Ross Levine is the Booth Derbas Family/Edward Lazear Senior Fellow at the Hoover Institution and co-directs Hoover’s new Working Group on Financial Regulation, which will hold its Banks and Beyond conference in April. He is also a research associate at the National Bureau of Economic Research. His latest article advocates for bank reforms that take on moral hazard before aggressively deregulating the sector.
Chris Herhalt: You advocate taking on moral hazard in financial institutions with a credible strategy. What does that consist of, and why does that need to happen before reforms are taken?
Ross Levine: Policy actions by the Federal Reserve and other US regulatory agencies over the past decade, along with the Dodd-Frank Act, have encouraged banks to take excessive risk; that is, they have dramatically intensified the moral hazard problem. To counteract the excessive risk-taking incentives unleashed by financial regulatory policies and actions, the government created a vast regulatory and supervisory apparatus to constrain those risks. If the authorities relax these constraints on excessive risk-taking before addressing the policies incentivizing excessive risk-taking, this could trigger a major financial crisis.
Herhalt: As for a credible strategy to take this on, it won’t be enough to have an official from the Federal Reserve or another agency simply says, “no more bailouts, we mean it.” Everyone recognizes that. But on the other hand, letting a major financial institution fail the next time there’s a crunch might be too extreme also. What is there in the middle? What options are there?
Levine: I want to reiterate one point that’s implicit in what you said: at some level, it doesn’t matter what the regulators and policy makers believe they will do when there’s a crisis. What matters is what banks think the government will do when there’s a crisis. If they believe the government will bail them out, they have incentives to take on excessive risk.
There are two elements to excessive risk-taking. One is that it can trigger a crisis. The other is that credit, and hence economic opportunities, flow to the wrong places. Bankers may pass up excellent investments to get more risk. These two elements create a fragile system and a system likely to produce slower growth in the long run.
Strategies have been proposed to address the moral hazard problem, each with its own weaknesses. One strategy is to increase capital, so that the bank is funded with more shareholder equity and less by borrowing. In this case, shareholders can absorb larger losses if the bank falters, reducing the likelihood of using taxpayer money to bail out the bank. In addition, if shareholders have more of their wealth exposed to the bank—more skin in the game—they will have stronger incentives to pressure bank executives to take more prudent risks. One potential problem is that small shareholders may be unable to coordinate and pressure bankers to reduce excessive risk-taking.
There can be complaints about capital requirements, because they involve the government telling banks how much they should be funded with equity. And why is the government intervening in the private sector? However, before there was deposit insurance and before governments started bailing out banks as completely as they do now, private investors in banks forced banks to fund themselves with over 30 percent of equity. Today, regulations require banks to fund themselves with about 10 percent of equity. The point is that government deposit insurance and bailout policies allowed banks to fund themselves with much less equity than when private markets operated more freely in banking.
Herhalt: What do you think were the reasons behind the federal bailout of Silicon Valley Bank (SVB)? Why would they decide to cover uninsured deposits there?
Levine: I think there are two reasons. One is that there were many banks like SVB whose net worth went to zero or below because they had undertaken the same types of investments. This evidence comes from my Hoover colleague, Amit Seru, who has done the most impactful and path-breaking work on banking and bank regulation in the past decade. So, bailing out SVB’s insured and uninsured depositors reduced the chances that the uninsured depositors in other banks would get nervous and pull their money out.
The consequences of that are at least twofold. One is that we now have a large part of the banking system operating with probably zero or negative net worth, which means the owners of those banks have nothing to lose. They’ve already lost it. The only way for them to win in the long run is to take excessive risks, that is, to gamble for resurrection. Second, the authorities have increased the moral hazard problem. They have signaled again that they will bail out uninsured depositors, infecting the rest of the system with additional excessive risk-taking incentives.
I think the other reason for the bailout is that even if it might be socially beneficial in the long run to let a large number of banks fail—to establish credibility that the authorities are not going to bail out uninsured depositors—there’s a risk that it could turn into a significant economic slowdown. Policy makers don’t want that as part of their legacy.
And it’s a lot easier to simply print money.
Herhalt: Are there any other strategies regulators could use to avoid moral hazard and force banks to take less risk?
Levine: There are other strategies that could be used in conjunction with higher capital standards. One is forcing the bank to borrow from large investors, where the government can hopefully make a more credible commitment that it wouldn’t bail out those large, sophisticated investors.
In that case, those large, sophisticated investors would have stronger incentives to constrain excessive risk-taking because they would have skin in the game. There can be complications with that strategy, as well. Maybe the authorities, when push comes to shove, will also bail them out. In the 2008 crisis, entities that nobody would have thought would have been bailed out two years earlier were bailed out.
And finally, there’s one other possibility, sometimes called clawbacks. In large banks, there typically is no large shareholder; there are lots of little, diffuse shareholders. None of them really can constrain risk-taking. They’re just not that big, they’re not that sophisticated, and they don’t have enough money on the line to monitor something as sophisticated as a large bank. Executives are typically the decision makers in large banks. If they have more of their personal wealth on the line, the would be less likely to take excessive risks. However, as I sometimes like to ask US regulators, if executives take excessive risk—not illegal, just excessive—and the bank fails, how much money do those executives lose?
And the answer is, typically nothing.
Clawback provisions aim to pay executives in a way such that if the bank doesn’t perform well over a certain number of years, even after the executives have left, you can claw back some of that money. Their money.
And this is a way of the executives having more of their own wealth on the line, giving them greater incentives to be prudent with the bank’s assets. This hasn’t typically been used in practice.
Herhalt: Do you have any idea what the Trump White House envisions for bank deregulation?
Levine: I have no direct communication with the people who will decide this. Looking into their comments over the years and assessing their approach to regulation in general, it’s to deregulate to let the market work better. And not only do I understand that, I’m one of the people who have done lots of research showing how many of the regulations used to constrain risk-taking limit competition, raise costs, hurt the efficiency of the banking system, curtail entrepreneurship, slow down economic growth, and constrain economic opportunities, especially for those at the lower end of the income distribution. So, not only do I understand why the Trump administration may seek to deregulate, much of my research over forty years advertises the potential benefits of such reforms.
However, things could be catastrophic if they don’t get the sequencing right. It’s very easy to do the deregulation. It’s very hard to implement the policy reforms that improve incentives.
Herhalt: Some of the steps sound like ones pro-market people in favor of deregulation wouldn’t like, especially the income clawback.
Levine: A pro-market person is likely to argue for getting rid of the policies that encourage excessive risk-taking and the ones that try to prevent excessive risk-taking but increase costs and reduce competition and innovation.
That sounds great. It’s just that policy makers, Democrat and Republican, have been unable to credibly commit to not bail people out. For example, in 2008, they bailed out everybody. Not just banks, not just insured deposits, not just uninsured depositors. They bailed out the investment banks and intervened to support the commercial paper market, the money market fund. Everything. The government and regulatory authorities cannot now credibly commit to not bail out investors in major financial institutions simply by promising not to do so. That is, the way things currently stand, the authorities can’t eliminate the regulatory-induced incentives for excessive risk-taking because they lack credibility—and for good reason. That is why I argue we should address those incentives before deregulating banks’ ability to take those excessive risks.
Herhalt: In commercials for banks since SVB’s collapse, I’ve seen a lot more pitches that say, “I’m a new financial institution and I want your deposits. I don’t have just the Federal Deposit Insurance Corporation (FDIC) coverage; I’ve gone out and secured private depositors’ coverage over and above $250,000. So, come to me because you’ll have not only FDIC but also coverage of anything else.” Is that a trend?
Levine: This is potentially a great thing. The regulatory authorities have shown that they will bail out people with deposits exceeding $250,000. If private insurance covers these deposits, taxpayers will pay less if the bank fails, and the private insurers may themselves constrain the bank from taking excessive risk. Clearly, somebody will pay for that insurance, and the depositors will probably pay by receiving lower interest rates on their deposits.
The big question is, will the entities insuring banks have the resources to cover depositor losses if the bank fails? Who is assessing the insurers? My guess is that everybody will expect the Fed or the FDIC to bail out the depositors if the insurance companies cannot. And would they be wrong? The last time banks failed—SVB, First Republic—all depositors got bailed out. Nobody believes the government can say, “We’re not going to bail you out next time.” If this is the case, I doubt many depositors will accept lower interest rates so that banks can buy that insurance.
