Journal of FinancialServicesResearch9:299-302 (1995) 9 1995KluwerAcademicPublishers

Comment STUARTI. GREENBAUM Olin School of Business, Washington University, St. Louis, MO 63130-4899, U.SM.

The following comments are directed at two articles: "Is The Banking and Payments System Fragile?" by George J. Benston and George G. Kaufman (hereafter B-K), and "Systemic Risk in OTC Derivatives Markets: Much Ado About Not Too Much" by Franklin R. Edwards. The discussion of B-K is more extensive and comes first. B-K insinuate a potpourri of beliefs and public policy prescriptions relating to financial system regulation, suffusing them in a selective review of the voluminous academic literature on bank runs, panics, and the interface between the financial and real sectors of the economy. For effect, the authors stress their disagreement with Irving Fisher, Charles Kindleberger, Martin Feldstein, Diamond-Dybvig, Adam Smith, Joseph Schumpeter, and Walter Bagehot, among others. The flavor of the B-K findings is conveyed by the following: The cost of individual bank failures is relatively small and not greatly different from the failure of any non-bank firm of comparable importance in its community. In fact, the societal cost of preventing insolvent banks from failing is greater... Further, B-K aver: 9 The widely observed proclivity of banks to fail--"inherent instability"--is mistaken. 9 The alleged contagion of bank failures is likewise mistaken. 9 The lender-of-last-resort (LLR) function of central banks is distorting and readily disposable. 9 Bank capital requirements should be further elevated, to some unspecified level, to mitigate moral hazard problems. 9 Sanctions for noncompliance with capital requirements should be swift, sure, and severe--"structured early intervention and resolution (SEIR)." 9 Market-value accounting (MVA) should replace generally accepted accounting principles (GAAP). 9 Virtually all geographical, functional, and ownership restrictions on banks should be eliminated. These and other positions are legitimized as inferences, suggestions, or even implications of the surveyed literature. Some are comfortably familiar. For example, the argument for replacing regulatory discretion with swift, sure, and severe sanctions for noncompliance with capital requirements was advanced at least a decade ago (Greenbaum, 1985).

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Nevertheless, these criticisms leap to mind: 9 Although B-K's findings are presented as if they follow from the literature reviewed, the linkages are not always transparent. For example, the "inherent instability" (undefined by B-K) of banks is debunked by marshalling evidence that recessionary shocks from the real sector of the economy often precede banking distress. Does such evidence obviate bank runs of the Diamond-Dybvig (1983) or Chari and Jagannathan (1988) variety? Would such bank runs constitute inherent instability? Not clear! 9 It is too easy, even niggling, to criticize a literature review for selectivity. But in light of the prescriptions advanced, important contributions are ignored. For example, Mailath and Mester (1994) on forbearance, O'Hara (1993) on MVA, Boyd and Gertler (1993) on too-big-to-fail (TBTF), and Chari and Jagannathan (1988) on bank runs, are widely cited on the questions at issue in B-K. Likewise, to dismiss the LLR in two double-spaced pages strikes me as heroic, at best. 9 At least one key point in B-K is contradicted internally. On the one hand, "the evidence is overwhelming.., that depositors have been able, at the margin, to differentiate between good and bad banks . . . . " On the other, " . . . past multiple bank failures are consistent with the asymmetric information hypothesis . . . . " 9 Given our messy world of second best, in order to be persuaded of the merits of B-K's proposals I would want to see them evaluated against alternative reform proposals. In this regard, I found it surprising that neither the U.S. Treasury's (1991) recommendations nor the more recent FIRREA Commission Report (1993) were mentioned. Also ignored were the Ely (1986) proposals for privatizing deposit insurance, the aforementioned Boyd-Gertler proposals regarding TBTF, and the pristine proposals to scale back, or even eliminate, deposit insurance. All of these have been seriously advanced with the same motivation as the authors', namely, to reduce moral hazards and other distortions of the safety net and to reduce subsidies flowing from taxpayers to bank owners and managers. The appropriate context for advocating the B-K reforms is that they in some compelling sense dominate these alternatives. Having chided B-K, in the spirit of candor, let me offer my own perspective. I thinkwe know the following: 9 Fractional reserve banks evolve naturally from goldsmiths as warehouse receipts become more widely accepted as payments media. 9 Even apart from asset quality problems, individual banks suffer periodic withdrawal crises owing to their production of liquidity (Edgeworth, 1888). 9 The probability that individual bank's distress will develop into panic increases with the opaqueness of banks. 9 Even very small probabilities of banking panics can imply large expected value losses to the community. (This is not to say that nonbank failures are incapable of generating important externalities. They are!)

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9 The liquidity problems of fractional reserve banks are readily addressed with a credible LLR. (This is not to say that a Federal Funds market can't effectively redistribute reserves under ordinary circumstances. But markets for liquidity occasionally gridlock, and credit rationing is reasonably well documented.) | However, the introduction of a central bank LLR immediately creates a moral hazard in that banks respond by reducing their cash-asset reserves; this is true at any finite discount rate. The dissipation of banks' cash assets transfers seigniorage from taxpayers to the banks. (Publicly provided and most-of-the-time idle fire-fighting capability is often found to be worthwhile despite a robust private market in fire extinguishers, sprinkler systems, and inexpensive and readily available water. Moreover, the public provision of fire-fighting services results in a moral hazard too.) 9 This is the most basic argument for prudential regulation. (Of course, if you could safely dispose of the LLR, the moral hazard disappears and along with it the rationale for regulation.) 9 But deposit insurance, TBTF, guarantee of the payments system and other safetynet features produce their own moral hazards. It would seem to follow that the discussion of bank regulation appropriately begins with how much safety net is needed--here I believe B-K and most of the academic profession would join hands as minimaiists-- and how much regulation would be required to sustain the public protection of banks and the payments system. At the next level lies the issue of regulatory design ("the devil is in the details"), and the most interesting cut here is one originating in the literature on macroeconomic stabilization policy, from Simons (1936) and Friedman (1948) to Kydland and Prescott (1977). That is, how much discretion ought public officials have, and how much can be accomplished with rules. Whereas Simons and Friedman questioned the motives and judgment of central bankers, and Kydland and Prescott introduced the issue of time consistency, the point here is different. Discretionary prudential regulation adds uncertainty- from the bank investor's standpoint, what Gerald Corrigan (1990) called "constructive ambiguity." This ambiguity may ameliorate some moral hazards (Boot and Thakor, 1993), but it also inflates the bank's cost of capital, and this cost typically is not internalized by the public regulator. Hence, if the regulatory problem can be addressed with rules that limit regulatory discretion, in the spirit of SEIR, the deadweight costs of regulation can be reduced. This, it seems to me, is the broader context within which to evaluate alternative banking reform proposals. Franklin Edwards' paper makes the plausible point that the systemic risk (however defined) posed by the recent explosive growth of over-the-counter (OTC) derivatives is very likely exaggerated, and that largely overlooked are the benefits of more cost-effective hedging opportunities. The author then proceeds to an interpretation of the Metallgesellschaft (MG) affair that brought one of Europe's great companies perilously close to the abyss owing to the (ab)use of derivatives. Edwards explains the loss of $1.5 billion in terms of inept management at the highest levels in MG, and the market's naive response to misguided accounting conventions. The lessons drawn include:

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9 9 9 9

Inappropriate accounting conventions can cause great harm. Managers should understand their firm's use of derivatives. Managers should understand the risk of regulator caprice. The market smoothly absorbed the precipitous liquidation of M G ' s massive open position in derivatives. 9 E u r o p e a n corporate governance may require re-examination. Here, I fault the author for timidity. What are the lessons for public regulation of O T C derivatives, if any? What about public policy regarding disclosure? One possible interpretation is that since market participants can be confused by accounting conventions, some form of public regulation is warranted. Moreover, since the New York Mercantile Exchange inappropriately elevated M G ' s margin requirements precipitating a liquidity crisis, should the self-regulating exchanges be brought u n d e r greater public sector scrutiny as well? T h e author's interpretation of the M G disaster suggests a host of fascinating questions, but these are left largely unaddressed. H e tantalizes, but ultimately frustrates the reader.

References Boot, Arnoud W. and Anjan V. Thakor. "Ambiguity and Moral Hazard." Working paper, Indiana University, 1993. Boyd, John H., and Mark Gertler. "U.S. Commercial Banking: Trends, Cycles, and Policy."NBER MacroeeonomicsAnnual (1993), 319-68. Chari, V.V., and Ravi Jagannathan. "Banking Panics, Information, and Rational Expectations Equilibrium." Journal of Finance 43 (1988), 749-61. Corrigan, E. Gerald. "Reforming the U.S. Financial System:An International Perspective." QuarterlyReview of the Federal Reserve Bank of New York 15 (1990), 1-14. Diamond, Douglas W., and Phillip H. Dybvig. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91 (1983), 401-19. Ely, Bert. Bailing Out the Federal Savings and Loan Insurance Corporation.Alexandria, VA: Ely and CompaW. 1986. Ely, Bert. The FSLIC Recap Plan is Bad Medicinefor Healthy Thrifts and for theAmerican Taxpayer.Alexandria, VA: Ely and Company. 1987. Friedman, Milton. '% Monetary and Fiscal Framework for Economic Stabilization." American Economic Review 38 (1948), 246-64. Greenbaum, Stuart I. "Deregulation of the Thrift Industry: A Prologue to Transitional Problemsand Risks." In: Financial Stability of the Thlifi Industry: Proceedings of the Eleventh Annual Conference, Federal Home Loan Bank of San Francisco. 1985,pp. 15-39, 41-45. Kydland, Finn E., and Edward C. Prescott. "Rules Rather than Discretion: The Inconsistency of Optimal Plans." Journal of Political Economy 85 (1977), 473-91. Mailath, George J., and Loretta J. Mester. "A Positive Analysis of Bank Closure." .lournal of Financial Intermediation 3 (1994), 272-99. "ModernizingThe Federal System:Recommendations For Safer, More CompetitiveBanks." Washington, DC: Department of The Treasury. 1991. National Commission on Financial Institution Reform, Recovery, and Enforcement. "Origins and Causes of the S&L Debacle: A Blueprint for Reform." A report to the President and Congress of the United States, Washington, DC, 1993. O'Hara, Maureen. "Real Bills Revisited: Market Value Accounting and Loan Maturity." Journal of Financial Intermediation 3 (1993), 51-76. Simons, Henry C. "Rules versus Authorities in Monetary Policy."Journal of PoliticalEconomy 44 (1936), 1-30.

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