I have argued earlier that the global financial crisis is really a run on all explicit and implicit forms of insurance, which is showing up as a freezing of credit markets at all but the shortest maturity. Here, I discuss the consequences of this and what to do about it. Specifically, I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.
An economy with no financial insurance operates very differently from the standard modern economies we are accustomed to in the developed world. The differences are:
1) There is limited uncollateralized or long-term credit (since such loans always have an insurance built in through the possibility of default), 2) the risk premium skyrockets and 3) economic agents hoard massive amounts of resources for self-insurance and real investment purposes.
Illustration: Jayachandran / Mint
During the last quarter, we witnessed the beginning of a transition from an economy with insurance to one without it. Even healthy companies began to draw down on their credit lines with otherwise solid banks, as they doubted their ability to do so at a later date.
In this environment, financially constrained agents obviously cannot go about their businesses with the flexibility they once enjoyed. However, the real hope for a recovery, as well as the concern for a meltdown, lies on the other side of the spectrum, on the unconstrained agents.
At this juncture of the crisis, there are mountains of investment-ready cash waiting for some indication that the time to enter the market has arrived. But investors are frozen staring at each other, and by so doing, they are further dragging the economy downward. The normal speculative forces that trigger a recovery are for everybody to want to arrive first, to “make a killing”. But with so much fear around us, investors have changed the paradigm and they are now content with letting somebody else try his or her luck first, so we are stuck.
Other cash-rich investors see great investment opportunities in the not-so-distant future but in the meantime, they do not unlock their resources for fear that the temporary investments may turn illiquid, a process which in itself contributes to widespread illiquidity, or because the lack of competition brought about by crisis almost ensures a better deal in the future. And yet others go one step further in profiting from illiquidity and panic itself—by shorting run-prone financial institutions, they close the circle of fear that fuels the runs.
We need to reverse this mechanism by restoring the appetite for arriving first.
My sense is that, to a first order of approximation, the correct policy response should build on the following three observations:
a) Many of the ex ante “imbalances” are more structural in nature than is implied in the consensus view, and hence will remain with us long after the crisis is over. They stem from a global excess demand for financial assets and, especially, for AAA financial assets.
b) The main policy mistakes took place during rather than prior to the crisis. The core aspect of the crisis is a collapse in all forms of (explicit and implicit) financial insurance due to a sharp rise in (Knightian) uncertainty. The policy response has been too slow in addressing this core issue. Until very recently, the US treasury’s response often exacerbated rather than reduced perceived uncertainty. The failure to prevent Lehman Brothers Holdings Inc.’s demise represents the worst of this dubious and ad hoc policy approach, but the “exemplary punishment” (of shareholders) policy during the Bear Stearns Companies Inc. collapse also failed to recognize its uncertainty impact.
c) Contrary to what investors thought at the peak of the boom, the (private) financial sector in the US is not able to satisfy the global demand for AAA assets when large negative aggregate events take place. The US government does, however, have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital.
These observations hint at a policy framework for the current crisis and for the medium run.
As long as the government becomes the explicit insurer for generalized panic-risk, we can in the medium run go back to a world not too different from the one we had before the crisis (aside from real estate prices and the construction sector). That is, specialized financial institutions can leverage their capital for the purpose of insuring microeconomic risk and moderate aggregate shocks. They cannot, however, be the ones absorbing extreme, panic-driven, aggregate shocks.
This must be acknowledged in advance, and paid for by the insured institutions. Reasonable concerns about transparency, complexity and incentives can be built into the insurance premia. Collective deleveraging, as currently being done, should not constitute the core response; macroeconomic insurance should. The structural policy framework for the medium run also carries over to the crisis policy itself, i.e., the “firefighting policy”. The essence of a solid recovery should build not from deleveraging and a forced and brutal contraction of the financial sector. Rather it should be built on the explicit and systemic provision of insurance against further negative aggregate shocks to the financial sector’s balance sheet that might be caused by panic or predatory actions.
The recent government intervention with respect to Citi—with its mixture of (paid) insurance and capital—is a promising precedent. So too, was the second government package for AIG.
These interventions need to be scaled up to the whole financial system (banks and beyond), and it is better to do it all at once, for in this case the likelihood of the government ever having to disburse funds for its insurance provision becomes remote.
The government must immediately replace the main insurance markets ravaged by uncertainty. The good news is that, unlike the situation in most other economies in the world, the US, as a whole, is perceived as a safe haven and hence, rather than triggering capital outflows, its financial crisis has done the opposite. The main implication of this safe haven status is that the cost of funding massive policy interventions is very low.
In formulating the list of insurance markets to be supported, it is important to look beyond the obvious. Surely, one of the first worrisome symptoms during the crisis was a contraction in all forms of non-overnight, uncollateralized lending among highly reputable financial institutions. Later on, we saw the corporate sector losing trust in these financial institutions and hence drawing on their credit lines, by which they shifted from insurance arrangements to a much more inefficient (from a systemic point of view) form of self-insurance.
Yet another, perhaps more subtle, insurance collapse came from the housing market crash itself, as households lost the buffer offered by home equity lines of credit against any shock they may face. This loss of insurance became all the more significant after Lehman’s demise, when the collapse in equity markets erased another buffer and overall economic uncertainty spiked. The sharp rise in margin requirements has played a similar role for leveraged investors.
In all these contexts, trimming the (lower) tail-risk offers the biggest bang-for-the-buck. In this sense, capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, certainly much more than the current Troubled Asset Recovery Programme (TARP). The reason is that Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events.
A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.
Real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system. But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.
The Knightian uncertainty perspective also sheds light on some of the virtues of the asset-purchase programme of the original TARP. In practice, financial institutions face a constraint such that value-at-risk must be less than some multiple of equity. In normal times, this structure speaks to the power of equity injections, since these are “multiplied” many times when relaxing the value-at-risk constraint. In contrast, buying assets reduces value-at-risk by reducing risk directly, which typically does not involve a multiplier. However, when uncertainty is rampant, some illiquid and complex assets, such as collateralized debt obligations (CDOs) and CDO-squared, can reverse this calculation. In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital more effectively than directly injecting equity capital.
Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons as well. The point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude (i.e., measure it in trillions).
Paradoxically, the weakness that has plagued emerging market economies for decades has now stricken the financial systems of developed economies and that of the US in particular. The weakness is the sudden loss of investors’ confidence which has ravaged credit markets and the stability of previously sound financial institutions. The conventional advice to emerging markets has been to accumulate international reserves and reduce short term liabilities. The message now for financial institutions in developed nations is to accumulate capital and deleverage.
Essentially, the US (and other) financial markets are experiencing the modern version of a systemic run as we had not seen since the Great Depression. It used to be that depositors ran from banks. Some of this still happens, but runs in modern financial markets, to be systemic, have to involve a larger class of assets. A run against explicit and implicit financial insurance is essentially a run against virtually all private sector financial transactions but for those with the shortest maturities. Thus, the modern lender-of-last resort facility has to be a provider of broad insurance, not just deposit insurance.
Edited excerpts. Published with permission from VoxEU.org. Ricardo Caballero is a professor of economics at MIT. Comment at firstname.lastname@example.org