Steve Waldman was a software developer who became fascinated by finance and started writing about it. He is now a doctoral student in finance at the University of Kentucky. He blogs at Interfluidity.

~~~

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 probabilistic, 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 that 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 asset 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.

Category: Bailouts, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “Forcing Frequent Failures”

  1. AHodge says:

    deep
    right on target
    the evidence is all around, of distortion
    bank bond yields are four ratings better
    their bond rates hugely lower than their balance sheets and risk would suggest
    this is not only complacency but a huge bubble blowing incentive

    the clean house argument needs to be specifically applied to banking
    the risks of highly leveraged credit
    have been understood since the first economist Adam Smith
    who pointed out that banking and levaged lending required unique and specific restraints and highly conservative behaior- just wiping out the strayers ex post may not be the best, especially if they all go down bust after the peak at once

    deciding on resolution will inevitably be an arbitrary regulatory discretion exercise
    if you do it real early and pick on someone–thats more extreme
    im ok with that with someone nearly superhuman in charge
    how and when? my answer a year ago would be leave it to Sheila
    what loser would do it now?

    i prefer light touch rules based regulation. “Resolution” is the opposite
    if you fix accounting and take away a guarantee for every goofy thing that Adam Smith warned about
    you will have done huge
    to not blow the bubble in the first place–or need fires or arbitrarily chosen sacrifices so much

  2. Greg0658 says:

    good interspection .. but .. 1st the paper chase is so much an easier path to take in this modern toys, tools & regs world – since we must chase the law – return to first 2 words

    maybe we should consider a new OpSys that regulates interest rates allowed to charge and payout .. force individuals & corporations to earn bread the hard way .. so all folks realize “it ain’t easy”

    I agree with the premise of smallness and small pain to grow via – we are not there now – we have supercorps and “they own the place”

    ~~
    cross post’g now (sorta) – the graphs seen here @TBP recently and the discussion of bull & bear tides – seems the OpSys is always / will always be – {I got mine} ‘ you’ll be gone, i’ll be gone ‘

    daily bread OpSys of CHOICE (ok Incompetentness of crowds in a superOpSys)

    ~~
    oh its possible to have a controlled burn in a forest and get the squirels out 1st – but not under capitalism law

  3. AHodge says:

    you can push this controlled burn analogy too far, you want it completely arbitrary, random victims
    pour encourager les autres?
    dont let the subsidised tinder even start to grow.
    or damp down credit crowth with countercyclical
    reserve requirements for ecample

  4. constantnormal says:

    … unnecessary … the reforms of the 1930s allowed us to go for over half a century without a single financial panic … the first (and only) time since the founding of the US that has occurred … it was predictable that once the banksters bribed the politicians to repeal all the regulations, that the panics would resume like clockwork, every 3 years or so …

    … that’s a relief valve of sorts, a lot like bloodletting to manage high blood pressure … hardly a recommended practice …

  5. willid3 says:

    while i can some limited upside to this idea. there is also a very large down side. if businesses and people can’t trust banks to be there when they need them, then they will stop using them. would likely be the end of them, and replace them with either credit unions, or with mattresses. and i doubt seriously that the FDIC would be able to handle the huge volume of bank crashes that would result.
    its sort of like flying. if the odds of safe arrival at your destination wasn’t really close 100% (say it was 1 in 10 flights that crashed) would you fly? probably not.

    and the reality is, you dont have to go just real far into the past to see what results of frequent bank crashes was like. just go back before the 1930s, and you can see that frequent bank crashes lead to bank runs if there was even a rumor of a bank having a problem. and when banks actually printed bank notes (like in the really old days) the ‘money’ you had might not worth the paper it was printed on

  6. interguru says:

    A few years ago, the historian William McNeill enunciated the law of Conservation of Catastrophe. The law states that solutions to one crisis lead the way for some equal or greater disaster in the future. This law may point to a future disaster in the Global Economy. Before going further into implications for the economy, I will give some examples of the law.

    Forest Fires.

    For over a hundred years the US Forest Service has aggressively doused any forest fire as quickly as it could. Small forest fires, usually ignited by lightning, which used to be very common are now rare. This allowed a century’s worth of debris to accumulate on the forest floor — making them into tinderboxes. Now we are seeing large uncontrollable fires fed by this debris.

    More on floods, warfare, the electric grid and the global economy below.

    Floods

    Flood control levees along our rivers have reduced the floods that were common every springtime. The former flood plains are now covered with homes and businesses. The levees have another effect, by confining the rivers they raise the level of the rivers during flood season. When there is a very wet season, the confined rivers go high enough to flood over even the best levees, leading to widespread flooding of areas that were not originally in the flood plain.

    The Electric Grid.

    For the past 50 years we have been linking our once separate local electric power grids together to allow them to swap energy and avoid blackouts when a power plant fails. It works, blackouts are rare. However when they do happen, they cover not just a city or a state, but a whole region for long times.

    Warfare

    Someone (I cannot recall who) quipped that the main purpose of civilization is to prevent men from killing each other and raping women. Stone age men killed each other at a rate now only seen in our worst neighborhoods. Now almost all of us can walk outside in relative safety. Then there is the another other effect of civilization — large scale war with widespread killing and rape.

    The Global Economy

    After the great depression, the US and the world implemented a set of financial reforms designed the prevent a repetition. These worked, for the past 70 years there has been no widespread economic collapse. Local collapses, such as the Asian economic crises, were contained within their region. Various bailouts and running the printing presses avoided the big collapse. Here comes the big question. Is this the economic version of Conservation of Catastrophe?

  7. VennData says:

    “…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….”

    This guy’s a moron. Calculated risk keeps track of Bank failures. They fail all the time, you don’t need to force failure.

    http://www.calculatedriskblog.com/2012/10/bank-failure-46-in-2012-excel-bank.html

    Get your useless PhD in finance and get a job at the Starbucks you right wing loonball.

  8. Frwip says:

    @VennData

    Before you call anyone a useless moron, check the long term record and you’ll see bank failures and assets at play are quite concentrated, big fires in dry forests, choke-full of tinder.

    http://2.bp.blogspot.com/_pMscxxELHEg/SyQxYhjpJ0I/AAAAAAAAHAk/Q4nrm0EGCHc/s1600-h/BankFailuresCOP.jpg

    The world is indeed Minskyian.

    That being said, I utterly disagree with Waldman’s approach.

    Even setting general rules is an invitation for the banks to practice an end-run around the rules. The only rule of central banking should be that there are no rules, only a certainty that commercial banks’ shareholders, bondholders and management are entirely disposable in the eyes of the central bank, and will be taken out and finished off at the slightest sign of trouble if the central bank deems it useful.

  9. Theravadin says:

    @Frwip

    I’d agree 100% with you if you added a 4th category to your list of people to be held disposable : depositors. But I don’t think we want to go there. As it is, with FDIC, it’s the insurer who gets to set the rules. In other types of insurance, where the manager of the asset and the potential beneficiary of insurance on that asset are essentially the same, insurance companies can simply deny payment where policy conditions have been breached. Unfortunately, in this case the managers and the beneficiaries are completely separate, so denying payment in the case of a breach would defeat the purpose of the insurance. Ergo bank regulation. Personally I don’t favour going back to pre FDIC wild west banking – systemic stability is generally desirable, from a social and business point of view. Doing business in developing countries has taught me to value what we have, in that regard!

  10. BradErvin1 says:

    Thank you for this intriguing article.

    Have I understood correctly that your proposal implies the introduction of frequent mini-failures at the level of the individual financial institution?
    That is, depending on the firm’s performance within the forced-failure-regime , shareholders may, from time to time, lose some of their shareholdings to bondholders (which themselves are losing some of their bond holdings)?

  11. ezrasfund says:

    Nassim Taleb has put forth the idea of “anti-fragility”, that is systems that become stronger and more resilient as a result of stress (our skeletal system is a good example), as opposed to the notion of a system that is simply resistant to breakdown. As he argued in “The Black Swan” systems that appear very stable and are protected from failure fail in spectacular fashion when they finally do collapse.

    A question I often asked is how can a nation at war win every battle but finally loose the war? Napoleon in Russia provides a good example (the US in Vietnam perhaps a more controversial study). As one side loses time after time it is hardened until the optimized fighting force encounters a fatal flaw and collapses almost of its own weight.

    The problem that businesses face is that optimization a robustness seem to have an inverse relationship. Will AAPL become a case study for this thesis?