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Deposit insurance reform: a functional approach
Carnegie-Rochester North-Holland
Conference Series on Public Policy 38 (1993) 35-40
Deposit insurance reform: functional approach A comment
a
Mark J. Flannery* University
of Florida,
Gainesville,
FL 32611, U.S.A.
Professors Merton and Bodie have provided us with an interesting and innovative paper. Despite the similarity of their policy recommendations to earlier
writers (including, most recently, Pierce (1991)), Merton and Bodie bring a novel perspective to the analysis. ’ Moreover, some of their assessments are notable, if controversial, even outside the confines of this paper’s policy reforms. In particular, note their contentions that: 1. asset opaqueness
is an extremely
2. equity imposes substantial
important
deadweight
economic
phenomenon,
costs on banking
firms, and
3. regulators must supervise along functional (rather than institutional) lines, particularly given the increasingly rapid evolution of financial firms’ institutional
mechanisms
for delivering
The paper’s logic can be summarized
services
and products.
as follows.
1. We have no need for deposit insurance except as a means of producing a riskless payments system (Section 3), which provides social benefits by sparing businesses and individuals the “[prohibitive] costs of acquiring information about the credit risk of every counterparty to every transaction” (page 4). *Thanks Remaining ‘See Pierce’s
to Joel errors
also Litan
Houston
for his insightful
and omissions (1987)
are, of course,
and Bryan
(1988),
comments entirely inter
on a draft
of these
remarks.
my responsibility.
alia, as well as my review
(1992)
of
book.
0167-2231/93/$06.00
0 1993 - Elsevier Science Publishers B.V.
All rights
reserved.
2. Because bank assets are “opaque,” outsiders Government rately assess their true value.’
cannot readily or accujudgments about asset
value are even worse and less timely than private creditors’
assessments.3
3. Asset opaqueness makes the cost of deposit guarantees prohibitive when the supervisory tools include only asset restrictions (Section 2.1), capital requirements
(Section
2.3), and premium assessments
(Section
2.4).
4. Consequently, the government can assure payments-system stability most efficiently by requiring demand deposits to be fully collateralized with risk-free,
liquid securities.
Merton and Bodie are recommending that banking firms be financially deengineered to separate their transactions business from their other financial services (lending, brokering, insurance, etc.). The value of this separation is described in Section 3.5, where the authors draw an intriguing distinction between a firm’s “customers” and its “investors”. (See also Merton, 1992, pp. 450-451, 463-467.) Customers are interested only in a firm’s comparative advantage in producing a product; investors care about the firm’s financial viability. An important characteristic of transaction deposits is that the customer must also be concerned with the service provider’s financial viability. Given the gains we generally associate with specialization, relieving transaction customers of the need to do credit analysis would presumably generate social benefits. The authors contend that a safe payments system can be attained with no (substantial) offsetting social costs via collateralization of transactions balances. Note that this recommendation eliminates the social value of deposit insurance, in a fashion that is reminiscent of Horvitz’ (1980) observation that perfect, costless monitoring of a bank’s asset value could reduce expected insurance losses to zero. My reservations about this paper (and therefore about this basic idea for policy reform) concern not what it says, but what it fails to say. Consider first their central
assertion
about the value of riskless transaction
“To achieve the primary goal of an efficient payments deposits should be completely ‘Many writers have previously value. This is a logical implication
system,
deposits:
. . . transaction
free of default risk” (page 4). While footnote
9
contended that bank assets are difficult for outsiders to of the fact that bank borrowers have chosen not to issue
public securities. Why should this problem be worse for banks than for industrial firms? Most likely, the difference lies in the banks’ ability to change their asset portfolios quickly (Diamond and Dybvig, 1986). Concerning banks, I have often wondered why markets can (apparently) set reasonable prices for banks’ equity claims - which are call options on bank portfolios of pricing
-
while asset opaqueness
put options
3See, for example,
renders those same market participants
incapable
on the same portfolio. Merton
and Bodie’s
description
good assets out of a failing, insured firm.
36
of how debenture
holders’
strip the
concedes that the government
is not necessarily
the least-cost
provider of pay-
ments safety, the authors base their ensuing analysis on the simple assertion that some combination of politics and economics means that .“Ultimately, . . . the government would still be the de facto guarantor of the system” (page 6). Because the paper’s analysis depends so importantly on this assumption, the authors should have spent more time evaluating the issue. In particular, their treatment of the government’s inability to precommit to a policy of letting financial firms fail deserves far more than a footnote (see footnote 16). I would also ances versus the economic agents. of the payments
like to see more discussion of the safety of transactions balsafety of the system for transferring those balances among The need for government intervention in these two aspects system might be very different!4
The paper fails to address a related question about payments-system stability: whether the marginal benefit of absolute payments safety exceeds its marginal cost (in terms of institutional restrictions or government regulations). Section 3.3 talks around this issue without addressing it directly. Because the authors believe that their method of providing perfect payments safety is effectively costless, they need not evaluate whether that safety is worth its (zero) cost. But if their proposal turns out to entail nontrivial costs, they would have to provide a more complete cost-benefit analysis of payments-system
safety. This would be a daunting task, even at a conceptual
level. Merton and Bodie’s assumption that the government ultimately guarantees payments will strike many readers as both realistic and plausible. However, without a specific delineation of how this policy will (or should) operate, the paper’s analysis suffers from a fundamental problem: how far does the government’s safety net extend ? Is it not plausible to assert that the government will absorb losses in any large financial crisis, even if the payments system is not directly involved? (Witness, for example, the historical treatment of Chrysler or New York City.) If the government implicitly extends
conjectural
guarantees
to the parts of Merton
firms which finance opaque assets, collateralizing completely eliminate deposit-insurance subsidies.
and Bodie’s
demand
deposits
financial will not
It seems likely that collateralizing demand deposits will have some of the salutary effects claimed in this paper, but I strongly doubt that this reform will entirely eliminate the deposit-insurance problem. Rather, collateralized demand deposits may simply shift the insurance subsidy to other parts of the firm, so long as government guarantees of troubled financial firms remain credible. I also believe that the preferred liability structure of opaque-asset 4For example, the (private) New York Clearinghouse Association implemented collateralization arrangements in 1991 which effectively CHIPS settlement system.
37
eliminate
counterparty
risk from the
financiers will continue to expose them to the type of liquidity risk which tends to elicit government intervention in times of crisis. Merton and Bodie would rely on market forces to determine a “nonbank” lenders’ leverage and debt maturity
distribution.
They thus implicitly
deny
that public policy should be concerned with the stability of those lenders. Yet I believe that strong economic forces will induce any firm financing a dynamic portfolio of opaque assets to issue relatively short-term liabilities (Flannery, 1993). A fi rm whose line of business entails routine replacement of some opaque assets with others will encounter unusually severe investment distortions when it issues long-term debt (Myers, 1977). Accordingly, banking firms will accept some illiquidity risk in order to mitigate the deadweight costs of distorted investment incentives. According to this view, a maturity-mismatched bank is no anachronism, but rather a rational means of financing opaque assets. Eliminating demand deposits as a permissible liability will lead financial firms to employ other short-term liabilities (e.g., federal funds or short-dated commercial paper). If the government is expected to support troubled financiers of opaque assets despite their isolation from the payments system, Merton and Bodie’s neat proposal for eliminating the social costs of conjectural guarantees will unravel. As economists, we cannot evaluate proposals for deposit-insurance reform without first defining the appropriate role of government in stabilizing the U.S. financial sector. The case for government intervention seems much stronger when many firms are endangered simultaneously than when the potential failures include only a few firms (even large ones) whose problems are basically idiosyncratic. 5 If economists could teach regulators to intervene only in the former cases, our financial system would be more efficient and productive. Of course, the societal interest in financial-system stability extends beyond economic issues, quickly blurring into political science and, at times, into politics. These realities notwithstanding, an economic consensus on the need for government intervention would provide support for policy advice and analysis. In the longer run, such a firm conceptual foundation would also improve the prospects for introducing political accountability to the regulatory system.
5At times, the distinction between an unstable system and unstable individual institution may be difficult to recognize. One interesting example of this distinction occurs in the model of Penati and Protopapadakis (1988), in which banking firms choose between two types of loans. They conjecture that “local” loans can default without government intervention, while “international” loans (which are shared by many banks in the system) will surely be subsidized if they cannot repay as agreed.
38
References
Bryan,
L.L.,
Siege.
Diamond, ance,
Breaking
(1988).
Homewood, D.W.
and Bank
Up the Bank:
Rethinking
an Industry
and
Dybvig,
Regulation.
P.H., Journal
(1986).
Banking
of Business,
Theory,
59,l:
Flannery, M.J., (1993). of Leverage: Optimally view, forthcoming. P.M.,
Litan, R.E., Institution. Merton, Myers, nancial
R.C., S.C.,
A R econsideration
Credit and Banking,
(1992). (1977).
Economics,
by James
of the Role of Bank 12:
L. Pierce.
Continuous
Determinants 5,2:
Time
Examination.
654-659.
What Sh,ould Ban,ks Do?
(1987).
Insur-
Debt Maturity Structure and the Deadweight Cost Financing Banking Firms. American Economic Re-
(1980).
JournaE of Money,
Deposit
55-68.
Flannery, M.J., (1992). R eview of The Future of Banking, Journal of Finance, 47: 417-420.
Horvitz,
Under
IL.: Dow Jones-Irwin.
Wa.shington:
Finance.
of Corporate
Oxford: Borrowing.
The
Basil
Brookings
Blackwell
Journal
of Fi-
147-175.
Penati, A. and Protopapadakis, A.A., (1988). The Effect of Implicit Deposit Insurance on Banks’ Portfolio Choice with an Application to Internation “Overexposure.” Journal of Monetary Economics, 21,l: 107-126. Pierce,
J.L.,
(1991).
The F u t ure of Banking.
Press.
39
New
Haven:
Yale University
Conference Series on Public Policy 38 (1993) 35-40
Deposit insurance reform: functional approach A comment
a
Mark J. Flannery* University
of Florida,
Gainesville,
FL 32611, U.S.A.
Professors Merton and Bodie have provided us with an interesting and innovative paper. Despite the similarity of their policy recommendations to earlier
writers (including, most recently, Pierce (1991)), Merton and Bodie bring a novel perspective to the analysis. ’ Moreover, some of their assessments are notable, if controversial, even outside the confines of this paper’s policy reforms. In particular, note their contentions that: 1. asset opaqueness
is an extremely
2. equity imposes substantial
important
deadweight
economic
phenomenon,
costs on banking
firms, and
3. regulators must supervise along functional (rather than institutional) lines, particularly given the increasingly rapid evolution of financial firms’ institutional
mechanisms
for delivering
The paper’s logic can be summarized
services
and products.
as follows.
1. We have no need for deposit insurance except as a means of producing a riskless payments system (Section 3), which provides social benefits by sparing businesses and individuals the “[prohibitive] costs of acquiring information about the credit risk of every counterparty to every transaction” (page 4). *Thanks Remaining ‘See Pierce’s
to Joel errors
also Litan
Houston
for his insightful
and omissions (1987)
are, of course,
and Bryan
(1988),
comments entirely inter
on a draft
of these
remarks.
my responsibility.
alia, as well as my review
(1992)
of
book.
0167-2231/93/$06.00
0 1993 - Elsevier Science Publishers B.V.
All rights
reserved.
2. Because bank assets are “opaque,” outsiders Government rately assess their true value.’
cannot readily or accujudgments about asset
value are even worse and less timely than private creditors’
assessments.3
3. Asset opaqueness makes the cost of deposit guarantees prohibitive when the supervisory tools include only asset restrictions (Section 2.1), capital requirements
(Section
2.3), and premium assessments
(Section
2.4).
4. Consequently, the government can assure payments-system stability most efficiently by requiring demand deposits to be fully collateralized with risk-free,
liquid securities.
Merton and Bodie are recommending that banking firms be financially deengineered to separate their transactions business from their other financial services (lending, brokering, insurance, etc.). The value of this separation is described in Section 3.5, where the authors draw an intriguing distinction between a firm’s “customers” and its “investors”. (See also Merton, 1992, pp. 450-451, 463-467.) Customers are interested only in a firm’s comparative advantage in producing a product; investors care about the firm’s financial viability. An important characteristic of transaction deposits is that the customer must also be concerned with the service provider’s financial viability. Given the gains we generally associate with specialization, relieving transaction customers of the need to do credit analysis would presumably generate social benefits. The authors contend that a safe payments system can be attained with no (substantial) offsetting social costs via collateralization of transactions balances. Note that this recommendation eliminates the social value of deposit insurance, in a fashion that is reminiscent of Horvitz’ (1980) observation that perfect, costless monitoring of a bank’s asset value could reduce expected insurance losses to zero. My reservations about this paper (and therefore about this basic idea for policy reform) concern not what it says, but what it fails to say. Consider first their central
assertion
about the value of riskless transaction
“To achieve the primary goal of an efficient payments deposits should be completely ‘Many writers have previously value. This is a logical implication
system,
deposits:
. . . transaction
free of default risk” (page 4). While footnote
9
contended that bank assets are difficult for outsiders to of the fact that bank borrowers have chosen not to issue
public securities. Why should this problem be worse for banks than for industrial firms? Most likely, the difference lies in the banks’ ability to change their asset portfolios quickly (Diamond and Dybvig, 1986). Concerning banks, I have often wondered why markets can (apparently) set reasonable prices for banks’ equity claims - which are call options on bank portfolios of pricing
-
while asset opaqueness
put options
3See, for example,
renders those same market participants
incapable
on the same portfolio. Merton
and Bodie’s
description
good assets out of a failing, insured firm.
36
of how debenture
holders’
strip the
concedes that the government
is not necessarily
the least-cost
provider of pay-
ments safety, the authors base their ensuing analysis on the simple assertion that some combination of politics and economics means that .“Ultimately, . . . the government would still be the de facto guarantor of the system” (page 6). Because the paper’s analysis depends so importantly on this assumption, the authors should have spent more time evaluating the issue. In particular, their treatment of the government’s inability to precommit to a policy of letting financial firms fail deserves far more than a footnote (see footnote 16). I would also ances versus the economic agents. of the payments
like to see more discussion of the safety of transactions balsafety of the system for transferring those balances among The need for government intervention in these two aspects system might be very different!4
The paper fails to address a related question about payments-system stability: whether the marginal benefit of absolute payments safety exceeds its marginal cost (in terms of institutional restrictions or government regulations). Section 3.3 talks around this issue without addressing it directly. Because the authors believe that their method of providing perfect payments safety is effectively costless, they need not evaluate whether that safety is worth its (zero) cost. But if their proposal turns out to entail nontrivial costs, they would have to provide a more complete cost-benefit analysis of payments-system
safety. This would be a daunting task, even at a conceptual
level. Merton and Bodie’s assumption that the government ultimately guarantees payments will strike many readers as both realistic and plausible. However, without a specific delineation of how this policy will (or should) operate, the paper’s analysis suffers from a fundamental problem: how far does the government’s safety net extend ? Is it not plausible to assert that the government will absorb losses in any large financial crisis, even if the payments system is not directly involved? (Witness, for example, the historical treatment of Chrysler or New York City.) If the government implicitly extends
conjectural
guarantees
to the parts of Merton
firms which finance opaque assets, collateralizing completely eliminate deposit-insurance subsidies.
and Bodie’s
demand
deposits
financial will not
It seems likely that collateralizing demand deposits will have some of the salutary effects claimed in this paper, but I strongly doubt that this reform will entirely eliminate the deposit-insurance problem. Rather, collateralized demand deposits may simply shift the insurance subsidy to other parts of the firm, so long as government guarantees of troubled financial firms remain credible. I also believe that the preferred liability structure of opaque-asset 4For example, the (private) New York Clearinghouse Association implemented collateralization arrangements in 1991 which effectively CHIPS settlement system.
37
eliminate
counterparty
risk from the
financiers will continue to expose them to the type of liquidity risk which tends to elicit government intervention in times of crisis. Merton and Bodie would rely on market forces to determine a “nonbank” lenders’ leverage and debt maturity
distribution.
They thus implicitly
deny
that public policy should be concerned with the stability of those lenders. Yet I believe that strong economic forces will induce any firm financing a dynamic portfolio of opaque assets to issue relatively short-term liabilities (Flannery, 1993). A fi rm whose line of business entails routine replacement of some opaque assets with others will encounter unusually severe investment distortions when it issues long-term debt (Myers, 1977). Accordingly, banking firms will accept some illiquidity risk in order to mitigate the deadweight costs of distorted investment incentives. According to this view, a maturity-mismatched bank is no anachronism, but rather a rational means of financing opaque assets. Eliminating demand deposits as a permissible liability will lead financial firms to employ other short-term liabilities (e.g., federal funds or short-dated commercial paper). If the government is expected to support troubled financiers of opaque assets despite their isolation from the payments system, Merton and Bodie’s neat proposal for eliminating the social costs of conjectural guarantees will unravel. As economists, we cannot evaluate proposals for deposit-insurance reform without first defining the appropriate role of government in stabilizing the U.S. financial sector. The case for government intervention seems much stronger when many firms are endangered simultaneously than when the potential failures include only a few firms (even large ones) whose problems are basically idiosyncratic. 5 If economists could teach regulators to intervene only in the former cases, our financial system would be more efficient and productive. Of course, the societal interest in financial-system stability extends beyond economic issues, quickly blurring into political science and, at times, into politics. These realities notwithstanding, an economic consensus on the need for government intervention would provide support for policy advice and analysis. In the longer run, such a firm conceptual foundation would also improve the prospects for introducing political accountability to the regulatory system.
5At times, the distinction between an unstable system and unstable individual institution may be difficult to recognize. One interesting example of this distinction occurs in the model of Penati and Protopapadakis (1988), in which banking firms choose between two types of loans. They conjecture that “local” loans can default without government intervention, while “international” loans (which are shared by many banks in the system) will surely be subsidized if they cannot repay as agreed.
38
References
Bryan,
L.L.,
Siege.
Diamond, ance,
Breaking
(1988).
Homewood, D.W.
and Bank
Up the Bank:
Rethinking
an Industry
and
Dybvig,
Regulation.
P.H., Journal
(1986).
Banking
of Business,
Theory,
59,l:
Flannery, M.J., (1993). of Leverage: Optimally view, forthcoming. P.M.,
Litan, R.E., Institution. Merton, Myers, nancial
R.C., S.C.,
A R econsideration
Credit and Banking,
(1992). (1977).
Economics,
by James
of the Role of Bank 12:
L. Pierce.
Continuous
Determinants 5,2:
Time
Examination.
654-659.
What Sh,ould Ban,ks Do?
(1987).
Insur-
Debt Maturity Structure and the Deadweight Cost Financing Banking Firms. American Economic Re-
(1980).
JournaE of Money,
Deposit
55-68.
Flannery, M.J., (1992). R eview of The Future of Banking, Journal of Finance, 47: 417-420.
Horvitz,
Under
IL.: Dow Jones-Irwin.
Wa.shington:
Finance.
of Corporate
Oxford: Borrowing.
The
Basil
Brookings
Blackwell
Journal
of Fi-
147-175.
Penati, A. and Protopapadakis, A.A., (1988). The Effect of Implicit Deposit Insurance on Banks’ Portfolio Choice with an Application to Internation “Overexposure.” Journal of Monetary Economics, 21,l: 107-126. Pierce,
J.L.,
(1991).
The F u t ure of Banking.
Press.
39
New
Haven:
Yale University