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Rethinking subsidized finance (Steve Waldman)


Steve Randy Waldman continues to say what few others are saying in his latest on subsidized (Government-backed) finance.

Before I save-down my favorite part from Waldman’s analysis, I have two questions:

  1. Is there a meaningful difference between “nationalization” and “bankruptcy” in a subsidized, government-backed banking system?
  2. Are government-backed institutions destined to be nationalized?

I think the answer to the first question may be a qualified “No.” Regarding the second, I believe the answer is an unqualified “Yes” to the second.

Why is nationalization similar to bankruptcy? In a bankruptcy proceeding, the assets of the defunct company are divvied up and liquidated. I’m not sure if that would be any different under a nationalization program. Sure, if the government starts backstopping the losses of bank debt- and equity-holders, then we’ve entered some gray area that favors more crony capitalism than traditional bankruptcy. On the other hand, if nationalization means orderly liquidation by the government, then we’re really talking more about a special-case bankruptcy.

In the end, I’m guessing that it’ll be the latter even though I fully expect some investors to get off better than they should.

Regarding the second question, it seems that an institution implicitly backstopped by the government, even only marginally, is destined to be backstopped fully in time. This is because government subsidization works towards this end by effecting behavior internally to the organization and externally to investors/creditors:

  • Internally, company stewards take on more risk than they can handle as risk, via government subsidization/backstop, is underpriced.
  • Externally, investors/creditors extend more capital to the company as they believe the company is less-risky (again government is subsidizing risk).

Via this two-fold process, over time the marginal government involvement/subsidiy ratchets up until the organization takes on so much additional risk that it must call the government on its risk-option. Because the government was complicit with the arrangement all along, it must answer the call. Again, this process ratchets up over time until the once only marginally subsidized institution is full-fledged government-run.

And the above process doesn’t stop with just companies — seems to work the same on just about any welfare recipient.

Here’s Waldman:

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 has 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.