Tuesday, May 13, 2014

Risk Sharing as a Way to Improve Financial Stability

There have been many proposals to improve financial stability going forward. Some of them are bound to disappoint, while others have great potential. A great example of the former are proposals for macroprudential regulation. These proposals would have central bankers regulate financial firms based on systemic risks rather than firm-specific risks. The idea is to dampen the inherit procyclicality of the financial system and make it more resilient to shocks. This includes adjusting capital requirements, allowable leverage, and other risk-preventing measures based on the state of the business cycle. A big problem with this approach is that it assumes regulators are omniscient in their knowledge and can outsmart markets. It also assume financial regulators will be uncorrupted and benevolent dictators in the adminstration of the duties. If you believe both of these assumption will hold then you have not been paying attention to financial markets over the past decade.

A better way to foster financial stability is to create mechanisms that do not depend on regulators getting it right. Two recent proposals that do that are ones based around automatic risk sharing for debt contracts. The idea is to automatically make lenders share in both the risk and return that individuals and firms face when they borrow. This is akin to making debt contracts more equity-like in nature.

The first risk-sharing proposal comes from Amir Sufi and Atif Mian in their new book. In it, they call for a risk sharing mortgage. Here is the Wall Street Journal's discussion of their proposal:
With such instruments, if a home’s value rose, the lender would share in the gain; if it fell, so would the principal balance as well as the interest payment. That way, both parties to the contract—and not just the homeowner—would have potential upside as well as downside... Adopting shared-risk mortgages would mean shifting the focus of both government and the financial system to equity from debt. Right now, Mr. Sufi said, the government tacitly backs debt through the mortgage-interest deduction, federal deposit insurance and support of highly rated assets. But if those implicit subsidies were removed or eased—admittedly a tall order—shared-risk mortgages might appeal more to potential lenders. The United Kingdom has been offering a form of such equity loans. Under the U.K.’s “Help to Buy” program, home buyers can put down 5%, receive an equity loan for 20% of the property’s value, and take out a traditional mortgage for the rest.
Lenders probably would not be thrilled about it, but it nicely align incentives up front. That is, lenders would be more careful to whom they lent and this would minimize the chances of downward equity adjustments occurring in the first place. Given how important mortgage financing is to the U.S. economy, this proposal by itself should make a big difference.

The second recent risk-sharing proposal was made by Kevin Sheedy at the Brookings Papers on Economic Activity conference. There, he presented a paper where he makes the argument for risk-sharing via a nominal income target:
Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.
As a long-time advocate of nominal GDP targeting, this risk sharing proposal is near-and-dear to my heart. As Sheedy notes, it is not a new argument for a NGDP target (see Selgin, 1997), but it is an often overlooked one.

It would be great to see these proposals adopted before the next crisis hits. Unfortunately, it is more likely less effective approaches to financial stability like macroprudential regulation will be widely implemented.


  1. When it comes to regulation, I favor the KISS---Keep It Simple Stupid.

    This is good for transparent democracy, and probably works well in practice too.

    I favor more-simple approaches, such as increased capital requirements, or taxes based on the flightiness of deposits. That is, a bank with a lot of short-term deposits but long-term loans, pays a tax.

    My guess is that a 25 percent capital requirement and taxes on short-term deposits would lead to a much sturdier financial system.

    Taxing interest income, but not dividends, might be another way to push the needle towards stability of the overall economy.

    Of course, the big answer is NGDP targeting.

    Any solution that requires a lot of administration, or has loopholes that can be lobbied into existence, will eventually go sour.

    Ergo, KISS.

    The other thing to remember: Higher living standards come from innovations in the real world, in technology, manufacturing, R&D. The financial sector does not need to be complicated. When the financial sector says it is being complicated to better allocate capital, I doubt it.

    Plus, the world is glutted with capital now. We do not need to go to the Nth extreme in efficient allocation of capital. We need a rugged, reliable system for the allocation of capital.

  2. The above "risk sharing" idea is inherent to full reserve (aka 100% reserve) banking. Plus of course the idea is inherent to Islamic banking, though Mohammed's reasons for pushing the idea were probably very different to those put by today's advocates of full reserve.