Is the regulatory problem in banking similar to that in the nuclear power industry?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig suggest that the causes of the global financial crisis were similar in some respects to the causes of the nuclear power disaster in Japan in 2011. In the case of the nuclear power disaster, the authors suggest that corrupted politicians and regulators had colluded with the Tokyo Electric Power Company to ignore known safety concerns. They comment:

'When an earthquake and tsunami occurred in 2011, this led to a nuclear disaster that was entirely preventable.

Weak regulation and ineffective enforcement were similarly instrumental in the buildup of risks in the financial system that turned the U.S. housing decline into a financial tsunami'.

It might seem obvious to just about everyone that government regulation of the nuclear power industry is desirable to prevent outcomes such as those experienced in Japan (even though regulation was spectacularly unsuccessful in this instance) but I feel inclined to step back a little to consider why such regulation is desirable. What is the problem that the regulation is intended to remedy in the nuclear power industry?

The obvious answer is that in conducting their business of providing electric power to their customers, there is a risk that nuclear power firms may accidentally cause harm to other people. But that is also true of many other business activities. Firms have an incentive to take precautions to avoid such incidental harm because they know that potential victims can sue for compensation.

So, why is additional government regulation needed in the nuclear power industry? Leaving aside the possibility of nuclear material getting in to the wrong hands, a need for additional regulation may arise because of the potential magnitude of the harm that might occur as a result of a nuclear accident. The harmful consequences of a nuclear catastrophe might be so great that the responsible firm would be unable to pay full compensation. That would pose a problem for government of whether to step in and help the victims, but it also poses the problem of how to ensure that the managers of the firm have a greater incentive to take precautions to avoid a catastrophe that would bankrupt the firm twice over, than to avoid a catastrophe that would bankrupt the firm only once. So, there might be a case for the government to step in to attempt to ensure that adequate precautions are taken.

Is there a similar case for regulation of major financial institutions? When I looked at this question a few weeks ago I suggested that when the failure of one bank leads to loss of confidence in other banks that have taken similar risks might just reflect a process in which the market is taking appropriate account of new information. For example, if a financial institution becomes insolvent because a decline in property values causes a decline in the asset backed securities in its balance sheet, that information could be expected to bring about a re-assessment of the value of assets of other financial institutions. It should not be surprising that those financial institutions that are considered to be at greater risk of becoming insolvent would suffer from a loss of confidence and have greater difficulty in conducting their business. That is the way an efficient market could be expected to weed out firms that can no longer be trusted to pay their bills. There does not seem to be anything in that scenario that is analogous to the harmful pollution released as a result of a nuclear accident.

Why do the authors argue that major financial institutions ought not be allowed to fail? The main reason they give is contagion, which adversely affects the broader economy. When a major financial institution collapses it is unable to meet its obligations to other institutions, which are also weakened. As more financial institutions anticipate liquidity problems and attempt to sell assets, there is likely to be a further decline in asset values. As financial institutions cut back lending, the broader economy is adversely affected.

Those effects on the broader economy would be dampened, in my view, if central banks were doing a good job of maintaining public expectations of steady growth of aggregate demand. Central banks were slow to use tools such as quantitative easing to do this during the global financial crisis. Even if central banks had made a more determined effort to manage expectations, however, it is doubtful whether they would have been entirely successful in countering fears that failure of several major financial institutions was likely to have severe adverse impacts on aggregate output and employment.

The authors make the point that it would be extremely difficult to allow large complex financial institutions to fail without major disruption when they became insolvent. Proposals that they could be taken over by public authorities until they were placed under new ownership would be difficult to implement because these firms have thousands of subsidiaries and other related entities spread over different countries. Separate resolution procedures would be required for different subsidiaries in different countries. Massive problems of coordination would be involved.

Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent. That does present governments with problems that are similar to those involved in regulating the nuclear power industry.

In a later post I will discuss Anat Admati and Martin Hellwig's views of how governments can reduce the risk of insolvency in financial institutions that are too big to be allowed to fail.

Postscript

I am writing this postscript before I have posted the article because I have had some further thoughts about market failure, a concept that I was tempted to mention above. An earlier post about financial crises led to a discussion with Jim Belshaw about the meaning of market failure. During the course of that discussion I conceded that the concept of market failure is of limited use and made the point (attributed to Harold Demsetz) that the relevant choice is not between an existing imperfect market and an ideal norm of a perfect market, but between real world outcomes under current institutional arrangements and a proposed alternative set of institutional arrangements. My new point (new to me anyhow) is that if some feasible outcome is superior to that which exists at present, then past failure to implement the changes necessary to achieve that outcome should be viewed as government failure rather than market failure.

How do you know when your brains are out of alignment?

You might think that is an odd question to ask a person who has only one brain. But how do you know you have only one brain?

In their book, 'mBraining: Using Your Multiple Brains to do Cool Stuff', Marvin Oka and Grant Soosalu have assembled some fairly impressive evidence that we have brains in our hearts and guts as well as in our heads.

At this point some readers might be thinking that a book with such a title is an unlikely place to find impressive evidence of anything. My own scepticism was heightened when I first saw information being presented as a 'cool fact'. I found it hard not to chuckle. Later, I wondered whether Ross Garnaut's laugh test – which he applies to economic modelling - involves the gut brain. At the time, I wondered how I had come to be reading such a book, but I was comforted by the memory that 50 years ago I had a strong desire to be cool. It is better for our heads to be cool, rather than too hot or too cold, even if the optimal temperature for a heart is warm.

The 'cool fact' that we have brains in our hearts and guts as well as our heads is based largely on the observation that the nervous systems in our hearts and guts are relatively autonomous. They perform their functions without a great deal of direction from our brains. They also link strongly to parts of the brain concerned with emotions and instinctive reactions.

The authors refer to the discovery of neural pathways whereby input from the heart can inhibit or facilitate the brain's electrical activity.  Research by Rollin McCraty and his colleagues at Heartmath suggests that as people learn to sustain heart-focused positive feeling states, the brain can be brought into entrainment with the heart, bringing about improvements in cognitive performance. Research findings also suggest that emotion and cognition can best be thought of as separate but interacting functions or systems, each with its unique intelligence. The power of emotion as a motivational force is reflected in the greater number of neural connections going from the emotional centres of the brain to the cognitive centres than vice versa.

There is evidence that the nervous system in the gut releases chemicals that are capable of relieving anxiety and pain and sends signals to the brain that affect feelings of sadness and stress. There is also evidence that gut bacteria can influence neural development, brain chemistry and a wide range of behavioural phenomena. For example, the balance between beneficial and disease-causing bacteria in an animal's gut can alter its brain chemistry, leading it to become either more bold or more anxious.

Michael Gershen, a pioneer of research relating to the gut brain, argues that while 'gut feelings' originate in the brain rather than the gut, our emotions can trigger a primitive response in the gut. That rings true to me when I remember what disgust feels like. Even though the gut brain is not doing any reasoning it can help us to make decisions.

The way Marvin Oka and Grant Soosala describe them, the prime functions of the various brains line up neatly with common metaphorical usage. The heart brain is the seat of love and desires, goals, dreams and values. The head brain is concerned with cognition and making meaning. The gut brain is concerned with what we should move toward and what we should move away from, with what should be assimilated into the self and what should be excreted from the self, with mobilization, self-preservation and core identity. When we are considering our options we need to be sure our hearts are in the right place, our heads are screwed on properly and that we take notice of our gut reactions. We should follow our hearts, keep cool heads and be gutsy.

So, how do we know when are brains are out of alignment? The answer provided by the authors is much as might be expected. When our brains are out of alignment we experience internal conflict between thoughts, feelings and actions, motivational problems, procrastination, unwanted behaviours and habits, self-sabotage and disempowering emotional states.

The more interesting question is how to get our brains into alignment. The first step that the authors recommend is to allow our breathing to become balanced – calmly breathing in for about six seconds and breathing out for the same length of time. That recommendation is based on the view of breathing as a bridge between mind and body.

In order to deal with motivational problems, the authors suggest that we conduct what seems to me like a high level meeting at which the leader offers inspiration, advisors provide an assessment of the options and the line manager brings the discussion down to earth. As the meeting of minds progresses, we feel the passion in our hearts, entertain curious thoughts about how to express that passion, allow curiosity to harmonize with and enhance our passion, allow our instincts to move us toward action, and then feel how the growing congruence between passionate feelings, curious thoughts and motivated action influences our feelings about who we are and what it is possible for us to achieve.

That is a highly abbreviated version of an exercise suggested by the authors to bring our brains into alignment. In addition to exercises to help bring our brains into alignment, the authors also propose exercises to promote higher expressions of creativity, compassion and courage, and ultimately achieve greater wisdom.

In reading the book I felt that there could have been greater recognition that the central nervous system involves more than just a head brain – it extends down our spines. This links to the importance of proprioception - the sense of the relationship of the body parts to each other – in helping to restore balance between our minds and bodies.

Something else that is missing from the book, in my view, is a discussion of the role of humour in restoring harmony between our conscious and unconscious minds. Since we are fallible humans, it is inevitable that there will be times when our conscious minds get in the way of our unconscious minds. This occurs, for example, when trying too hard (too much conscious effort) adversely affects performance when we are playing sports. If we can see the humour of getting in our own way, that may help us to wipe the slate clean and to trust ourselves to a greater extent in future.

My overall view is that this book is well worth reading to see how that the common metaphors of multiple brains link neatly with both ancient wisdom and modern science. The exercises presented seem to make sense as ways to help people to overcome motivational problems and to manage their own lives. In other words, mBraining is cool!

Should the Australian government continue to guarantee bank deposits?

In a recent post I suggested that government guarantees of bank deposits tend to encourage banks to become highly geared because they make depositors less cautious about depositing their funds with banks that are at greater risk of default. Such guarantees could be expected to make it possible for highly geared banks to obtain access to deposits at lower cost than would otherwise be possible.

A regular reader of the blog, kvd, objected to my reasoning. In his comments he suggested:

 'your acceptance that 'the market' should play any part in the securitisation of depositors' funds (alongside equity participants) offends against my own beliefs. …

I would not seek in any way to regulate or limit the rich investing their money in any way they wish. But government failure to differentiate between the basic needs of their populace, and the desires of a relatively small, select group of players - that I find a complete abrogation of a basic government role - more specifically, a responsibility.

By all means let's limit government involvement and guarantee - but let's first more clearly delineate what it is that government should be obliged to protect.' 

In the subsequent discussion kvd clarified that what offended against his beliefs was the idea that depositors should be expected to take account of differences in the risks involved in placing their funds in different institutions. 

He explained his position further in a later comment:

 'My interest was initially piqued by what I referred to as the 'securitisation' of a significant part of the funds sources available to banking institutions - namely those funds deposited in the ordinary course of getting on with one's life. If you accept my figures, this amounts to somewhere north of 20% of the funds available for them to pursue their objectives.

While I would be the last to suggest any of the 'big four' are in danger of collapse, I do think that in your higher level analysis of 'marketplaces' and 'risk assessment' it begs the question as to just what is represented by the 20+% of unsecured creditors (because that's effectively how depositors' funds are treated; and that's why there were recent queues outside various high street banks and building societies in the UK) which I termed 'transactors'.

My simple point remains that these funds should be regarded more as the old fashioned 'Trust Fund' one sees in any solicitors' practice. Yet that is not where they presently sit in calculation of leveraging. Within that they are subsumed in those funds available to satisfy any higher-secured obligation. Except for shareholders, they are in fact last in the queue, along with any other trade creditor.

When one thinks of such funds, Winton mentions the 'mum and dad investor'; the implication being that the sums are small, difficult to manage, an annoyance really in terms of transaction costs. [Editorial note: I didn't intend to imply that the sums are small or an annoyance to banks.]

But when I think of those funds I'm referring to my working cheque account …  . These funds are sloshing around in the banking system, available (God forbid) at any time for our banks to satisfy secured creditors. Come a crunch, my funds are essentially an unsecured interest free loan to my bank, available for them to pursue (did you term it?) enhanced shareholder returns.

Too much regulation involved to protect such funds? I'd suggest a reclassification of such funds as first charge government backed liability. Would that would necessitate a recalculation of the risk attaching to other funding sources? Yes, and so be it; the market will decide that.'

Before considering the question of bank guarantees, I will first attempt to consider whether it would be possible or sensible to make the status of bank deposits more like that of solicitor's trust funds. I write 'attempt' because my knowledge of the law concerning solicitor's trust funds is rudimentary. My understanding is that solicitor' trust funds remain the property of the client. There is a great deal of regulation about what solicitors can do with those funds but I expect that they would normally be deposited in a trust account at a bank. That would probably be the safest thing to do with them, even though the funds might still be at risk in the event of bank failure. Perhaps that risk might be covered by solicitor's insurance, I don't know.

The underlying point that kvd is making seems to be that, in the event of default, depositors should be accorded the same ranking as secured creditors. My immediate reaction was that it might be difficult to give depositors a lien over a bank's loan portfolio, but further thought led me to the view that there is nothing to prevent bank deposits from being secured by a lien over other bank assets such as holdings of government securities.

The idea of giving a class of depositors a lien over a bank's holdings of a particular class of assets makes a lot of sense to me. In the absence of government guarantees, this could be expected to be most attractive in relation to transaction accounts of those depositors who are most concerned about security. As at present, such deposits would earn little or no interest and transactions charges would apply. The important point is that these deposits could be expected to be fully covered against loss in the event of bank default – unless, of course, shits are trumps and bank default is caused by default by governments (in which case, government guarantees would also be worthless).  

So, let us now consider whether the government guarantee of deposits should remain in place. Some recent history might help.

Banking in Australia functioned without a government guarantee of deposits prior to the global financial crisis. The Wallis report into the financial system (1997) recommended against the introduction of government-backed deposit insurance on the grounds that it 'was not convinced that such a scheme would provide a substantially better approach or additional benefits compared with the existing depositor preference mechanism' (p355). According to Wallis, the depositor preference mechanism 'provides that the assets of a bank shall be available to meet depositor liabilities prior to all other liabilities of the bank' (p 354).

An article on depositor protection by Grant Turner (RBA Bulletin 2011) suggests that the recommendation against deposit insurance by the Wallis inquiry 'reflected concerns that introducing deposit insurance could weaken incentives to monitor and manage risk' (p 49).

In my view such concerns are warranted. I can understand that depositor guarantees were considered desirable in the midst of the global financial crisis, but it would be good to be rid of them as soon as possible. The best way to phase out such guarantees would be to make them unnecessary by ensuring that governments will never be called upon to honour them. Could that be achieved by requiring that the guarantees will apply only to deposits that are secured by a lien on government securities held by deposit-taking institutions?

Postscript:

I have had second thoughts on the question of how the deposit guarantee should be removed.

My further discussion with kvd, see comments below, makes it clear that in the absence of the guarantee, deposits would rank after secured liabilities in the event of bank liquidation. This has become particularly important since the guarantee was made 'permanent' because the existence of the guarantee has been used as an excuse to allow banks to raise funds using covered bonds (i.e. secured liabilities).

It is probably reasonable to expect that if the deposit guarantee was removed, the market would eventually find a way to give demand deposits the highest priority in the event of bank liquidation. However, it might take some time before banks began to see it as in their interests to provide sufficient asset backing to demand deposits to enable that to occur.

It seems unlikely that any government would remove the guarantee unless it considered depositors to be adequately protected. I think that could be achieved by giving demand deposits the priority that is currently accorded to APRA in order to recover funds it pays to depositors under the current guarantee arrangement. As I understand the situation, the Banking Act gives debts and liabilities to APRA the highest priority in the event of bank liquidation.

In my view, legislation should give demand deposits the highest priority in the event of bank liquidation in order to maximize the potential for banks to be able to honour the promises that they make to allow depositors to withdraw such funds on demand. 

What questions should the 'science of morality' be seeking to answer?

In a recent article on Scepticblog entitled 'Towards a Science of Morality', Michael Shermer suggests: 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. I agree, more or less, but see some problems with the reasoning he uses to get to that point, and urge him to consider more explicitly the questions that the science of morality should be seeking to answer or the problems it should be attempting to solve. (By the way, thanks to Steven Pinker for drawing attention to Shermer's article via Twitter.)

Shermer's first proposition is a 'principle of moral good': 

'Always act with someone else's moral good in mind …'.

Why? Perhaps I misunderstand, but that seems to imply that it is always good, for example, to sacrifice your health for the benefit of others. I can think of real world situations where in my judgement such conduct has not been good for either the actor or the recipient. I think an impartial spectator would say that it is good for people to act with some regard for their own needs as well as seeking to benefit others.

What is the basic moral principle? My answer is that we should always seek to act ethically. I guess that stems from a belief that moral instincts and a capacity for moral reasoning are part of human nature and exist for good reasons. Humans have a basic need to feel that they are acting ethically.

Shermer's second proposition is that to find out whether an action towards some other individual is right or wrong we should ask them. I agree. We should recognize the rights of other individuals (adults) to decide whether or not to accept proposed actions that are intended for their benefit. But that proposition seems to me to belong after establishing that 'the survival and human flourishing of the individual is the foundation for establishing values and morals'. Acceptance that we all begin our lives with a passion to survive and flourish seems to me to gives greater moral force to the observation that different individuals have different goals in life and a capacity to take responsibility (as adults) for decisions they make.

Is it defensible to argue that the survival and flourishing of the individual is the foundation for establishing values and morals? That seems clearly defensible if we think of the passion of humans to survive and flourish as a product of evolution. The moral intuitions of our ancestors could be expected to have pre-disposed them to favour theories of morality in which human flourishing is viewed as the purpose of life. It is also defensible if we think in terms of codes of morality and as the outcome of cultural evolution. As Hayek and others have suggested, those groups with codes of morality most conducive to individual flourishing – thou shalt not do things that infringe the rights of other individuals - have tended to be more successful.

If we accept that individual flourishing is the foundation on which our moral intuitions are based, does it necessarily follow that 'determining the conditions by which humans best survive and flourish ought to be the goal of a science of morality'. No! We can't derive an 'ought' statement from an 'is' statement. Nevertheless, there is nothing to stop us from feeling that there is a smooth transition between the two statements, or that the statements are closely aligned.   

As I see it, however, it is worth taking a step back to ask what our purpose is in asserting that some topic ought to be the goal of a science of morality. It seems to me that the purpose is to assert that the science of morality should be aiming to answer a particular question (or set of questions) or to solve some problem.

So, why not simply assert that the science of morality should be concerned with questions relating to human survival and flourishing? The assertion can be justified with reference to evolutionary considerations, by Aristotle's question about the chief good that is desired for itself rather than because it enables us to obtain something else, by introspection or other considerations. The important issue is whether the assertion is able to stand up to criticism.

One possible basis for criticism is that the science of morality should be concerned with questions relating to the survival and flourishing of other living things as well as humans. Perhaps that objection might be overcome by asserting that questions relating to human survival and flourishing are an important part of the science of morality.

However, that still leaves open the potential for confusion over the meaning of 'the science of morality'. What I think it means is that preferences relating to moral proposals should be based on their ability to stand up to criticism rather than that they are falsifiable. (That probably means rejection of the boundary that Karl Popper attempted to draw around science, but it is consistent with his broader views about the importance of criticism.) Some moral proposals involve value judgements that can be criticized, but cannot be proved wrong. Perhaps we can avoid confusion by further rephrasing our assertion along these lines:

Given the importance of human survival and flourishing it is important to for all questions relating to this topic to be fully explored, including the influence of values, social norms, constitutions, laws and regulations.

After asserting that the conditions by which humans best survive and flourish ought to be the goal of a science of morality, Shermer proceeds to provide examples of moral actions directed toward survival and human flourishing. These actions included reducing extreme poverty and facilitating economic growth and hence improvement in average levels of subjective well-being.

I agree with the examples that Michael Shermer provides, but having asserted the importance of exploring questions relating to human survival and flourishing it seems to me to be important to attempt to clarify the nature of the problem. In order to do so it would be appropriate to attempt to consider relevant questions in a sequence which recognizes that the way we answer one question may influence the way we frame subsequent questions.

For example, in Free to Flourish, my first set of question was about whether human flourishing should remain largely the responsibility individuals in voluntary cooperation with others, or whether it should be pursued primarily through government action directed toward achieving national goals. My answers to those questions led me to then consider the characteristics of societies that are most conducive to human flourishing. My answer to that question led to a consideration of the main drivers of progress and the greatest threats to progress.