Careful with the tail there February 6, 2012 at 7:19 pm
This guy is slick. Goodness me yes. Check this out:
One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced.
It is, of course, the Epicurean Dealmaker, and I think he is quite right on the essentials. There will always be a tail of financial risk that society must absorb, and the policy debate should be about how much there should be of it and what compensation society extracts from the financial system for taking it, not how to remove it (because that is impossible).
[As an aside, one could imagine trying to price it. For instance, suppose that banks have to be 100% deposit funded, and all deposits must be insured but there is limited insurance. Banks have to bid for the available insurance. That would at least establish a market clearing price for deposit insurance.]
TED puts the general argument nicely though:
But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects.
Now, you may hate the following. I certainly do. But what if putting financial intermediaries less on the hook is better for society? What if it creates growth that more than pays for its extra costs? I’m not saying that is true – I don’t know – but the possibility must be acknowledged. Thinking about the problem as tail risk allocation at least saves us from knee-jerk responses which are unlikely to lie on the efficient frontier.