Martin Wolf, FT, Wednesday, March 21, 2018:
Martin Wolf draws some robust conclusions relative to the priorities for macroeconomic research after the recent financial crisis. According to him, it is vital to focus on two tasks:
“The first is how to make the body economic more resistant to the consequences of manias and panics. The second is how to restore it to health as quickly as possible. On both counts, we need to think more and do more. These are the practical challenges before us.”
Indeed, and we must say that on both counts some decisions taken after the crisis, without any deep economic analysis about the unintended consequences, may be rather worrying. Top of the list, we find the extraordinary bail-in powers given to regulators to seize banks over the week-end if they are deemed to be insolvent. It is obviously a good idea to protect the tax-payers and to make the shareholders and some creditors pay whenever a bank has made some large losses. And the threat of a bail-in may convince the banks to be more cautious when they provide credits to their customers. But at the same time, it is very clear that the new system will be very pro-cyclical, something which is not yet apparent since we are in the positive phase of the economic cycle. During a downturn, when it is necessary to encourage companies to continue to invest in order to avoid a Keynesian trap (with a rather vicious circle between low demand and low investments), banks are likely to be excessively cautious in order to avoid the risk of expropriation. The flow of credit is likely to be interrupted at the worst possible of time. Not the best way to “make the body economic more resistant to the consequences of manias and panics” as rightly advised by Martin Wolf.
The problem with bail-in powers is that they are way too much discretionary (see what happened to Banco Popular in June 2017) and that faced with a risk of bail-in banks are likely to be excessively cautious. It is also likely that during the next economic downturn rising risks for shareholders will weigh heavily on banks’ stock prices, making very difficult for banks to issue new shares to reconstitute their capital base. The defenders of the new large bail-in powers would probably argue that regulators would use these powers only against banks with little equity left. But in the midst of a panic and a sharp economic downturn, no accountant can estimate the true value of a bank. It depends too much on assumptions regarding future defaults on banks’ credits, and thus on the highly uncertain prospects for the economy (quick recovery or deepening of the recession?). Thus, valuing a bank is a very difficult exercise, which is not the job of accountants or regulators but really the job of the equity markets where a large number of investors confront their opinions on the long-term profitability of various financial institutions. An equity market which will be completely paralyzed by bail-in fears, and as a result will probably envoy some very strong pessimistic signals!
Obviously, something had to be done to avoid in the future large bail-out costly for tax payers. Yet, the solution is not to give extraordinary powers to regulators without any clear view of how they will be used, how they may trigger panics and, as a result, may make financial crisis even worse (more on that here).