The Root of the Root of the Perverse Incentives in the Banking Sector: the Wrong Monetary Policy Regime

As I have described before, the banking sector is a mess – or as Mervyn King put it: “Of all the many ways of organising banking, the worst is the one we have today.”

At the root of the problem are explicit and implicit government guarantees for bank debt. These constitute a subsidy of debt financing and provide an incentive for banks to minimize equity to asset ratios. Razor-thin capital ratios again incentivize banks to take on excessive risk. At some point excessively risky investment behavior will produce heavy losses and lead to a solvency crisis.

Government guarantees for bank debt do not only stand at the beginning of this causal chain – they also stand in the way of a solution to the solvency crisis. Undercapitalized banks do not necessarily need to engage in credit rationing. The much simpler solution would be to issue more capital. But the taxpayer subsidy for debt has made capital artificially expensive relative to debt. Hence, banks are reluctant to issue more capital and the solvency crisis drags on.

So, if the government abolished deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and also announced that there would be no bailing out of creditors any more in the future, would this eliminate the perverse incentives in the financial industry?

Without being accompanied by certain changes in the institutional environment (described below) such an announcement would simply not be credible and hence not effective: there are, at the moment, banks that are (potentially) “too important to fail”. Hence, the government has a strong incentive to renege on its promise and rescue such banks in the event of a crisis.

Anticipating this too-important-to-fail problem facing the government, the creditors of such banks will be content with relatively low risk-premiums. Again, the capital structure irrelevance principle will not hold and the banks will still be able to reduce their weighted average cost of capital by increasing their leverage to astronomical levels.

Without first solving the too-important-to-fail problem, the government cannot credibly commit to not bail out failed banks. But is there a solution to this problem at all?

The failure of a sufficiently large bank (or several banks) may well cause a massive negative shock to aggregate demand that cannot be offset by conventional monetary policy (i.e. by cutting the nominal safe interest rate). The economic cost associated with such an outcome (especially the cost in the form of a potentially significant rise in unemployment) may well be deemed too high to be politically acceptable.

The fact that the central bank’s power to offset negative aggregate demand shocks by cutting the safe nominal interest rate is limited (namely by the zero lower bound) is the main argument put forward to rescue failed banks with taxpayers’ money.

However, while there is obviously a limit to reductions in nominal interest rates, there is no limit to the extent to which the central bank can increase the money supply. That was Milton Friedman’s point when he complained about the failure of US monetary policy in the 1930s.

Of course, it is not enough to just increase the money supply. In order for the expansion of the money supply to increase aggregate demand, markets have to believe the increase of the money supply will be permanent. In short: the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.

A fixed inflation target cuts off the Friedmanite money expansion route to boosting aggregate demand at the zero lower bound. If the central bank does not commit to deviate from its inflation target, market participants know that the central bank will collect the newly printed money again as soon as the economy is not subject to the aggregate demand shock any more. Hence, the effect of the monetary expansion on spending will be negligible.

The problem is that at the moment central banks across the world have a fixed inflation target, which means that the central bank’s power to offset negative aggregate demand shocks caused by the failure of sufficiently large banks is limited by the zero lower bound, which is again the root of the too-important-to-fail problem.

What’s wrong with the banks?

In the 19th century banks funded themselves with 40% to 50% equity. In 2007, the US banking industry’s equity to asset ratio was 3.8 percent. For the 10 largest banks it was only 2.8 percent. What had happened?

The reason for the drastic decline in capital ratios during the 20th century is simple: since the Great Depression bank debt has been explicitly or implicitly guaranteed by the government. If creditors of a bank will be repaid regardless of the condition of the bank, they stop worrying about the condition of the bank. In particular, they will give the bank a discount on the cost of the funds it borrows and will not demand compensation for a lower capital ratio (i.e. a higher probability of bankruptcy).

In short: the government guarantee is a massive subsidy of debt financing. And minimizing equity to asset ratios maximizes the value of this subsidy to the banks’ shareholders.

The problem is that a razor-thin capital ratio creates perverse incentives for a bank’s investment decisions.

Consider the following example:

A bank is funded by 3 billion of capital and 97 billion of debt. The bank’s management can choose between two alternative strategies:

  1. Strategy A: The bank invests the 100 billion in relatively secure government and company bonds. After one period the return will be either 110 billion or 100 billion (with a probability of 50%, respectively).
  2. Strategy B: The bank invests the 100 billion in US subprime mortgages. After one period the return will be either 65 billion or 125 billion (with a probability of 50%, respectively).

In order to keep things simple, we normalize the interest rate on debt to 0%. Then the different stakeholders’ payoffs for the two possible strategies are given as follows.

Payoffs for strategy A (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 13 110
return if unlucky 97 3 100
expected profit 0 5 5

Payoffs for strategy B (in billions):

creditors shareholders overall
Investment 97 3 100
return if lucky 97 28 125
return if unlucky 65 0 65
expected profit – 16 11 – 5


Note that strategy A is the efficient strategy because it maximizes the expected return from lending. However, by following an inefficiently risky business model (strategy B) the bank can increase the expected profits for its shareholders. If we assume that the bank’s management acts in the interest of the shareholders, it will choose strategy B.

In order to rein in on the perverse incentives created by deposit insurance (which is, of course, not insurance in the true sense of the word but simply a government guarantee) and other more implicit guarantees for bank debt (e.g. in the case of institutions deemed “too big too fail”) , governments around the world have been creating an ever-growing mountain of regulations.

Already before the financial crisis, the banking industry was the most heavily regulated sector in the economy. However, thousands and thousands of pages of regulations are not able to change the perverse incentives introduced by government guarantees for bank debt.

And make no mistake about it: these perverse incentives underlying the banking industry will lead to further crises.