What Should Government Guarantee? - EconLog

Summary:
Arnold Kling says that financial markets are inherently unstable because they are based on trust and inherently lacking transparency. In fact, trust and reputation replace transparency in financial intermediation; if it were perfectly transparent, there would be no need for it, one could do its business oneself. Deposit insurance helps facilitate trust. It removes all motivation for the consumer to worry about the bank's risk management. It is, however, up to the insurer (FDIC) to worry. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks. Bear Stearns, Freddie and Fannie, Lehman, and AIG were not FDIC-insured banks, yet there creditors are being rescued. Ad hoc-ness of Fed and Treasury causing some resentment. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc. (Published: 16/09/08)

Notes:

• financial markets are inherently unstable
• because financial intermediation inherently replaces transparency with trust
• if my bank were perfectly transparent, then I would know everything about its loans
• including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money
• in that case, I would not need a bank,I could just make those loans myself.
• so if you assume perfect transparency, you assume away the need for financial intermediation
• you have to assume the opposite of perfect transparency, highly imperfect transparency
• with reputation and trust serving as substitutes

• deposit insurance helps facilitate trust
• private insurance pool might work, but people trust government-provided deposit insurance even more
• the consumer loses all motivation for worrying about the bank's risk management
• by contrast: the insurer has to worry a lot
• in the U.S., the FDIC has been getting better over the years, but you can never get complacent
• any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks
• Bear Stearns, Freddie and Fannie, Lehman, and AIG
• institutions that are not FDIC-insured banks
  
• question arises about whether some of their creditors ought to be protected by the government
• note: financial blow-up has not come from private hedge funds
• highly leveraged and unregulated business
• having some regulated, insured institutions, like the banks, is good
• we can or should not try to regulate everyone
• regulators should try to anticipate crises and prevent them
• but almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc