How can governments stop encouraging banks to be highly geared?

A reader of my book, Free to Flourish, is puzzled by a brief comment I made about fundamental weaknesses in the financial system. He asks whether the following passage implies the existence of a fundamental market failure with respect to the financial system:

'The underlying incentives that the system provides for participants to take risks with borrowed funds might even tempt saints to behave imprudently. Another outbreak of gambling with borrowed funds will become increasingly more likely as memories of the recent crisis recede, unless fundamental reforms are introduced. Required reforms include the removal of any implicit guarantees that any financial institutions are 'too big to fail' - by taking action to penalise rather than assist the owners of financial institutions which are at risk of default - and removal of distortions in tax systems which favour debt funding relative to equity funding' (Chapter 8).

I accept that there may be market failure in the financial system. There can be negative externalities associated with bank failures. If the failure one bank leads to loss of confidence in some other banks, there may be a market failure involved. Then again, there may not be. If the failure of one bank leads to loss of confidence in banks that have taken similar risks, leaving other banks unaffected, it would be reasonable to argue that the market is just taking appropriate account of new information. Nevertheless, at an aggregate level, I accept that central banks may be able to play a useful role in sustaining expectations of ongoing growth in aggregate demand when bank failures occur.

However, my concerns about the fragility of the financial system – as it exists at present – cannot be attributed to market failure.

The following hypothetical example might help to begin to explain the nature of the problem as I see it. Let us focus on two banks competing in a free market, without government interventions. Both banks are the same in nearly all respects, but while Bank A is profitable, Bank B is having difficulty competing for deposits. The reason for this is that the level of shareholder equity in Bank A is relatively high and potential depositors feel that the interest rate being offered on deposits in Bank B (the same as for Bank A) would not adequately remunerate them for the additional risks they would be taking. 

There are several options that Bank B might consider to become more competitive. For example, it could offer a higher interest rate to reflect the greater risks involved for depositors; it could reduce the risks in its asset portfolio (perhaps by having a higher proportion of its portfolio in relatively safe government securities); or it could issue more equity capital and become more like Bank A. The optimal level of equity depends on factors such as the riskiness of the bank's asset portfolio and the extent to which depositors require higher interest to compensate for risk.

Is this example plausible? Is it conceivable that it might be possible in a free market for a bank to be profitable with a relatively high level of shareholder equity? Many would argue that the example I have given is unrealistic because an equity risk premium must be paid for access to equity capital. On that basis, it is argued that banks with relatively high equity could be expected to have a relatively high cost of capital and thus to be less profitable than banks with relatively low equity.

Anat Admati and three of her colleagues provided a pertinent response to the suggestion that increased equity would increase funding costs for banks in their paper: 'Fallacies, Irrelevant Facts and Myths in the discussion of Capital Regulation: Why Bank Equity is Not Expensive'.  These authors draw attention to the Modigliani-Miller (MM) analysis which shows that increases in the amount of equity relative to debt financing simply re-distribute risk among investors. The total funding cost is determined by the total risk that is inherent in the bank's asset portfolio and is independent of gearing. In that context, any losses from using less borrowed funds must be offset by the correspondingly lower cost of equity capital.

The essential assumption of the MM analysis - apart from the assumption (discussed below) of no government intervention favouring either debt or equity funding - is that investors are able to take account of portfolio risk and gearing when pricing securities. Admati et al make the telling point that banks make this assumption in managing their risks.

So, what happens if we relax the assumptions of the MM model by introducing a tax system that encourages debt relative to equity, a government guarantee that banks will not be allowed to fail and protection for depositors? We should expect to get banking systems that are highly geared and fragile – like our current banking systems.

How can governments remove those distortions?  The obvious answer is just do it! However, removal of the tax distortions will require major tax reforms in countries that have classical company taxes. The problem in relation to government guarantees and protection of depositors is that announcements  that they will no longer apply are not likely to be credible (except when made by governments that are so heavily indebted already that further bank bailouts would be impossible in any case).

Does that mean that the best option is for governments to regulate bank behaviour to such an extent that bank failure becomes highly improbable? That approach would suggest that if Basel III is not restrictive enough to make bank failure sufficiently improbable, we should be prepared to move on to Basel IV, and then Basel V, and even to nationalisation of banking if necessary.

At that point I begin to see red. If we are not dealing with a market failure, why are we attempting to displace the market? Is it really necessary to put the entire banking system into a regulatory strait jacket, with all the inefficiencies that involves, in order to live with the consequences of past regulatory failure? Would it not be possible for governments to make a credible commitment never to bail out another bank if they were prepared to spell out punitive action to be taken if regulatory agencies assess banks to be at risk of default? For example, why not announce plans for pre-emptive action to install administrators to restructure banks if they are assessed to be at risk of default?  

Postscript:

With the benefit of comments from kvd and Jim Belshaw (see below) it is clear that the line of argument presented above is not as clear as it could be and contains some unnecessary red herrings.

1.      The definition of banks. For the purposes of this discussion, the distinguishing characteristic a bank is that it is a company with relatively low shareholder equity and a relatively high proportion of debts repayable on demand. Later in the post, my focus is narrowed to financial institutions with deposits guaranteed by governments and/or viewed by governments as 'too big to fail'.

2.      The definition of externalities and market failure. The discussion in the paragraph immediately following the quote from Free to Flourish raises issues concerning the technical definition of externalities and market failure that are a largely a red herring from the perspective of the general line of argument I am developing here. All I needed to say was that while I acknowledge that there may be a case for government intervention based on the existence of market failure, that is not the basis for my concerns about the fragility of the banking system. (Nevertheless, the discussion is raising interesting points. There might be something wrong with our definition of market failure if new information about bank solvency that leads to the collapse of the banking system does not qualify as evidence of market failure. The question that kvd has raised about whether there is a case for government guarantees to cover use bank facilities for every day transactions using is alsoof interest to me. I will try to follow that up in a subsequent post.)

3.      My hypothetical example involving Bank A and Bank B. The example seems to have clouded the point I was trying to make, rather than illustrate it. The point the example was intended to illustrate is that in a free market banks would not have an incentive to seek ever-greater leverage. The rate of return on shareholder funds may rise as leverage increases, but depositors and shareholders would have an incentive to take account of the increasing risk of bank insolvency. As leverage increases the cost of borrowing additional funds could be expected to rise (i.e. the interest rate on deposits would need to rise). And at some point the increase in expected return on shareholder's funds will not be sufficient to compensate shareholders for the increased risk of failure of the firm.

4. Should the Australian government continue to guarantee banks deposits? That is the title of a later post in which I discuss issues raised by kvd.

Will 'Lincoln' encourage people to give more thought to modern forms of slavery?

Since seeing 'Lincoln', the movie, I have felt a need to find out more about modern versions of slavery – often described as human trafficking and debt bondage. Why? The movie made me feel that as author of a book entitled Free to Flourish and of this blog about freedom and flourishing, I should be making more of an effort to come to understand the issues involved in modern versions of slavery and similar restrictions on liberty.

'Lincoln' is basically about wheeling and dealing of politics, at a time when politics was possibly even more venal than it is today. Some people (myself included) find that kind of thing intrinsically interesting. This movie manages to entertain a broader audience because it has colourful characters and a story-line in which the goodies have to win in the end. In my view, the story is inspiring because it shows that fallible leaders can sometimes use democratic political processes to overcome entrenched interests for worthwhile purposes.

Given the history of slave ownership in the US it is not surprising that many politicians would have seen powerful reasons to keep deferring abolition, even while claiming to be opposed to slavery. While slave ownership remained profitable, slave owners had an interest in seeking to retain what they would have seen as property that they had acquired legally. Against that background, it seems amazing that sufficient numbers of representatives were eventually persuaded to take advantage of the opportunity to abolish slavery before the end of the civil war. (I still find it hard to accept that the civil war was necessary, but that is another story.)

I was intrigued by the part of the movie in which Thaddeus Stevens (played by Tommy Lee Jones) tempered his remarks in congress to avoid frightening conservatives that abolition of slavery would be a slippery slope leading to full equality. He refused to be goaded by an interjector to support the view that 'all men are created equal', rather than supporting 'equality before the law' even though he was a lifelong advocate of full citizenship rights:

'How can I hold that all men are created equal, when before me stands stinking the moral carcase of the gentleman from Ohio, proof that some men are inferior, endowed by their Maker with dim wits impermeable to reason with cold pallid slime in their veins instead of red hot blood! …

After further castigating the interjector, the passage ends:

' … even worthless unworthy you ought to be treated equally before the law.'

Those looking for further discussion of the movie should read, among other things, Jim Emerson's article, 'It's true because it works'.

I haven't managed to get far at this stage in learning more about human trafficking and debt bondage. Human trafficking has been defined to include a range of nasty activities - some worse than others in my view.

The UN's 'Protocol to Prevent, Suppress and Punish Trafficking in Persons' defines human trafficking as: 

'the recruitment, transportation, transfer, harbouring or receipt of persons, by means of the threat or use of force or other forms of coercion, of abduction, of fraud, of deception, of the abuse of power or of a position of vulnerability or of the giving or receiving of payments or benefits to achieve the consent of a person having control over another person, for the purpose of exploitation'. 

The US State Department's Trafficking in Persons Report (2012) suggests that trafficking doesn't necessarily require movement of people:

'People may be considered traficking victims regardless of whether they were born into a state of servitude, were transported to the exploitative situation, previously consented to work for a traficker, or participated in a crime as a direct result of being traficked. At the heart of this phenomenon is the trafickers’ goal of exploiting and enslaving their victims and the myriad coercive and deceptive practices they use to do so'.

The State Department also uses the ILO's term 'forced labour' to describe human trafficking. The ILO's estimate of the number of people engaged in forced labour throughout the world is 20.9 million – not much less than the population of Australia. Most forced labour apparently takes place in Asia, although prevalence as a percentage of population is higher in former communist countries of eastern Europe and Africa.

It is fairly easy for people in countries like Australia to claim that that human trafficking is a minor problem as far as we are concerned - and largely beyond our influence. However, people associated with the abolitionist movement in Britain in the 19^th century – people such as John Bright who was also a prominent advocate of free trade – did not take that view with respect to slavery in America.

When Lincoln was assassinated he apparently had in his pocket a testimonial from John Bright calling for him to be re-elected.

Is the history of freedom of speech relevant to the current debate in Australia?

Free speech is certainly in the news in Australia. Early in the week we had the reaction to Tim Mathieson's suggestion that the best way to have your prostrate digitally examined would be to 'perhaps look for a small, Asian, female doctor'. I thought George Brandis, shadow attorney-general, struck the right note when he responded:

'I don't think we want to have in this country a culture of finger-wagging and confected outrage every time someone says something that might be better left unsaid'.

A day or so later, Nicola Roxon, the attorney-general (A-G), backed away from the 'offensive behaviour' provisions of her draft anti-discrimination bill, saying that the main purpose of the bill was to simplify and consolidate discrimination laws and that it 'has never been the government's intention to restrict free speech'. That seems to imply that inclusion of the offensive behaviour provision was due to the Minister's incompetence. I suspect, however, that the A-G knew exactly what she was doing and that she still intends to reinforce the restrictions on free speech in existing discrimination laws.

In an opinion piece in 'The Australian' on Jan. 10, the A-G suggested: 'telling a female staff member "shorter skirts would be better for all girls in the office" might well breach discrimination laws'. I am prepared to accept her word for that, but the example seems to me to raise questions about the desirability of discrimination laws that restrict speech to that extent.

Should anti-discrimination law be applied whenever men refer to their adult female work colleagues as girls (or women refer to their male work colleagues as boys, or even 'old boys') and make mildly sexist remarks about their clothing. I imagine that most males who might use words such as those quoted by the A-G would be intending to engage in good-humoured banter with female colleagues - whom they consider as equals, in the sense of being capable of 'giving as good as they get'. (Foreign readers should understand that friendly exchanges of mildly offensive remarks are a characteristic of Australian culture.) Of course, those who make sexist comments, even in jest, run the risk that work colleagues will consider their behaviour unacceptable and ask for an apology.

That is my point. In modern Australia, when people working in offices find themselves subjected to objectionable speech, they do not need to threaten legal action to ensure that perpetrators suffer humiliating consequences. The A-G apparently thinks threats of legal action are the most appropriate response to bad manners.

In the same article, the A-G suggested her aim is to 'get a tricky balance right' by ensuring that freedoms are subject to 'appropriate limits that provide protection in certain circumstances'. She gives the impression that she accepts free speech as the rule, with restrictions only to be imposed in certain circumstances. Yet, her proposed bill reverses the normal burden of proof. Those accused of discrimination bear the onus of proving that their speech has not been for alleged purposes that are contrary to the discrimination legislation.
 

Politicians might be less keen to use the coercive powers of the state to enforce their notions of political correctness if they read In Defence of Freedom of Speech, by Chris Berg. The main point to emerge from the book is that freedom of speech is at one with freedom of thought. When governments restrict freedom of speech they interfere with the rights of individuals to express themselves. The heroes of Berg's story, Benedict Spinoza and Benjamin Constant, did not confine themselves to support for politically correct speech.

Benedict Spinoza (1632-1677) argued that the presumption should be on protecting freedom of expression rather than limiting it, even though espousal of some doctrines could have negative consequences for society. He blended two arguments for freedom of expression: the natural rights argument that the state cannot control thoughts; and the pragmatic argument that attempts to do so creates more problems than it solves. In relation to the latter point he noted that states which limit freedom find their regulations abused by interest groups seeking to benefit at the expense of others.

Benjamin Constant (1767-1830) also admitted the possibility that free speech 'may corrupt manners or shake the principles of morality', but he argued that people 'should be taught to preserve themselves from these dangers by their own efforts and reason'. Constant suggests that governments that try to enforce uniform belief encourage hypocrisy and resistance:

'To prop up an opinion with threats invites the courageous to contest it'.

Berg acknowledges the contribution to development of free speech by a range of other people. He points out, however, that many of those who have been widely quoted as supporters of free speech were only prepared to advocate freedom of speech under certain circumstances or for certain groups of people.

My only qualification about this book is that I would like to have seen greater recognition of defamation as a legitimate reason for restriction of freedom of speech. At one point, Berg suggests:

'The analogy between property and reputation is widely used but deeply incoherent'.

I disagree. Damage to the reputation of a person or business is equivalent to loss of property. This is most obvious when damage to the reputation of a public company results in a decline in its share price. In many other instances there is a loss of future earnings and/or additional costs incurred that have an assessable monetary value. It seems to me that the relevant issue in relation to defamation is whether individuals or firms have a right to expect the state to defend their reputations. Those who have unwarranted reputations for good conduct, should not have those reputations defended by the state.  

Overall, however, this book seems to me to provide an excellent account of the evolution of free speech in western civilization. 

Postscript:

Soon after this post was written, Nicola Roxon resigned from the position of Attorney-General. We will have to wait and see what that means for the future of free speech in Australia. As James Patterson has noted, the new Attorney-General, Mark Dreyfus is on the record as saying that he considers 18C of the Racial Discrimination Act - the section apparently contravened by Andrew Bolt - is a good law.

I haven't studied the Bolt case, but the judgement does seem to have muffled public discussion of the question of how aboriginality should be defined for public policy purposes. I suspect that potential commentators are now concerned that if they openly express their genuine beliefs on such matters of public interest, they might be required to prove that their remarks constitute fair comment.

Does the value of free speech depend solely on its contribution to democracy?

Several rationales for free speech were discussed in the Finkelstein report on media regulation, which was released in March last year. Incidentally, the report states that it 'must be attributed' as the 'Report of the Independent Inquiry into the Media and Media Regulation'.

Since the report discusses rationales for free speech in a chapter headed 'The democratic indispensability of a free press', it is obvious from the table of contents that Ray Finkelstein sees the rationale for free speech mainly in terms of its contribution to democracy.

I agree that free speech is the life blood of democracy but, as discussed in Free to Flourish, my prior conviction is that the rationale for freedom and democracy rests on their contribution to human flourishing. As I see it, a balanced account of the contribution of free speech to human flourishing would recognize that free speech – freedom of expression - expands the opportunities available to individuals in ways that are not necessarily associated with democratic institutions. It would note that democracy emerged as an outcome of a process intended to protect the rights of citizens (including their right to free speech). It would also acknowledge that the merits of democracy still depend on the potential of democratic processes to defend free speech and the other freedoms that provide the basis for human flourishing.

Defenders of Finkelstein could suggest that 'self-fulfilment and autonomy' and libertarian rationales for free speech are discussed in his report. However, the discussion of self-fulfilment focuses on the views of Katherine Gelber – a follower of Martha Nussbaum– who seems only prepared to defend speech 'that is constitutive of the formation and planning of one's life in ways commensurate with one's informed conception of the good'. Elitist nonsense! Who is to decide what constitutes 'an informed conception of the good'? Are adults who do not have 'an informed conception of the good' to be denied the right to speak their minds?  

Finkelstein's discussion of libertarian theories of the press is under the heading, 'Social responsibility: a theory of the press', so it is not surprising that libertarianism is given short shrift. From what I had previously read about the report, I was expecting that the idea of a free press would be assaulted on the grounds of monopoly, potential abuse or power etc. yawn, yawn. But, after going through all that, Finkelstein asserts that libertarian theory did not provide a workable solution to the challenge provided by broadcasting and that governments 'found it necessary to intervene …'. He adds: 'This amounted to a rejection of libertarian theory'.

Gulp!  So, why doesn't Finkelstein tell us what he thinks, rather than pretending that there was no workable solution other than regulating to control the activities of broadcasters? The workable market solution, as Ray and just about everyone must know, is allocation of the broadcast spectrum, like other scarce resources, to the highest bidder. Does the author have good reasons to believe that would not enable scarce resources go to their highest value use? If the Honourable Ray Finkelstein, QC, former judge of the Federal Court and former president of the Australian Competition Tribunal, thinks that the way government currently allocates the broadcast spectrum is better than the market solution, why doesn't he make the case?

Finkelstein's discussion of the 'search for truth' as a rationale for free speech raises discussion of the 'marketplace of ideas'. He seems somewhat pessimistic about the ability of people to discover truth, but nevertheless remains optimistic about the benefits of democratic discourse – subject to government regulation to ensure social responsibility. He ends up seeing a need to obtain a balance between demands that the media be accountable for exercise of its power and the need for the media to be free to hold governments to account.

I found that discussion to be peculiar. Once the concept of a market for ideas was introduced, it would be logical to expect some exploration of the nature of this market. There is mention of monopoly and competition in the rejection of libertarianism, but no discussion of contestability. Elsewhere in the report, the idea of the conventional media being increasingly exposed to competition from on-line sources is mentioned, as is public scepticism about the veracity of media reports, but the discussion of the rationale for free speech proceeds as though every media outlet has exclusive access to the minds of its customers.

Contestability seems to me to be at the crux of the issue of whether media proprietors and editors have power to exert undue influence on public opinion. The report provides some evidence of media outlets presenting false or misleading reports, but doesn't provide any evidence that these have gone uncorrected elsewhere in the media.

Overall, in my view, the Finkelstein report on media regulation provides an unbalanced account of the rationale for free speech. This part of the report seems to me to display an amazingly brazen degree of bias from an author who favours greater regulation to ensure balance in private media reporting. Some readers might be thinking that comment just reflects the fact that different people have different views of what reporting and analysis is balanced and unbalanced. That is a valid point to make whenever issues of balance arise. In this instance, however, I doubt whether many people who have some knowledge of the topic would view this report as providing a balanced account of the rationale for free speech.

In my last post, I promised to review In Defence of Freedom of Speech, by Chris Berg. Unfortunately, that will have to wait. I thought it would be a good idea to take a quick look at the Finkelstein report before writing my review – and got myself side-tracked!