Forcing frequent failures

I’m sympathetic to the view that financial regulation ought to strive not to prevent failures but to ensure that failures are frequent and tolerable. Rather than make that case, I’ll refer you to the oeuvre of the remarkable Ashwin Parameswaran, or macroresilience. Really, take a day and read every post. Learn why “micro-fragility leads to macro-resilience”.

Note that “micro-fragility” means that stuff really breaks. It’s not enough for the legal system to “permit” infrequent, hypothetical failures. Economic behavior is conditioned by people’s experience and expectations of actual events, not by notional legal regimes. As a matter of law, no bank has ever been “too big to fail” in the United States. In practice, risk-intolerant creditors have observed that some banks are not permitted to fail and invest accordingly. This behavior renders the political cost of tolerating creditor losses ever greater and helps these banks expand, which contributes to expectations of future bailouts, which further entices risk-intolerant creditors. [1] In order to change this dynamic, even big banks must actually fail. And they must fail with some frequency. Chalk it up to agency problems (“you’ll be gone, i’ll be gone“) or to human fallibility (“recency bias”), but market participants discount crises of the distant past or the indeterminate future. That might be an error, but as Minsky points out, the mistake becomes compulsory as more and more people make it. Cautious finance cannot survive competition with go-go finance over long “periods of tranquility”.

So we need a regime where banks of every stripe actually fail, even during periods when the economy is humming. If we want financial stability, we have to force frequent failures. An oft-cited analogy is the practice of setting occasional forest fires rather than trying to suppress burns. Over the short term, suppressing fires seems attractive. But this “stability” allows tinder to build on the forest floor at the same time as it engenders a fire-intolerant mix wildlife, creating a situation where the slightest spark would be catastrophic. Stability breeds instability. (See e.g. Parameswaran here and here. Also, David Merkel.) We must deliberately set financial forest fires to prevent accumulations of leverage and interconnectedness that, if unchecked, will eventually provoke either catastrophic crisis or socially costly transfers to creditors and financial insiders.

Squirrels don’t lobby Congress, when the ranger decides to burn down the bit of the forest where their acorns are buried. Banks and their creditors are unlikely to take “controlled burns” of their institutions so stoically. If we are going to periodically burn down banks, we need some sort of fair procedure for deciding who gets burned, when, and how badly. Let’s think about how we might do that.

First, let’s think about what it means for a financial institution, or any business really, to “fail”. Businesses can fail when they are perfectly solvent. They can survive for long periods of time even when they are desperately insolvent. Insolvency is philosophy, illiquidity is fact. Usually we say a business “fails” when it has scheduled obligations that it cannot meet — a creditor must be paid, the firm can’t come up with the money. The consequence of business failure is that creditors — the people to whom obligations were not timely met — become equityholders, often on terms that prior equityholders consider disadvantageous. The business may then be liquidated, so that involuntary equityholders can recover their investments quickly, or it may continue under new ownership, depending on its value as a going concern.

Forcing failure by rendering banks illiquid is not a good idea, for lots of different reasons. A better alternative is to jump straight to the consequence of illiquidity. We’ll say a bank has “failed” when some fraction of its debt is converted to equity on terms that affected creditors and incumbent equityholders would not have voluntarily arranged. [2] “Forced failure” will mean provoking unwelcome debt-to-equity conversions by regulatory fiat.

Failure isn’t supposed to be fun. Forced conversions to equity should be unpleasant both to creditors and incumbent equity. Upon failure, equityholders should experience unwelcome dilution, while creditors should find themselves shorn of predictable payments and bearing equity risk they do not want. Converted equity should not take the form of public shares, but restricted-sale instruments that are intentionally costly to hedge. Over the long-term, ex post as they say, there will be winners and losers from the conversions: If the “failed” bank was “hold-to-maturity” healthy, patient creditors will have received a transfer from equity holders via the dilutative conversion. If the bank turns out to have skeletons in its balance sheet, then converted creditors will lose, bearing a portion of losses that would have been borne entirely by incumbent equityholders. In either case, unconverted creditors (including depositors and public guarantors) will gain from a reduction of risk, as the debt-to-equity conversion improves the capital position of the “failed” bank. And in either case, both creditors and shareholders will be unhappy in the short-term.

One might think of these “forced failures” as what Garrett Jones has called speed bankruptcies. (See also Zingales, or me.) There are devils in details and lots of variations, but as Jones points out, “speed bankruptcy” needn’t be disruptive for people other than affected creditors and shareholders. Managed forest fires do suck for the squirrels, but we’d never be willing to adopt the policy if it weren’t reasonably safe for bystanders. Related ideas would be to frequently force “CoCos” (contingent convertible debt) to trigger or public injections of capital on terms that dilute existing equity.

But if we are going to “force” failures — if these failures are going to be regulatory events rather than outcomes provoked by market counterparties — how do we decide who must fail, and when? There is, um, some scope for preferential treatment and abuse if it becomes a matter of regulatory discretion whose balance sheets get painfully rearranged.

A frequent-forced-failure regime would have to be relative, rule-based, and stochastic. By “relative”, I mean that banks would get graded on a curve, and the “worst” banks would be at high risk of forced failure. That is very different from the present regime, whereunder there is little penalty for being an unusually risky bank as long as your balance sheet seems “strong” in an absolute sense. During good times, behaving like Bear Stearns just makes a bank seem unusually profitable. Given agency costs, recency bias, and the vast uncertainty surrounding outcomes for all banks should a crisis hit, penalizing banks only when they are in direct peril of regulatory insolvency is inadequate. We want to create incentives for firms to compete with one another for prudence as well as for profitability. Even during booms, creditors should have incentives to discriminate between cautious stewards of capital and firms capturing short-term upside by risking delayed catastrophe. The risk of forced conversions to illiquid equity would create those incentives for bank creditors.

Forced failures should obviously be rule-based. The current, discretionary system of bank regulation and enforcement is counterproductive and unjust. Smaller, less connected banks find themselves subject to punitive “prompt corrective action” when they get into trouble, while more dangerous “systemically important” banks get showered with loan guarantees, cheap public capital, and sneaky interventions to help them recover at the public’s expense. That’s absurd. Regulators should determine, in placid times and under public scrutiny, the attributes that render banks systemically dangerous and publish a formula that combines those attributes into rankable quantities. The probability that a bank would face a forced restructuring would increase with the estimated hazard of the bank, relative to its peers.

And “probability” is the right word. Whether a bank is forced to fail should be stochastic, not certain. Combining public sources of randomness, regulators should periodically “roll the dice” to determine whether a given bank should be forced to fail. Poorly ranked banks would have a relatively high probability of failure, very good banks would have a low (but still nonzero) probability of forced debt-to-equity conversion. The dice should be rolled often enough so that forced failures are normal events. For an average bank in any given year, the probability of a forced restructuring should be low. But in aggregate, forced restructurings should happen all the time, even (perhaps especially) to very large and famous banks. They should become routine occurrences that bank investors, whether creditors or shareholders, will have to price and prepare for.

Stochastic failures are desirable for a variety of reasons. If failures were not stochastic, if we simply chose the worst-ranked banks for restructuring, then we’d create perverse incentives for iffy banks to game the criteria, because very small changes in ones score would lead to very large changes in outcomes among tightly clustered banks. If restructuring is stochastic and the probability of restructuring is dependent upon a bank’s distance from the center rather than its relationship with its neighbor, there is little benefit to becoming slightly better than the next guy. It only makes sense to play for substantive change. Also, stochastic failure limits the ability for regulators to tailor criteria in order to favor some banks and disfavor others. (It doesn’t by a long shot eliminate regulators’ ability to play favorites, but it means that in order to fully immunize a favored future employer bank, a corrupt regulator would have to dramatically skew the ranking formula, whereas with deterministic failure, a regulator could reliably exempt or condemn a bank with a series of small tweaks.) It might make sense for the scale of debt/equity conversions to be stochastic as well, so that most forced failures would be manageable, but investors would still have to prepare for occasional, very disruptive reorganizations.

Banking regulation is hard, but in a way it is easier than forest management. As Parameswaran emphasizes, when a forest has been stabilized for too long, it becomes impossible to revert to the a priori smart strategy of managed burns. Too much tinder will have accumulated to control the flames, to permit any fire at all would be to risk absolute catastrophe. It is clear that regulators believe (or corruptly pretend to believe) that this is now the case with our long overstabilized financial system. Lehman, the story goes, was an attempt at a managed burn and it almost blew up the world. Therefore, we must not tolerate any sparks at all in the vicinity of “systemically important financial institutions”. No more Lehmans! [3]

However, unlike physical fire, with bank “failures” there are infinite gradations between quiescence and conflagration. A forced-frequent-failure regime could be phased in slowly, on a well-telegraphed schedule. Both the probability of forced failure and the expected fraction of liabilities converted could rise slowly from their status quo values of zero. Risk-intolerant creditors would, over time, abandon financing dangerous banks at low yields, but they would not flee all at once, and early “learning experiences” would provoke only modest, socially tolerable, losses. Over time, the cost of big-bank finance would rise. Of course, the banking community will cry catastrophe, and make its usual threat, “Nice macroeconomy you got there, ‘shame if something were to happen to the availability of credit.” As always, when bankers make this threat, the correct response is, “Good riddance, not a shame at all, we have tools to expand demand that don’t rely on mechanisms so unstable and combustible as bank credit.” We will never have a decent society until we develop macroeconomic alternatives to loose bank credit. Bankers will simply continue to entangle their own looting with credit provision, and blackmail us into accepting both.

There are a lot of details that would need to be hammered out, if we are to force frequent failures. Should debt/equity conversions strictly follow banks’ debt seniority hierarchy, or should more senior debt face get “bailed in” to haircuts? (Senior creditors would obviously take smaller haircuts than those experienced by junior lenders.) As a matter of policy, do we wish to encourage the over-the-counter derivatives business by exempting derivative counterparties from forced failures, or do we prefer that OTC counterparties monitor bank creditworthiness? (If so, “in the money” contracts with force-failed banks might be partially paid out in illiquid equity.) If risk of forced conversion is relative, banks may try (even more than they already do) to “herd”, to be indistinguishable from their peers so their managers cannot be blamed if anything goes wrong. Herding is already a huge problem in banking — “If everybody does it, nobody gets in trouble” ought to be the motto of the Financial Services Roundtable. (See also Keynes, and Tanta, on “sound bankers”.) Any decent regulatory regime would impose congestion taxes on bank exposures to ensure diversification of the aggregate banking sector portfolio.

These are all policy choices we can make, not barriers to imposing policy. We can, in fact, create a more loosely coupled financial system where risk-intolerant actors are driven to explicitly state-backed instruments and creditors of large private banks genuinely bear risk of losses. The hard part is choosing to do so, when so many of those who rail against “bailouts” and “too big to fail” are protected by, and profit handsomely from, those very things.


Acknowledgments:

This post was provoked by recent correspondence/conversation with Cassandra, The Epicurean Dealmaker, Dan Davies, Pascal-Emmanuel Gobry, Francis O’Sullivan, Ben Walsh and of course Ashwin Parameswaran. And whoever I’ve forgot. Unforgivably. The good stuff is almost certainly lifted from my correspondents. The bad stuff is my own contribution.


Notes:

[1] Note that “too big to fail” has nothing to do with how Jamie Dimon talks to his cronies in the boardroom. It is a Nash equilibrium outcome in a game played between creditors, bank managers and shareholders, and government regulators. Legal exhortations that try to compel regulators to pursue a poor strategy, given the behavior of creditors and bankers, are not credible. If “the Constitution is not a suicide pact”, then neither was FDICIA with its “prompt corrective action”. Nor will Dodd-Frank be, despite its admirable resolution authority.

[2] Note that “creditors” here might include the state, which is the “creditor from a risk perspective” with respect to liabilities to insured depositors and other politically protected stakeholders.

[3] Some argue that Dodd-Frank’s “living wills” and resolution authority give regulators tools to safely play with fire “next time”, and so they will be more willing to do so. I’m very skeptical of claims they did not have sufficient tools last time around, and don’t believe their incentives have changed enough to alter their behavior next time. Perhaps you, dear reader, are less cynical.

Update History:

  • 20-Oct-2012, 11:35 p.m. EEST: “easier that than forest management”, “should be probabilistic stochastic, not certain”, “aggregate banking sector asset portfolio”
 
 

35 Responses to “Forcing frequent failures”

  1. vbounded writes:

    Mr. Waldman, “Squirrels don’t lobby Congress, when the ranger decides to burn down the bit of the forest where their acorns are buried. Banks and their creditors are unlikely to take “controlled burns” of their institutions so stoically. If we are going to periodically burn down banks, we need some sort of fair procedure for deciding who gets burned, when, and how badly. Let’s think about how we might do that.

    “Regulators should determine, in placid times and under public scrutiny, the attributes that render banks systemically dangerous and publish a formula that combines those attributes into rankable quantities. The probability that a bank would face a forced restructuring would increase with the estimated hazard of the bank, relative to its peers.”

    The econo-technocrats are not smarter than the market. As soon as they lay out a proposed regulatory scheme for limited bailouts, smart people will be paid lots of money to lobby for loopholes and then back up the truck to the public fisc. If people don’t want abuse of the public fisc through bailouts, people have to give up on childish fantasies that regulators control the market. The US bankruptcy rules work because they assume the market is smarter than regulators in restructuring businesses and re-allocating assets and talent to more productive uses. The nutty bank regulate and bailout schemes don’t work because they assume the regulators are smarter than the market.

    I’m just waiting for some econo-technocrat to apologize the way Robert McNamara eventually did about Vietnam. Too little, too late. It’s not as if one can sue him for all the damage his theories caused.

  2. vbounded writes:

    If someone can think up a way to sue Rubin and his proteges, let me know.

  3. Steve, this is (as per usual) completely fascinating. But here’s where you begin to lose me a bit on the policy specifics:

    “Banking regulation is hard, but in a way it is easier that forest management”

    To which my immediate thought was: there is an important respect in which bank regulation is a million times harder than forest management – trees are not strategic actors. They don’t lobby or schmooze the forest managers, or try to game the criteria for deciding where to burn. As you rightly say:

    “There is, um, some scope for preferential treatment and abuse if it becomes a matter of regulatory discretion whose balance sheets get painfully rearranged”.

    And I guess what I’m saying is that your relative, stochastic rule regime (which is a really ingenious idea, by the way) would likely end up having sufficient complexity in the underlying analysis that seemingly innocuous changes to small assumptions could easily change the outcome. This appears to be true of bank capital regulation now – there is no fact of the matter how much regulatory capital a bank has because the analysis requires too many assumptions. How would this exercise be different? Could this not end up sneaking regulatory discretion through the back door, with the added problem that what is now at stake is the probability a firm will be forced into bankruptcy? I think I know myself well enough to recognise I have a bias in the direction of knee-jerk ‘public choice’ objections to these sorts of proposals, but isn’t there a real danger here?

    Also, on a completely different point, I have the lingering sense this would be unconstitutional in the US. I’m not sure why, but involuntary bankruptcy by regulatory fiat based on a ‘role of a dice’ just seems like the kind of thing that would be…

  4. chrismealy writes:

    I’ve read Ashwin’s blog, and I’m 100% for the ecological approach, but one problem is that it’s oriented at the level of the firm. What about people? We already have big problems with underemployment, and less stability is not going to help.

  5. chrismealy writes:

    (I meant Ashwin’s ecological approach)

  6. Greg Taylor writes:

    Jack Welch let about 10% fail each year – at least until he thought he’d routed out the deadwood. I’ve wondered how much fear that put into the organization. It might solidify the short-term management thinking plaguing corporations and banks today. I’m always a bit wary about using fear as a motivator. Perhaps fear would facilitate a necessary transition period from a failed system. It hasn’t worked in public education though.

    Once burned, the forest renews naturally. If we burned about 10% of banks each year, we’d need to think carefully about renewal so that a phoenix will arise from the ashes instead of further concentrating power into fewer and fewer banks.

  7. Sergei writes:

    Being solvent on hold-to-maturity basis is the function of cost of funding. Together they produce a circular reference.

    Problems of banks come from the payment system. If we split banks from the payment system then we can easily let them fail as they wish. Technically we will not even need a regulator to supervise them. Does anybody care when some hedge fund or private equity fails?

  8. Sergei: “Does anybody care when some hedge fund or private equity fails?”

    Four words for you: Long Term Capital Management…

  9. Steve Roth writes:

    Not really on the subject of this post, but can’t resist:

    “when bankers make this threat”

    And also: “Yeah, fine guys, we’ve got plenty of lubricant in the system, we don’t need it sloshing around all over the shop room floor. Small businesses have been telling us for decades that credit and financing are the Very Last Things on their list of business constraints (NFIB), and the biggest business (by market cap) in the history of the world has no debt at all, and what, $60, $80 billion stuffed in the mattress?.

    “So yeah, guys: I’m really afeared. Go have your picnic with John Galt and we’ll just proceed about our business here.”

  10. David Merkel writes:

    Ashwin is a favorite of mine and is entirely reliable on economic matters. Thanks for mentioning me, Steve.

  11. [...] Forcing frequent failures – interfluidity [...]

  12. Sergei writes:

    Richard Williamson, as we say – “exceptions only prove the rule” :)

  13. Drfrank writes:

    As policy, this is dreamy and, of all things, financial institutions are not ecological systems. What is the point of maintaining the tiered capital structure of banks? Why not simply legislate out of existence everything except deposits and common equity? Why not compell banks to straightforwardly report a ratio of assets to liabilities, an old fashioned acid test, using for the numerator assets about which there is no serious complexity as to valuation or liquidity? Assets that a not too smart regulatory examiner can understand. A ratio that John Q Public could use to evaluate the safety of a depository, in a system that had a much lower level of insured deposits. A phrase like lack of transparency does not come close to describing the protective obscurity in which the banks operate now. A controlled burn could not happen in a bog.

  14. [...] A fit financial system would be one in which bank failures are a ‘routine occurrence.’  (Interfluidity) [...]

  15. Dennis writes:

    Richard Williamson,

    “We” cared about LTCM failing because it was going to bring down the banking system with it because most banks in there either had significant investment into LTCM or were holding the same bonds that would have been crushed in a LTCM liquidation. If we could tolerate the failure of the ‘bulge bracket’ then LTCM could have failed, brought down Morgan Stanley/Goldman/Merryl/Bear/Lehman and no one would care.

  16. Unanimous writes:

    I’ve often wondered if randomly setting central bank interest rates would stabilise the business cycle. “The pile of sand” sometimes used to illustrate stability and chaos theory doesn’t become unstable if it is subject to vibration. In addition to being stressed randomly and having to buffer some of the effects, banks would pass on interest rate fluctuations to some extent to the rest of the economy also.

    Banks aren’t the only organisations that can become too big to fail. If only banks were occasionally shaken by some means, then wouldn’t there arise after a while some too big to fail financial companies “insuring” the banks or bank creditors.

  17. PEG writes:

    Thanks for the name-check!

    I don’t see anything to disagree with this.

    I guess my point would be that one way to encourage frequent failure would be to encourage *entrepreneurialism* in the system. We really do want a Silicon Valley of finance, where’s there’s a bunch of innovation (both innovation, and “innovation”), because failure is grist for such a system, failure of the kind we want to see. And the first place to doing that is to radically lower barriers to entry in the arena, regulatory and otherwise. And if you have radically lower barriers to entry, you WILL get failures almost by definition.

    And if you’re reducing barriers to entry, you need to reduce size, and the best way to reduce size is to mandate employee ownership, which also fixes agent/principal situations.

    That plus (limited, public) deposit insurance ensures a healthy ecosystem.

  18. tspare writes:

    I think what is proposed still doesn’t solve the agency problem nor the regulatory capture currently exist in financial services. Punishing the bond holder by forced equity conversion does nothing to hold the management liable. Its far better to make the senior management defer a chunk of their compensation x number of years into the future so that they don’t try to game the system for short term gains. In addition, there will always be someone out there selling CDS to protect bond holders against forced conversion which render the problem moot until the CDS counterparty cannot handle a systematic important firms (which brings us back to square one again).

  19. Ashwin writes:

    Steve – Thanks! As my posts show, I stand on the shoulders of giants – Hyman Minsky and Buzz Holling being the two most prominent ones.

    As always an intriguing idea and you have already identified the major hurdle in all such ideas which is to avoid the banks gaming the system. I’m not convinced stochasticity solves this problem but it is a big step forward from the current regime.

    One way to find out how gameable this idea (or any idea) is would be to run some sort of simulated game. You play the central bank and a bunch of banker-hackers try and find holes in it for fun and profit. I reckon a few such games will deliver more insight into whether a idea will work than all the academic papers out there on this subject.

  20. [...] interfluidity.com – Tagged: Compelling View on Counterparties.com → Amazon.com Widgets var [...]

  21. McGoncile writes:

    They did let two unhealthy trees burn down, MER and BEAR. Then they realized the fire would storm the whole market and burn every bank cross-invested in it, and the conceptual ‘moral hazard’ argument of defending any individual bank was expediently put aside because of the unexpected but highly predictable size of the exigency.

    Now, the government is openly manipulating the market in which it has a huge stake across several bodies. It owns stock and it is vested in the sucess of the market it is supposed to regulate, which is obviously not a good thing and should be illegal, but is also clearly the roots of the next crash.

    One i like every earnings season is when JPM, GS and C report higher earnings because their stocks holdings are up. Of course they are up, the market is up. But they do not sell…the mark to market and hold…and they themselves are stocks whose performance affects the market…

    When the market is crashing, they will not perform well, and that will crash the market further…the synthetic derivative hedges will magnify the problem, as most of the bearish hedges will have been thrown away at this point of QE3 in order to magnify long leverage and short term gain.

  22. [...] Regulations Why “we must deliberately set financial forest fires” at random – Interfluidity [...]

  23. [...] Forcing frequent failures – interfluidity [...]

  24. small business quicken writes:

    I have seen sites online where they claim that you can get a free macbook pro. Are these legit? And if so which one is the one to try?

  25. mgblock writes:

    This is an excellent idea, but I fear it is too complicated and doesn’t go far enough. Arguably the economy at large should be subject to failure, random and forced — not just for banks. The stability, or instability, of the financial system is of course a huge issue, but we cannot forget the role of everyone else in the economy who don’t act with prudence because no central banker or government will allow sparks to fly. This is not to let the banks off the hook, but they are only one part of the problem. Because the culpability is so widespread, it is hard to see society allowing widespread failure to just happen. People cannot resist the urge to intervene, either to “fix” things when they are going bad or to do everything possible to preserve the status quo when the good time are rolling.

  26. John B. writes:

    “Stability breeds instability”

    Sometimes I think that economists should leave their books and focus more on what is possible to change. But on the other hand, it is also important to think outside of the box. Your proposal lacks both – possibility to be executed and it still works under the same global capitalist paradigm.
    There is not a single politician who would submit to follow your plan. The reform you are seeking is not inside of the economy, but in the political system. When political parties convert themselves into parasites (aka cartel parties) and professional politicians are financed from the funds of powerful companies, it is against their interest to let them fall.

    It is the same as the condo market. By letting one or two companies fall down you won´t resolve the problem. You may achieve some correction, but the prices will stay the same in the end, since the problem is not in the companies, but in the speculation over the condo market as a whole (as it is explained Strong Average Price Growth). With the same logic, you “cure” this problem of the bailout, but new problem would arise and replace it. The irresponsible bankers or bank owners will just change their strategy.

  27. [...] Steve Waldman: “As a matter of law, no bank has ever been ‘too big to fail’ in the United States. In practice, risk-intolerant creditors have observed that some banks are not permitted to fail and invest accordingly… In order to change this dynamic, even big banks must actually fail. And they must fail with some frequency… So we need a regime where banks of every stripe actually fail, even during periods when the economy is humming. If we want financial stability, we have to force frequent failures. An oft-cited analogy is the practice of setting occasional forest fires rather than trying to suppress burns. Over the short term, suppressing fires seems attractive. But this ‘stability’ allows tinder to build on the forest floor at the same time as it engenders a fire-intolerant mix wildlife, creating a situation where the slightest spark would be catastrophic. Stability breeds instability.” [...]

  28. SW:
    Welcome aboard! I’ve said this for 32 years!

    IA

  29. Nichol Brummer (@Twundit) writes:

    Nice example of using stochastical methods for policy. In this case on banks. I think such methods could be useful much wider, but always have trouble convincing my friends that random decisions that nobody can argue with are a good way to make choices between alternatives between which it isn’t easy to choose. Because they are all acceptable. But where some variation over time is also advantageous. An added advantage would be that random variations in (parameters of) policy would provide statistical data that can be used to measure the effectiveness of certain policies as well.

    It wouldn’t even be a completely novel idea: the ancient Athenian democracy used random lots to appoint people in various positions, even on a board of army generals, I presume together with a chosen leader. Even Socrates found himself in the position of a ‘strategos’ once.

  30. vlade writes:

    Steve,
    While I agree with the central proposition – we need failures – I disagree with the implementation on many fronts.

    It’s still gameable (so, I convert debt to equity. If I’m seen as sound, what’s to stop me to issue tons of debt and purchase the equity, or do do equity to debt swap to get back to where I was before?).

    It doesn’t really hit the agency problem, which IMO is one of the most serious problems we have.

    If you want to have safe banking, you have to resolve that, and there’s a fundamental problem with it, because if you make banks partnerships they won’t be able to raise enough money to provide capital to large (or even medium risky) projects, but if you let them raise money from public you’ll get screaming orphans and widows now and then and then state bailout.

    I have ideas around that, but it’s too long for a post, so if you’re ever in London (or Prague for the matter), let me know and we’ll talk it over a beer or three (or another beverage of your choice).

  31. vlade writes:

    @Nichol Brummer: I’ve long argued that we’d look back at some of the ancient regimes, as they had fundamentaly dealt with similar issues (corruption, plutocracy etc.) as we do.

    Athenian sortition would be much preferred to the voting (and statistically should have about the same outcomes as if everyone voted), and clauses such as that politicians in charge were financially responsible for any embezzlement that occured under their authority would change politics very dramatically too (it would have the drawback that talented poor w/o sponsor wouldn’t be able to get into an office though, so it’s not as clearcut choice).

  32. [...] Steve Waldman at Interfluidity on the systemic importance of allowing business (including bank) failures. [...]

  33. David Merkel writes:

    Steve,

    Maybe it should be like this: set a standard for liquidity and leverage where regulators leave a bank alone. Then set a standard for liquidity and leverage where regulators take a bank over. Between those two areas, let the regulators score the banks, creating a rating between zero and 100. Then once a year, let the regulators roll the dice, four in all, and if the cumulative probability of the number obtained is below the score, they get takes into conservation.

    My but a lot of banks would get up to the leverage and liquidity standards, and fast, after the first few conservations.

  34. David Merkel writes:

    Corrected:

    Steve,

    Maybe it should be like this: set a standard for liquidity and leverage where regulators leave a bank alone. Then set a standard for liquidity and leverage where regulators take a bank over. Between those two areas, let the regulators score the banks, creating a rating between zero and 100. Then once a year, let the regulators roll the dice, four in all, and if the cumulative probability of the number obtained is above the score, they get taken into conservation.

    My but a lot of banks would get up to the leverage and liquidity standards, and fast, after the first few conservations.

  35. [...] frequent failures (Interfluidity) “If we want financial stability, we have to force frequent failures. An analogy is the [...]