That's mispricing risk. Now the depositors have no reason to care whether their bank is creditworthy or well-managed, so the bank has the incentive to gamble with their deposits as much as possible. If they get lucky they get to keep the winnings, if they go belly up the FDIC eats the cost.
You guys are familiar with how we arrived at this particular regime of mispricing risk, right? It’s preferable to the alternative. This is why banks are tightly (but imperfectly) regulated.
Similar observations apply to that more fundamental instrument of mispriced risk - limited liability business entities. The worst possible arrangement, except for all the others.
Personally I prefer to tilt at the windmill of the asymmetrical payoff diagram of US CEO compensation structures. While it’s still the case that nobody much cares about my opinions on the subject, this one at least has less of an aspect of battle-tested socioeconomic optimality.
Americans didn't arrive at this particular set of institutional arrangements by some rational process that weighed the alternatives properly.
Really, have a look at eg https://www.cato.org/blog/there-was-no-place-canada for a comparison between American finance and Canadian finance. The Canadian arrangements were much superior to the old and new American system.
> Similar observations apply to that more fundamental instrument of mispriced risk - limited liability business entities. The worst possible arrangement, except for all the others.
I don't see what's wrong with it? In most countries you can form both limited liability business entities as well as unlimited liability business entities.
When you do business as a company you (typically) have to clearly declare what kind of business you are, and your counter-parties can decide whether they want to deal with you based on that information.
(At least for the most part. If a limited liability contractor paves my driveway, and they damage my neighbour's roses while they are at it, my neighbour never got a choice.)
> Personally I prefer to tilt at the windmill of the asymmetrical payoff diagram of US CEO compensation structures. While it’s still the case that nobody much cares about my opinions on the subject, this one at least has less of an aspect of battle-tested socioeconomic optimality.
Related:
In the years after the big financial crisis of 2008, Credit Suisse paid their bankers' bonuses in the form of 'toxic assets'. See eg https://archive.is/x3GKl
That make got the 'toxic assets' off Credit Suisse's balance sheet. It was also popular with the general public. And, the best part, over time those ostensibly toxic assets actually mostly paid off in full, so the bankers got a much better bonus than if they had gotten straight up cash.
The windmill I like to tilt at is the different tax treatment of equity vs debt in many tax systems around the world. Both shareholders and creditors demand a return on their capital. But when your business pays creditors, via interest and return of principal, that's usually with money that's less taxed ('pre-tax money') than when they pay dividends or do share buybacks ('post-tax money').
Most people agree that an economy with less leverage, ie less debt and more equity, is more stable and less prone to crises. But then we have tax systems that prefer debt.
We should at least treat them equally, or even better, tax debt higher than equity, to nudge company's in the direction of more equity.
(And, of course, there's also the big, big windmill of land value taxes being superior to almost every other form of taxation. But almost no one uses them.)
> If a limited liability contractor paves my driveway, and they damage my neighbour's roses while they are at it, my neighbour never got a choice.
Limited liability doesn't mean no liability. You can still go after them and get the assets of the company or its recent profits, which will generally be more than the value of some roses. You just can't get company owner's house.
But that sort of thing is always the case. There is no such thing as unlimited liability because nobody has unlimited assets. You can cause a million dollars in damage when you only have a hundred dollars to your name and there is nowhere for the money to come from.
Limited liability is just choosing the line at which we say something is closely enough associated with another thing to have to pay for its mistakes.
> But when your business pays creditors, via interest and return of principal, that's usually with money that's less taxed ('pre-tax money') than when they pay dividends or do share buybacks ('post-tax money').
It's worse than that. Corporate acquisitions use pre-tax money, which encourages business consolidation.
The real solution is to use consumption taxes instead of income taxes, which are much fairer, harder for tax laywers to avoid and less invasive of individual privacy, and are one of the best ways to tax international corporations. Then if you want a progressive tax system you just give each individual a tax refund in a fixed amount, which creates a progressive effective rate curve.
This would also have the benefit of disadvantaging debt, because you would have to borrow enough to pay the tax on whatever you buy and then pay interest on the higher amount, discouraging debt-based purchases.
But there are a bunch of misguided claims that it would hurt the poor somehow (even though they would be paying less in total tax after the refund), probably because it would actually work and the people who benefit from the status quo have to put out some argument against it.
The industry eats the cost, not the FDIC, which funds it through industry taxes.
If your gamble fails, not only do you lose everything related to your endeavor, but now banking as a whole is more expensive, more people centralize into the big banks, and whatever business you want to start up or run afterwards is going to be more expensive.
This is why most banks don't gamble, because gambling like SVB did is really fucking stupid. You can be a boring bank and most likely mint profit for yourself for eternity, while also being seen as a positive actor in your city! The only people who aren't satisfied with such a set up are the same "Gotta grift everyone" silicon valley style assholes who think an economy is an idle game and they have to have the highest number because they are smartest and bestest.
> The industry eats the cost, not the FDIC, which funds it through industry taxes.
So in other words the FDIC eats the cost but the FDIC is really the taxpayer, or the customers of "banking industry" which is to say basically everybody.
> If your gamble fails, not only do you lose everything related to your endeavor, but now banking as a whole is more expensive, more people centralize into the big banks, and whatever business you want to start up or run afterwards is going to be more expensive.
But if your gamble succeeds you make an enormous amount of money and if it fails someone else pays most of the cost, so it's more profitable to make the gamble because you have privatized gains and socialized losses.
> You can be a boring bank and most likely mint profit for yourself for eternity, while also being seen as a positive actor in your city!
Are banks known for their desire to leave money on the table?
Isn't "banks will be conservative and responsible" the argument for not having mandatory insurance?
> Isn't "banks will be conservative and responsible" the argument for not having mandatory insurance?
The problem is not so much that the insurance is mandatory, but that it's provided by an entity whose pricing is set by the government, and which also enjoys the (implicit or explicit) backing of the government.
Privately and competitively provided insurance, even if mandated by the government, wouldn't be quite as bad.
Though I agree that giving banks the choice whether to get insured is a good one. Otherwise, you'd have to write regulation about what counts as 'good enough' insurance. Instead of letting customers of the bank decide what they are ok with.
> The industry eats the cost, not the FDIC, which funds it through industry taxes.
One problem is that FDIC does an insufficient job at charging banks of different riskiness different premiums.
Privately organised deposit insurance without an (implicit or explicit) government backstop would avoid that problem.
> You can be a boring bank and most likely mint profit for yourself for eternity, while also being seen as a positive actor in your city!
Banks caring about individual cities is a weird Americanism. Mostly stemming from their long standing bans on branch banking.
Minting profits for eternity is nice, but having money right now is also nice. A company can use their 'cost of capital' metric to make a rational decision between the two.
> The only people who aren't satisfied with such a set up are the same "Gotta grift everyone" silicon valley style assholes who think an economy is an idle game and they have to have the highest number because they are smartest and bestest.
Leave the ad-hominem at the door, please.
Managers have a fiduciary duty to the owners of the company. For most companies, and especially most banks, that means they have a duty to make money for the shareholders. (Shareholders can have other goals that they can task management with; making money is just the default.)
If managers shirk their fiduciary, shareholders can sue them. And that includes when they are shirking making the right trade-off between long term profits and short term profits:
Use your cost of capital to calculate the present value of future cash flows. Choose the path that has the largest present value.
If interest rates are high enough, it _is_ economic rational to chop down the entire forest for wood today, instead of harvesting it sustainable.
Btw, most banks do 'gamble'. They just differ in how much they gamble and on what.
Right, the depositors (up to the limit) don't have to care if it is solvent. They also don't get to keep any winnings by the bank.
The shareholder both get to keep the winnings and can get wiped out. So they are the ones who set the bank policy.
Factually, it seems that retail banks, those covered by the FDIC, don't tend to be poorly managed. There were some recent counterexamples in 2023 with rising interest rates, but in general bank failures are pretty rare. In the heights of the 2008 mess (which was in 2009/2010) around 2.5% banks were failing annually. That's not bad.
> The shareholder both get to keep the winnings and can get wiped out. So they are the ones who set the bank policy.
But it's the depositors' money they're gambling with.
Suppose you can put a million dollars of your money in something that has a 10% chance of netting you 20 million dollars and a 90% chance of losing your million dollars plus 20 million dollars of the depositors' money. That now has a positive expected value for you even though it has a negative expected value overall and results in a 90% chance of triggering a 20 million dollar claim against the FDIC.
Meanwhile your counterparty is quite happy because you gave them 21 million dollars in exchange for a 10% chance to less than double "your" money.
Shares in a bank essentially behave like call options on the assets of the bank, where the strike price is the sum of debt and other liabilities of the bank.
When you are pricing an option ahead of time, you can still misprice them; even if it turns out that at the end of the day, the option turned out to expire out-of-the-money (ie the bank's shareholders get wiped out).
