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.
Read more: http://www.interfluidity.com/v2/3531.html
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.
Read more: http://www.interfluidity.com/v2/3531.html
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