When the government supports the debt of financial firms, it actually makes the jobs of its executives much harder if not impossible. Whether the guarantee is explicit or implicit because the bank is Too Big To Fail, the market reacts to the government backstop in ways that make risk management pretty much impossible.
This dynamic isn’t widely understood. The standard story by critics of bailouts is that they create “moral hazard,” tempting banks to take on too much risk because the government will absorb the losses. But this misses something even more fundamental: the government aid distorts the markets and makes it almost impossible for banks to discover when they have become too risky.
That’s because the only real way to run effective risk management is to watch exogenous signals about the risk of a firm. That is, management needs to be able to look to see how the market is reacting to their size, their leverage levels, their trading books, and their business models. These, rather than an academic’s mathematical model of Value at Risk or some other modelled risk profile, are the best guides to risk management.
When the government can be counted to bail out a failing firm, these signals get obscured. Shareholders and creditors stop acting as checks on risk, size, and leverage. The business model’s appropriateness becomes largely unmeasurable. The managers no longer can use the market process as a system for discovery. They are flying blind, without the compass of the market to guide them.
In short, the implicit guarantee enjoyed by the biggest banks does something far worse than incentivise them to take on risk (as the moral hazard theory would have it). It makes them unable to read market signals that would tell them if they are taking on more risk than they should. It fosters an impression that their investments are far less risky than they are–after all, their stock kept going up, their creditors kept lending money! If they were screwing up, wouldn’t the market have told them this?
On today’s edit page, the Wall Street Journal describes how Fannie and Freddie were great examples of how government backing leads to ruin:
Too big to fail also masks the market signals that might warn about the risks of getting too big. Fannie Mae and Freddie Mac are now black holes for taxpayer money because government guarantees juiced demand for their debt and allowed them to grow almost without bound. Even multibillion-dollar accounting scandals didn’t quell demand for their debt or equity because investors were confident the government would never let them default. A private debt issuer receives vital information about market perceptions of the risks it’s taking on from the prices it pays for incremental capital.
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