A decade after the start of the financial crisis you would hope the Economics profession would have a good grasp on why the global financial system is designed the way it is designed. Unfortunately, your hopes would be sadly dashed.
One of the co-authors of the latest example of this failure to learn is none other than Joseph Stiglitz. Mr. Stiglitz won the Nobel prize for a number of contributions to Economics including the Antique Dealer Problem. Regular readers will immediately recognize the Antique Dealer Problem is one of the two quadrants of the Information Matrix in which information asymmetry exists.
|Does Seller Know What They Are Selling?|
|Does Buyer Know What They are Buying?||Yes||No|
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
It is clear from reading his article on bail-ins and bailouts, Mr. Stiglitz is either unaware of or intentionally ignores the existence of the Blind Betting quadrant. It makes no difference which reason is correct. The failure to recognize the existence of the Blind Betting quadrant means he doesn’t understand why the global financial system is designed the way it is designed.
If you were going to build a financial system from scratch, in which quadrant would you like 100% of the activity to occur?
If you work on Wall Street, you would like all the activity to occur where buyers and sellers are blindly betting. While this is good for Wall Street, there is no reason to think this is good for anyone else.
The quadrants defined by information asymmetry are similarly flawed.
This leaves only one remaining quadrant and I think we can all agree we want 100% of the activity to occur in the Perfect Information quadrant.
It is only in this quadrant that investors are truly able to make the fundamental risk/return assessment that drives the efficient allocation of capital across our economy.
It is only in this quadrant, caveat emptor takes place and investors limit their exposure to any asset to what they are comfortable losing given the asset’s risk.
It turns out reform of the global financial system during the Great Depression focused on the need for information. Reform was heavily influenced by Justice Brandeis’ observation “sunlight is the best disinfectant”. But it was more heavily influenced by the Pecora Commission’s finding “opacity is Wall Street’s best friend”.
With this understanding of why the financial system is designed the way it is, the problem of bail-ins and bailouts becomes much less complicated than Mr. Stiglitz asserts it to be.
We show that the existence of credible bail-ins is related to the amplification of the shock through the financial system, which occurs through liquidation losses, bankruptcy costs, and negative feedback effects between highly interconnected banks in distress. Credible bail-in strategies exist if, and only if, this amplification lies below a certain threshold. If it exceeds this threshold, the losses to the real economy are too great for the government to idly stand by. The government thus cannot credibly threaten to not bail out the distressed banks. Since banks are aware of this fact, they refuse to contribute to a bail-in, which leaves a public bailout the only possible intervention option. If, in contrast, the amplification lies below the threshold, the ‘no intervention’ threat is credible and banks can be incentivised to contribute to a rescue in order to avoid a default cascade. A corollary to our result is that the network structure plays a fundamental role in deciding whether a rescue has to be paid for by taxpayer money or from sources within the financial sector.
The existence of credible bail-in strategies affects the socially desirable network structure. In earlier work without considering intervention, dense connections between financial institutions seemed to enhance financial stability, unless a shock was large enough to cause a systemic default (Allen and Gale 2000, Gai and Kapadia 2010, Acemoglu et al. 2015). Our findings reverse these presumptions and indicate that a more sparsely connected network may be beneficial for two reasons:
sparser connections enlarge the range of shocks for which a credible bail-in strategy exists; and
banks are willing to make larger contributions to a bail-in, thereby lowering the necessary taxpayer contributions from the government.
The less complicated way of stating his conclusions: the need for taxpayer funded bailouts goes away if banks limit their exposure to each other to what they can afford to lose if the other party goes bankrupt.
And, as if by magic, it turns out the global financial system is designed to get exactly that result with no additional regulation needed.
Banks are suppose to be in the Perfect Information quadrant. They are suppose to disclose their current exposure details. This way each bank is capable of assessing the risk of every other bank. Each bank can then limit its exposure to the other banks to what it can afford to lose based on the risk of the other banks.
And to ensure this happens, banks in the Perfect Information quadrant are subject to market discipline. Knowing their investment is at risk, investors have an incentive to assess whether a bank has taken on too much exposure to another bank and to take action if it does. This ends the risk of contagion regulators find troubling.
It turns out all the network effects Mr. Stiglitz finds are simply a result of opacity. Banks are black boxes and don’t disclose their current exposure details. Hiding behind the veil of opacity, the banks take on much more risk, including exposure to each other, than they can afford to lose.