A Capital-less Financial System

World financial markets are being ravaged by uncertainty and fear. The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared. Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire sale asset prices quickly wipe out their capital and, simultaneously, destroy their option to raise new capital since equity values implode.

The conventional advice is for these institutions to deleverage and to raise capital. While this is sound advice when dealing with a single institution in trouble, I believe this is exactly the opposite of what we need at this juncture of a massive systemic crisis. Forcing institutions to raise capital, be it private or public, at panic-driven fire sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fueling the downward spiral.  This is self-defeating.

The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses.

I believe it is feasible to run such a system for a while, because, essentially, distressed financial institutions need (regulatory) capital for two basic purposes: To act as a buffer for negative shocks, and to reduce their risk-shifting incentives by exposing them to their losses. However these two functions can be replaced, respectively, by the provision of a comprehensive public insurance, and by strict (and intrusive) government supervision while this insurance is in place.

A few days ago the U.K. announced a policy package that almost got it right, by pledging to insure banks’ balance sheets and other private liabilities. Unfortunately, it backfired and caused a worldwide run on financials because it did not dissipate, and even exacerbated, the fear of forced capital raising (or nationalization).  The events following Lehman’s demise should have taught us that this fear needs to be put to rest until we can return to normality. Financial institutions are too intertwined to predict with any precision the impact of diluting any significant stakeholder, and the markets are too fearful to feed them more uncertainty. Strong guarantees with strict supervision, and the commitment of no further capital injections at fire sale prices (directly or through convertible bonds) should go a long way in building a foundation for a sustained recovery.

With some dismay, I read that an enormous amount of time is being spent discussing what should be the price of the insurance and the first-loss threshold. It seems to me that given the extreme severity of the crisis and the asymmetries involved in failing in one or the other direction in each of these issues, the answers are rather obvious: The price of the insurance should be very low – say risk-neutral pricing plus 20 or 50 basis points of markup; and the first-loss threshold should be sufficiently low that no new capital will need to be raised in the short run if a loss arises. The second intervention of Citi offers a micro-model of such an intervention, but it needs to be scaled up within each bank and massively across all banks and other key financial institutions.  It also needs to be made much more attractive to all systemic financial institutions, even those that are not in deep distress.

What about the taxpayers? The best that can happen to all of us is that the financial crisis ends as soon as possible. This is the first priority, the rest can wait. If the transfer to the financial institutions ends up being too large for society’s taste, then it is always possible for the government to undo some of it through ex-post taxation of excessive earnings. Conversely, if the transfer is too low (the price of the insurance and the first-loss threshold too high), it may well be that we do not get another chance, at great cost not only to financial institutions but also to taxpayers.


6 Responses to "A Capital-less Financial System"

  1. Guest   January 23, 2009 at 10:27 am

    A sound thought, if your interest is in keeping the bankers who screwed us all in power.otherwise don’t listen to this man, he wants us to have to carry water for people who have engaged in large scale fraud.he is i suspect vested in keeping the fraud of fiat currency printed by the federal reserve going.the brenton woods agreement was violated in 1971 when nixon took us off the gold standard, it completely failed last august and international trade is breaking down.this man has no prescription to fix this, only a prescription to make sure the federal reserve board, the ones who did this to us, are still in power when it’s over.do not believe any liars or parasites who talk about how we might have to eat these losses as tax payers, the banks are bankrupt, push them into bankruptcy, it will be easier to clean up later.

  2. Not in Lalaland   January 23, 2009 at 2:15 pm

    Another economist who proposes solutions without first understanding the problem. They still haven’t learned: If your model is fatally flawed, your solution will be fatally flawed too.Too many economists frame this as a liquidity problem — we just need to tide the banks over until the markets come back. (Prof. Roubini is extremely generous to give them so much space on his site!)Over in the real world, many of us are aware that the real problem is that too many of the biggest financial institutions have been booking revenue ON BOTH SIDES of credit default swaps that are the liabilities of insolvent banks. The insolvent banks have booked the CDS premia as a income stream, while CDS buyers (e.g. Goldman, Deutsche Bank) have booked the revenue they expect to receive when the underlying defaults. That’s the wonder of derivatives that are priced by model — both sides of the trade get to book an asset.Economists who don’t bother to study the problem assume that mortgage backed securities are comparable to conventional assets. They are way behind the times. MBS are full of swaps — aka empty promises — that people like Prof. Caballero think governments should now step in and guarantee.He needs to remember that if the US government bails out the big banks at the expense of a dollar crisis that devastates US borrowing ability, the big banks don’t need to hang out in a devastated country — they can just move on to wherever the next financial center is — Beijing maybe.

  3. interested reader   January 28, 2009 at 11:03 am

    either banks and asset prices deleverage, or the real economy will. I prefer that banks do.

  4. Anonymous   January 30, 2009 at 2:46 am

    If you have a “lemon” bank (or car) there is no point to insure it and try to sell it. It’s a lemon! No tricks, no more cheating!

  5. Guest   January 30, 2009 at 4:32 am

    I marvel sadly at these posts – a shocking mix of confusion,ignorance and arrogance you would expect from tabloid readers rather than from an economics blog. Who are these people (apparently they think they “understand” finance) that accuse Prof Caballero of “not bothering to study the problem” while saying things like: “MBS are not conventional assets” but are “full of swaps”. This is so utterly meaningless and devoid of intelligence it could be humorous, except Caballero, who is a serious economist, is talking about a serious topic here.Having structured several European MBS I can tell you are clueless (and no, none of these deals have or will ever default – despite trading at high spreads -evidence of a liquidity problem – and they are not “full” of imaginary “swaps”). Some of the other posts are really useless as well. Honest advice guys, you should puruse some other more productive interests.

  6. Anonymous   January 31, 2009 at 5:55 am

    I think Prof Caballero is on the right track. Why is there no capital? Is it really a capital-less financial system? No, The producer nations and soverign wealth funds have capital (savings). The consumer western industrialized nations US and Europe and other free market countries have deficits. Since 1973 western Bankers have tried to use various bits of legerdemain to avoid reckoning with the imbalance brought by commodity cartelization and it worked for a time. Now the waiter has brought the check and the diners are broke. Globalization without a coordinated Global bank will fail and will inevitably lead to war and protectionism. The few who profit mightily from globalization will be overwhelmed by the masses who are or have already lost everything. Its a rising tide that will eventually swamp the globalists unless a global common market GCM and global common bank GCB are formed that can effectively regulate currencies and “free market” capital flows and restore balance. The producers may resist this but in the end they are dependent on prosperous consumers for their own prosperity.