What to do with financial tail risk

The Epicurean Dealmaker and Deus Ex Macchiato have been engaged in an interesting discussion of what to do with financial tail risk.

The trigger for the discussion was an article by the Bank of England's Andy Haldane in which he discusses how the banking system has moved from unlimited liability that produced too little credit to limited liability that produced too much credit.

Both bloggers agree with Mr. Haldane that more credit is better as it allows the economy to operate closer to full capacity.

The question then turns to the issue of how we allocate, limit and distribute financial risk.  In the environment of unlimited liability, 100% of financial risk fell on the owners of the bank.  In the environment of limited liability, how much falls on the bank and how much on society?

The Epicurean Dealmaker has a reader, Ms. Sissoko, who attempts to make the case that 100% of the financial risk should continue to fall on the banks even though the shareholders have limited liability.

In responding to her comment, the Epicurean Dealmaker choses to focus on "book" capital as the amount that exists pre-loss.

Capital is, in my understanding, at base a buffer against loss .... capital serves a very important protective function at the “local” level of real creditors and borrowers. Capital absorbs loss, and either stops or slows the propagation of that loss through the daisy chain of economic interrelationships economic actors maintain. 

It is like the collapsible drums filled with water at the top of a freeway exit, whose function is to slow or impede the destructive progress of a runaway car. Sure, a runaway car will eventually stop of its own accord due to friction and gravity—if not another car or building—but do we really want to conclude from this that crash drums aren’t desireable or necessary?

.... Being unable to anticipate all the ways financial loss can occur and directions from which it can come, I would much prefer to have various pools of capital sitting around the system, hopefully helpfully positioned between me and disaster.

If bank capital actually operated this way in times of financial crisis, then the Epicurean Dealmaker's argument would be valid.

But this argument is not valid because bank capital does not act this way in times of crisis.  The financial crisis that began on August 9, 2007 has provided amble evidence that confirms this fact.

Please show me one large global financial institution since the Lehman bankruptcy that has positioned itself between the excesses of the financial markets and the real economy by realizing all the losses on and off its balance sheet.

Even the banks that have been effectively taken over by national regulators have not stepped up and realized their losses.

In fact, the failure of the banks to perform like the Epicurean Dealmaker's collapsible drums has accelerated the propagation of the financial losses into the real economy as the banks have taken resources out of the real economy to further fill these unused collapsible drums.

Let's now return to what Ms. Sissoko had to say

from a theoretic point of view, a banking system doesn’t need capital, it needs trust.

Regular readers immediately see that her argument parallels the discussion on this blog.  Specifically, this blog has observed that banks can continue in operation when their book value is negative because of trust.

Depositors trust that the government will make good on its deposit guarantee.  Unsecured creditors trust that either they will be covered by an implied guarantee from the government (which was confirmed by the programs global policymakers put in place in 2008/2009) or that central banks will provide liquidity so they can be repaid.

So if banks can continue to operate with negative book equity, then their book capital truly has the ability to perform like the collapsible drum.  It can absorb all the losses on the excesses in the financial system today.

But why hasn't this happened?

The Epicurean Dealmaker provides an insight:

Besides, without capital, how can we enforce incentives? Capital belongs to someone. I thought the point was to reduce unnecessary systemic risk by presenting those positioned to create the risk of loss in the first place with incentives not to do so recklessly. How else can we do this except by making them the first to bear that loss; i.e., lose their capital?

In short, what happens if banks are required to step up and act like the collapsible drum and recognize all of their on and off balance sheet losses?

What happens to those positioned to create the risk of loss in the first place and those who benefitted from the risk.

If their financial institutions was not nationalized, shareholders, who stood to benefit from the risk, would probably find themselves in a position where there would be no dividend payments until such time as the bank's book capital had been rebuilt through the combination of retention of earnings and share issuance.

One might anticipate that shareholders are not going to be happy with the limited prospect for financial return until book capital is rebuilt.  If shareholders are unhappy, they might look at how to increase earnings.

Naturally, their attention might fall on the compensation of those who created the risk of loss in the first place and in particular, banker's bonuses.  While bonuses might still be available, they too will be restricted to payment as stock (this restriction in turn will tend to redue the size of the bonuses as shareholders want to minimize dilution).