Chari and Kehoe on Bailouts

V. V. Chari and Pat Kehoe have a very nice article on bank reform, "A Proposal to Eliminate the Distortions Caused by Bailouts," backed up by a serious academic paper.

Their bottom line proposal is a limit on debt to equity ratios, rising with size. This is, I think, a close cousin to my view that a Pigouvian tax on debt could substitute for much of our regulation.

Banks pose a classic moral hazard problem. In a financial crisis, governments are tempted to bail out bank creditors. Knowing they will do so, bankers take too much risk and people lend to too risky banks. The riskier the bank, the stronger the governments' temptation to bail it out ex-post.

Chari and Pat write with a beautifully disciplined economic perspective: Don't argue about transfers, as rhetorically and politically effective as that might be, but identify the distortion and the resulting inefficiency. Who cares about bailouts? Well, taxpayers obviously. But economists shouldn't worry primarily about this as a transfer. The economic problem is the distortion that higher tax rates impose on the economy. Second, there is a subsidy distortion that bailed out firms and creditors expand at the expense of other, more profitable activities. Third there is a debt and size distortion. Since debt is bailed out but not equity, we get more debt, and the banks who can get bailouts become inefficiently large.
For sake of argument, I think, Chari and Pat take a benign view of orderly resolution and living wills. Their point is that even this is not enough. Though functioning resolution would solve the tax distortion and subsidy distortion, the debt-size externality remains.

The extent of regulator intervention depends on the aggregate losses due to threatened bankruptcies. Individual firms do not internalize the effect of their decisions on aggregate outcomes and, therefore, on the extent of such intervention. Just as with bailouts, individual firms have incentives to become too large relative to the sustainably efficient outcome 

Their alternative: A regulatory system that

limits the debt-equity ratio of financial firms and imposes a Pigouvian tax on the size of these firms.

The paper is not specific beyond this suggestion. It's intriguing for many reasons outside the paper.

First, they limit the ratio of debt to equity, not the ratio of debt to assets. Current bank regulation is centered on the ratio of debt to assets, but then we get in to the mess of measuring risk-weighted assets, many of them at book value.  Abandoning this whole mess is a great idea.

Thinking about some of the same issues, I came to the conclusion that a simple Pigouvian tax on debt would work better than current debt-to-asset regulations. If you borrow $1 (especially short) you pay an 5 cent tax per year.

There is an interesting question then whether this tax on debt or a regulatory debt-to-equity ratio limit will work better.

Chari and Pat don't say what the optimal debt/equity ratio should be, and how that should be enforced dynamically. If up against the limit, do they want banks to sell assets ("Fire sales" and "liquidity spirals" banks will complain), to issue equity ("agency costs", banks will complain) or what?  Chari and Pat also don't say whether they want regulators to target the ratio of debt to book value of equity or to market value of equity. I like market value, further avoiding accounting shenanigans. I suspect the regulatory community will choose book value, so inure themselves from responding to market signals.

I like announcing a price rather than a quantity -- a Pigouvian tax on debt rather than a debt-equity ratio -- as it avoids the whole argument, and the just this side vs. just that side of any cliff.   My tax could rise with size, to address their size externality as well.

But they don't analyze the idea of a tax on debt rather than their ratio, so perhaps both would work as well within their model. Their ratio of debt to equity is sufficient for their ends, but perhaps not necessary.

Chari and Pat take a benign view of debt, and the functioning of resolution authority: They

start from the perspective that because debt contracts are widespread, they must be privately valuable and, in all likelihood, also valuable to society in general.

They also posit that "orderly resolution" authority will in fact swiftly impose losses on creditors, and that by using "living wills" the offending banks can be quickly broken up.

I think they make these assumptions to focus on one issue. That's good for an academic paper. But in contemplating a larger regulatory scheme, I think we should question both assumptions.

In a modern economy, liquidity need not require fixed value, and I think we could get by with a lot less debt.  That leads me to much more capital overall. They implicitly head this way,  presuming that debt is vital, but then advocating debt equity ratio regulations that will presumably mean a lot more equity.

I suspect that resolution authorities, hearing screaming on the phone from large financial institution creditors of a troubled bank,  and with "systemic" and "contagion" in mind, will swiftly bail out creditors once again.  I think that a bank too complex to go through bankruptcy, even a reformed bankruptcy code, is hopeless for the poor Treasury secretary to carve up in a weekend. So another reason for more equity is to avoid this system that will not work, as well as to patch up its remaining limitations even if it works perfectly.

Chari and Pat also step outside the model, stating that the resolution authority

is worrisome because by giving extraordinary powers to regulators, it allows them to rewrite private contracts between borrowers and creditors...[this]... can do great harm to the well-being of their citizens. Societies prosper when citizens are confident that contracts they enter will be enforced

Their closing sentence is important

We emphasize that regulation is needed in our framework not because markets on their own lead to inefficient outcomes, but because well-meaning governments that lack commitment introduce distortions and externalities that need to be corrected.