and to lend and invest recklessly. Their creditors are after all the beneficiaries of a free government guarantee. If their bets come off, management, super-employees shareholders and creditors benefit. If they fail, the shareholders may still lose (I hope), but taxpayer picks up the tab for the rest.
At first sight, this seems reasonable. But there are things that can be done to mitigate this moral hazard.
- We need a new insolvency regime for banks, which allows regulators to intervene at an early stage [and obviously includes intervention due to liquidity as well as solvency]. It should ensure that equity holders only get something once everyone else, including the lender of last resort, has been paid back at market rates. This mitigates moral hazard for equity holders as they do not benefit from the rescue. In order to get this right we may need to reduce some of the statutory rights of equity holders, so perhaps we will end up with a new instrument, bank stock, which grants the holder less control than ordinary equity.
- Revisions to compensation practices should ensure that employees, particularly senior employees, are paid in shares that lock up for an extended period. This combined with the above encourages employees to avoid the need for a rescue.
- Enforced liquidity ratios are needed to limit the amount of debt the bank has compared with deposit funding. That means that although debt holders benefit from government intervention, there at least aren’t too many of them. Obviously this regime should apply to off balance sheet liabilities too, including derivatives contracts in the trading book.
- There is little moral hazard with retail depos as most of them are government guaranteed anyway. We could force banks to buy insurance against interbank and commercial deposits too if need be.
I am not necessarily suggesting all of the above is a good idea. But it does make it clear that moral hazard can be mitigated if you are willing to make enough changes.
Never mind the quality, feel the fees February 18, 2008 at 6:15 pm
Oh to be a litigator today. There are so many delicious cases to sate yourself on. Should you take on one of the ‘significant legal challenges which will hold up the resolution of the monoline issues for years‘? Sue the State of New York perhaps, or something in Wisconsin? Or maybe you want to represent CPDO investors in a suit against the banks who ran them, the ratings agencies who rated them, or both? With the current deleveraging, these cases may well be filed soon. Or perhaps you fancy having a go at Citigroup over their suspension of hedge fund redemptions? Then of course there are the hedge funds who own significant positions in Northern Rock. And that’s just one day’s news.
Update. A nice take on subprime-related litigation is here.
Not too hard, Darling February 17, 2008 at 8:33 pm
Good grief, Alistair, there was no need to react that way. One minute I’m calling him a wimp and the next he’s nationalised a bank. That, to be fair, does show backbone, and is probably the best thing for the public purse. Certainly if the Virgin and management bids did not offer value to the senior creditors, notably the Bank of England, Darling was right to nationalise the bank. Undoubtedly there will be lawsuits from shareholders who are still under the (mistaken) impression that the stock has any value, and there may well be a judicial review of the tripartite authorities’ actions, which could provide further embarrassment to FSA. But for the moment Darling has done the best thing he could to stem the flow of public funds into the rock. Further coverage from the FT is here and Darling’s statement is here. The crock is dead: long live the crock.
Update. It appears that the government is going to let an independent assessor decide what shareholders in the Crock are going to get. How about this for a way of making the assessment: shareholders can either take max(0,PV(current assets) – PV(current liabilities)) [which is probably zero], or they can hang on to their shares until the son of the Crock is floated in two, three, four or whatever years time. Anything more than that is simply a taxpayer subsidy to the hedge funds. As Martin Wolf says
Shareholders live and die by the judgment of the market. In this case, they have died. That is what “risk capital” means.
False positives and false negatives January 29, 2008 at 9:52 pm
The Treasury select committee report on Northern rock has some criticism for a range of targets from Alistair Darling, through the board of the bank itself, to FSA. While none of it boils down to ‘hang them from the nearest telegraph pole’, FSA in particular comes in for considerable censure.
According to the FT:
Sweeping new powers to oversee financial stability and prevent a repetition of the Northern Rock crisis should be handed to the Bank of England, a parliamentary committee proposes on Saturday in a report that lambasts the Financial Services Authority for systemic failure in its duty as a regulator.
I don’t know the details of what FSA did or didn’t do, so I won’t comment on the specifics. But a few general remarks about financial supervision might be appropriate.
- Firstly it is utterly inappropriate for a regulator to comment on bank strategy. Yes the Rock had a strategy that turned out to be flawed, but provided the necessary statutory disclosures were made and the bank was capitally adequate, what could FSA do about it even if they understood the issue? Having regulators comment on strategy is tantamount to them writing a put to shareholders.
- Regulators have to be careful about calling wolf, especially given the impact any public intervention would have on the market. The balance between intervening too early and too late is a very difficult one, especially for a public body that is necessarily bureaucratic (not least because its actions are susceptible to judicial review). Again I’m not suggesting that FSA didn’t get it wrong in this case, just that to make an informed judgment we also need information from the thousands of cases where banks did not fail. The skeptic might suggest that thousands of banks a year don’t get into trouble so doing nothing is usually safe, and I’d agree, but that just emphasises the difficulty of finding a true positive in a sea of negatives.
- What on earth makes the Treasury select committee believe that the Bank of England would be any better at bank rescues than FSA? Surely one lesson from this debacle is that the tripartite system has one (or perhaps two) legs too many. Having a part of the Bank for FSA to hand over problem cases to will just exacerbate the communications overheads and inter-institutional conflict in the system.
Few would suggest FSA is the perfect regulator. But having a single body responsible for banks, investment firms, insurance companies, and financial intermediaries is a good start. Fewer regulators not more would make a good motto, as the BIS recently pointed out. Why not make a merged Bank of England/FSA truly responsible for the whole thing from soup to nuts, including authorisation, regulation, deposit protection, rescues, rate setting and the operation of the discount window? Then nothing can fall between the cracks between institutions and if something goes wrong we will really know who to blame. That might be too controversial a suggestion for the Treasury select committee, but it would be better than yet another regulatory kludge.
Update. It seems Alistair Darling agrees. He rejected the committee’s advice, saying that plans put forward by a committee of MPs were flawed and would not deflect him from his own reforms of Britain’s system of financial regulation.
Having your cake and eating it November 20, 2007 at 7:15 am
The news that bids for Northern Rock are considerably below the current share price is hardly surprising but it does remind us that equity is a residual interest. It only has value if the firm can pay its debt in a timely fashion. Every so often shareholders forget that. Then when a firm fails, they clamour for restitution, as with Metronet or Railtrack: doubtless it will be the same with Northern Rock. These claims undermine the financial system: the logic is totally spurious. If equity holders want the returns that come from owning a residual interest, then they should take the risk, and bear any losses in silence. If they don’t want that risk, they should not buy equity.
The priority now, as James Harding puts it in the Times, is first to depositors and the financial system, and last to shareholders. The best option may well be nationalisation. It certainly won’t be something that leaves tax payers with exposure and grants a return to shareholders.
All Hail The King September 17, 2007 at 7:39 pm
Here is the edifice that houses the Lutine Bell in Lloyds of London. Traditionally the bell was sounded to signal bad (or good) news in the insurance market.
Talking of bad news, two Bloomberg reporters seem to have it in for Mervyn King:
Two days after King, 59, told lawmakers on Sept. 12 that central banks should avoid giving the impression they will help lenders that made bad decisions, the Bank of England provided emergency funds to Northern Rock Plc in the biggest bailout of a British bank in three decades.
Subsequently the Bank has been forced to guarantee all of Northern Rock’s depositors (as opposed to 100% of the first £2000 then 90% of the rest up to a maximum of £33,000* under the UK’s Financial Services Compensation Scheme).
“It’s a crisis of confidence, and the bank is confused,” said Patrick Minford, an economics professor at Cardiff University who advised former Prime Minister Margaret Thatcher. “They want to be hands-off, but in this situation they can’t be. I don’t think this has done King any good.”
Minford was Thatcher’s economist, a recognised hardliner and currently out of political favour. Perhaps he isn’t the most disinterested observer of the situation?
Bloomberg continues:
King’s credibility is in question for his refusal to emulate other central banks and take early action to help cash-strapped lenders. With Northern Rock’s failure, he is finding himself subject to the same charge of excessive caution being leveled at U.S. Federal Reserve Chairman Ben S. Bernanke, whose office adjoined King’s at the Massachusetts Institute of Technology in the 1980s.
Horror of horrors, two intellectuals. Your money cannot possibly be safe with anyone who went to M.I.T.
King held back until markets forced his hand. Last week he said that too much help “encourages excessive risk-taking, and sows the seeds of a future financial crisis.”
And he was right to do so. The only criticism of King I would offer is that he failed to engineer a takeover of Northern Rock by Lloyds or HSBC earlier in the week, something that would have represented the typical dirigiste approach of the Bank to a crisis (cf. ING’s purchase of Barings). But someone will come along sooner or later with an open pocket, and meanwhile King is rightly signalling to the market that institutions must bear the consequences of their own liquidity risk management decisions.
*One might argue having only a 90% guarantee introduces an incentive which encourages bank runs: no one wants to lose 10% of a chunky amount of money. Perhaps now we are actually seeing bank runs again HM Treasury, the Bank and FSA might like to redesign the scheme?
Update. Willem Buiter and Anne Sibert writing in the FT are wrong about liquidity premiums:
The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too.
This risks the Japanese problem of excess liquidity and a lack of liquidity premiums causing falling returns on illiquid assets, deflation, and a reluctance to invest. The Bank absolutely should not accept dodgy collateral at the window in ordinary conditions. It should widen the definition of eligible collateral when necessary to manage the three month swap spread but not otherwise.
