Risks externalities and optimal global policies

Posted by on 27 February 2009

Since “limited liability” was legalized in England in 1855, the financial world experienced systemic non-monetary booms and busts1. It allows some people to carry an incredible amount of risks without to have to bear the full cost of losses. In that sense it creates a “risk externality”, in the same way as a very fast driver has a higher chance to hurt an innocent bystander. While car-driving is well regulated, issuing all sort of leveraged assets with limited downside-risks has been so far quite free of regulations. Is there any rationality in the severity of driving regulations in contrast to the liberal attitudes toward financial instruments? We investigated this question and found that regulating limited liability is a central piece of all stabilization measures.

When the risk producer and the final bearer of risk are well known, the State uses 3 main regulatory tools in order to reduce the level of risk-externality: 1. Allowing an activity, which can be a cumbersome administrative procedure, 2. Requesting an insurance ex ante (downpayment, reserve ratio, insurance premium, aso), 3. Penalizing the risk-producer when a negative outcome happens (civil and penal responsibility, clawing back bonuses, aso), which is very restricted in the case of limited liability2. However when the producer of the risk, the final bearer of the risk or the risk itself is not known, regulations attain quickly their limits and the State has sometimes no other choice than to use general policies3. In this task the State is very often alone, as there is parallely a market failure due to the presence of an externality associated with an information asymetry. The honour to be a natural monopoly as the “insurer of last resort” is obviously a mixed blessing, in particular when a systemic crisis strikes. Very often those general policies are inadequate as they are not targeted due to a lack of information. In the following paragraph we will try to judge what kind of risk-externalities does occur when an economic agent default and what kind of State intervention could be possible even when few information are available. The following discussion concentrate itself on bankruptcies and foreclosures, although there exists now many other financial instruments including an implicit “limited liability”. At the present stage of discussion, the optimality of proposed policies can not be yet proven, but there exists empirical tests which could prove their efficiency later.

1. Risks externalities in the housing market:

We will start with the housing market. The question is to spot economic agents who are going to be affected when a homeowner is not able to back pay its mortgage payment. The following points can be mentioned:

  1. The neighbors are going to be negatively affected, as homeowners with a negative equity have a lower incentive in maintaining their house. In that case the State could compensate neighbors by taking care of the quality of the neighborhood. This kind of intervention is already included in the Obama plan. A simpler tool would be to negotiate an explicit obligation of maintenance when a loan is renegotiated (see Zingales(2008)).
  2. The biggest casualty of the present crisis has been the refinancing market which has almost collapsed. Every investors fear that is has become a lemon market (i.e. that only the worst of the worst is going to be refinanced). By taking over Fannie Mae and Freddie Mac the US State has done already a huge step in reviving this market. In the future it could be simpler to distinguish clearly between old loans and new loans by qualifying better portfolio of new mortgages (i.e. that all the mortgages are “affordable” and guaranteed in a precise way, which could imply a loan insurance). In that regard a public certificate will have a higher value that the opinion of rating agencies.
  3. In the presence of negative equity, the homeowner might get stuck with his house, which reduces his mobility. Hence the homeowner will probably not look for a new job far away, especially a challenging one. If he finds a job in another State, a foreclosure becomes very tempting. Only a few firm will be willing to warrant a negative equity in order to get the best person. So far there does not exist a plan that allows a homeowner to move by continuing to pay his negative equity on favorable terms if he has strong professional credentials.
  4. The children of defaulting homeowners might not be able to afford to go to the University which is best suited for them. So it is important that students loans should be linked only to applicants abilities. The students loan market seems however to have its own problem and it would be important to get them fixed.
  5. It is unclear what kind of externality the new US foreclosure plans are trying to address. Visibly the State fears a snowball effect from foreclosures, as if market mechanisms are an externality in themselves or as if real estate markets were famous for overshooting. In fact past experiences with similar plans did not attract a lot of interest; Households with negative equity still have an interest to go bankrupt; If house prices are still higher than what households are willing to pay in the long-term, such instruments could be costly and counter-productive; foreclosure plans do not seem to lower the delinquency rate; As bad credit records generalize themselves, getting one is less stigmatizing while finding a new home gets easier. All this explains probably why the new foreclosure plans were received with a lot of scepticism by the financial markets. However there exists an externality which could justify such plans: it can be called the “social network externality”. In that case a rational household would still want to stay in his own home, if moving means loosing an old social network and recreating a new social network at a cost. For example it is well known that moving is detrimental for young children at school. Therefore the US foreclosure plans would be more convincing, if they would target explicitly households with a recognizable “social network” who can prove that it is rational for them to accept their negative equity. The existent of a “social network externality” could weakly legitimize the State intervention, although it should be considered more as a social program than anything else. So, if those social programs are proven popular, why should they be financed by the TARP?

So our first review of risk externalities in the housing market indicates that most of them are not yet properly recognized and that most States interventions are formulated inadequately in order to deal with them.

2. Risks externalities in the financial world:

The question of this section is what kind of externalities generate a financial institution which goes bankrupt. After the failure of Lehman Brothers we have now a real-live experiment of the worst kind, which economists have not finished to study. This is why I have no intention to propose a comprehensive discussion here. The whole argumentation goes around the concept of third-party risks.

When Lehman Brothers failed, its various kind of creditors were totally unsecure on what kind of money they would get back and when. This created a wave of fear in the whole financial community as nobody knew who would be concerned. Some central banks and Germany intervene efficiently, as they secure 1. the interbank market on a temporary basis, 2. the money market as well, and 3. traditional deposits up to a maximum amount. So the three major canals through which some risk externalities could have emerged have been rapidly stopped.

The weirdest thing is that, because Lehman Brothers chose a chapter 11 procedure, its top management was not fired, demonstrating the notion of “limited liability” to its best. Similarly it is very revealing that the notion of responsibility has become so relative when States even worry that those poor banks shareholders feel “unsecure”, in particular in the face of a possible necessary nationalization. Sorry, but the word “decadence” inadvertently comes to my mind. It must be the case that I did not detect an extraordinary positive and unmeasurable externality that those people created. Any suggestion?

Finally firms are also going to feel the cold of the present crisis, if it will become very difficult for them to finance new projects and to refinance their old credits, even though their business strategy are perfectly fine. Some States reacted promptly in recapitalising banks, in cleaning bad debts and in setting-up a form of temporary loans insurance, So we can hope that the worst has been avoided ..., well unless of course firms themselves start to fall bankrupt which is the subject of the next section.

By concluding I would say that the present financial crisis showed that States were perfectly able to come to the rescue of the financial sector effectively by following “old rules”, but also with some very interesting innovations. With the new theory of risk externality we should be able to evaluate the efficiency of those innovations in the future.

3. Risks externalities in the business world:

The question of the present section is the kind of externality is created when a firm goes bankrupt.

  1. First many of its employees are fired, even if they worked well. A good unemployment insurance seems a necessity nowadays and it could do a better job in targeting employees who have been fired. Several reforms are in the discussion which could improve the efficiency of unemployment insurance (see for example Card, Chetty and Weber(2007)).
  2. Second customers and suppliers will need to reorganize themselves. For customers it is normally not painful, if other firms produce similar products, but there are frequent exceptions as firms are getting more specialized in a globalised world. For those case entrepreneurs (eventually under a mandate from customers) should be allowed to completely reorganized a firm facing some difficulties in order to keep on its production. The State could help, for example with a tax-credit related to bankrupt firms accumulated losses. For suppliers finding new business relationships could be difficult in the short-term. In that case they should also rethink their business model. The State can help by having a favorable view of venture capital, private equity and investors-owners, a flexible bankruptcy code and an open market. But it would be a considerable mistake to help firms which produce goods and services that customers do not want. This is why State aids, without the participation of private equity, has attracted so much criticisms (for example for the “big three”).
  3. Competitors are normally going to thank a firm which decide to go bankrupt, but this is not considered an externality.
  4. When entire business sectors fail, the financial sector is also going to be affected, multiplying the risk externality. History shows us that such occurrence is rare and not so destabilizing in the modern times. It generally happens after a “fundamental innovation” start to be exploited successfully (like railways, the new economy, aso). Weirdly this kind of “overinvestment crisis” is not always damaging for the long-term growth prospect (see for example Rancière, Tornell and Westermann (2008) for a somewhat controversial contribution). Anyway it should be a manageable risk.
  5. The credibility of rating agencies is again a victim of the present crisis (although they can’t be described as “bystanders”). This is the only market failure which has been known since a long time. It will likely persist as long as they will be paid by debt issuers. A complete rethink about their role is necessary. It could go in the direction a penalty when a downgrade becomes necessary. Ordering them to give up their “consultation services” will not be enough to ensure their “independence”.

As we can see, when firms go bankrupt, they do not create a lot of negative risk externalities. Economic history shows that business crisis are solved quickly. Some libertarians think even that no public intervention is necessary. This is almost correct, as only efficient bankruptcy procedures, basic prudential rules for the financial market, a good unemployment insurance and a healthy entrepreneurial framework are recommended. Overall a cost-benefit analysis of limited liability in the business sector should demonstrate a net gain, which is less obvious for the financial and the real estate sector.

4. The State can also generate risks externalities!

Although this is not the subject of this article, we shall not forget that historically the main source of risk externalities comes from “failed States” and “failed policies”, even in countries with strong institutions. To my knowledge only strong international organizations are able to limit such disasters, by promoting best practices and peace. We need them more than ever. In that context the context of subsidiarity has proven effective. Indeed almost all proposed reforms are compatible with the subsidiarity principle.

From my point of view what is really important is not the financial power of international organization or voting rights, but the sharing of responsibilities between international organizations and national governments. In particular the question remains if the US and other big States will accept a mechanism for the mandatory implementation of international recommendations in their own country, like it exists at the WTO. What seems already agreed is that international organizations will be allowed to set-up collectively a “Financial Tsunami Warning System”. What is uncertain is the kind of penalty that the international community will be allowed to inflict a country which does not respect international recommendations and generates large risk externalities. Honestly an important lesson from the present crisis should be that any State is able to diffuse doubtful assets worldwide and generates a systemic crisis. In that regard the question of enforcement is the most important political question. The De Larosière report (2009) brings some first response.

A usual victim of systemic crisis is also international trade. The WTO seems to be an efficient watchdog for the moment, but few doubts that it must reinforce its monitoring mandate. A success of the Doha round would be the best signal of an effective end of the crisis.

5. Literature and testable results of the theory of risk-taking externalities:

One can sum up the preceding analysis of risk externality due to limited liability by distinguishing four major types of crisis: 1. Business crisis, which should be mild in OCDE countries, 2. Financial crisis, where the sophistication of the policy intervention is essential, 3. Real estate crisis where no proper toolbox exists, 4. Policy crisis, where States should reverse their past errors. Each type of crisis has different implications in terms of length, depth and affected variables depending on the relevance of the policy response.

In the literature the notion of risk externality appeared for the first time in Hilber(2005) who could not explain otherwise some phenomenon on .... the real estate market. So the concept has already been proven relevant empirically. The notion reappears in Zingales&Hart(December 2008), which accuses economists to have lost their principles. Considering that the notion of risk externality is relatively new, a better title of the Zingales&Hart paper should have been “Economists never found the right principle sofar”. In addition Zingales&Hart did not examine in details the notion of “risk externality”.

In order to test the theory, following tests could be undertaken:

  1. First the theory predicts that stabilization policies should have a favorable impact on welfare and growth, if risk externalities are successfully lowered. Crisis which are generated by firms should disappear quickly, as they generates little risk externalities, but they could still be problematic in the developing world. Banking crisis can have a considerable impact if States do not act quickly and properly. Real estates crisis are the worst, because the level of externalities is maximum and because States did not consider so far their specificities.
  2. What is important is not only the sophistication of financial markets, but also the sophistication of policy response. So far the notion of sophistication of policy response has not been measured, as far as I know.
  3. The theory should fit all past crisis. At first sight it seems to perform pretty well.
  4. The theory predicts that at the local level some risk externalities are stronger than at the national level. So some aspects could be significant at the local level and not at the national or international level and vice versa (for example Higgins, Levy and Yang(2006) would be a good way to start).
  5. The theory of risk externalities deals a lot with third-party risks when financial markets are concerned alone. So far third-party-risks are generaly not considered by economic agents. Some of them can be measured, and their theoretical value compared with observed value.

In the future those tests will be also able to analyse the optimality of policy response in more details. Such a study would extract the level of risk externalities first and compare it with the cost of intervention.

6. Radical criticisms of this new approach:

But before to give any policy recommendation, we need to be sure that the concept of risk externalities is viable. So I tried to formulate below the hardest criticisms against the new approach that I could conceive.

Imagine that States will in the future cover all possible risks externalities. In this perspective, optimality is closely linked to the fact that humans are partial optimizers, i.e. all economic agents are unable to digest the amount of information necessary in order to take a fully rational decision. Nevertheless each economic agent can be a specialized optimizer. This creates a network of information exchanges in which each agent is taken responsible for his own actions. In that context a systemic crisis can nevertheless occur due to mistakes done on the other side of the earth before most economic agents get a chance to be aware of its emergence. The role of the State is to try to avoid that this interconnected economic network suffers too much when mistakes are done. At the end this should encourage economic agents to specialize themselves and thus should help growth. Against this point of view I found four radical criticisms:

  1. Are we not going to repeat the mistake of Basel II, i.e. by believing that when each individual agent assume the risk that he creates or bears the system as a whole will be stable? Indeed this could happen again with a “mass movement” where individual economic agents lose sight of the big picture (for example with bubbles, the Keynesian illusion of saving, investors herding, aso.). But first the actual highest priority is to stop the worldwide domino effect. Controlling all risks externalities is the best immediate way to bring this outcome. Only after stabilization will be reached will a stimulus plan work fully, if countries believe that their economic potential is underexploited. However this is another type of policy intervention which has barely to do with risks, as it is a return to the “average”. Second by trying to measure risks externalities, we will be able to put an estimate on the premium4 that the economy will be willing to pay in an upturn, so that the State can assume its responsibility as an insurer of last resort and do its best in avoiding the next crisis. By taxing “mass movements” with a correct premium, we are not going to repeat the mistake of Basel II. However each country might want to choose its own approach, as the value of systemic risk and the optimality of their taxes system are different. But so far I haven’t heard too much in the literature about the necessity of a proportionality between the premium and the value of risks taken over by the State as the insurer of last resort. In other word our approach will allow in the future to give a solid microeconomic foundation to the value of stabilization policies in terms of insurance.
  2. Even if we deal with all type of third-party risks, how shall we deal with the Knightian uncertainty (what is left when all risks are explained)? First it is reasonable to assume that the Knightian uncertainty can be approximated by a nth-party risks. The State by stopping as soon as possible and efficiently the impact of third party-risks, is highly likely to stop at the same time the emergence of the Knightian uncertainty. If it still appears and does not go away even when all third party-risk are controlled, it probably means that there is a problem not with risk, but with the average, i.e. an incoherent long-term growth path. In the present situation this is barely the case, as the only growth factor which has been heavily affected so far is the factor of capital including housing. So we can be pretty sure for the moment that when financial markets will return to a healthy outlook, the rest of the economy will follow. In the meantime governments should really be upbeat about the future and the sustainability of the global growth path (for example with a green deal, a success of the Doha round, by helping new technologies, bringing peace, setting-up efficient financial and real-estate institutions in the developing world, aso).
  3. Is it possible to insure risks externalities when the price of such an insurance is not known? Of course it is better to have a price system, but it is not always wishful(hard-to-measure externalities) or possible(market failures). But the intervention of the State has several advantages: 1. It is normally the only one available in order to eliminate an externality. 2. The State is the only agent who has an infinite time-horizon, so with a wider range of possible arbitrage, 3. It has the deepest pocket, which is necessary for an insurer of last resort. For example the State can be one of the rare investors able to hold some assets which can’t be priced until their maturity. Nevertheless such price systems can (and should when possible) be developed ex post.
  4. It is generous to consider that economic agents should not be held responsible for third-party risks or similar risks? Today the world is so complex that economic agents are able to perform some financial arbitrage only among incomplete markets depending on their ability. However incomplete markets and heterogeneous agents are the two basic assumptions that justify a State intervention (for example Fostel and Geanakoplos(2008)), especially if its actions are so targeted that it is able to complete markets. Of course economic agents should be held responsible for their own action. But which private agents did mistakes in the last real-estate bubble? Most of them acted in a responsible way under the information and the arbitrage abilities they had. To my knowledge the only private agents who sent totally wrong signals were the rating agencies, while on the other hand nobody listened carefully to the correct signals emitted by international organizations. In that case it is reasonable to reallocate resources in favor of economic agents that produced the correct signals and to limit the nuisance from agents who sent wrong signals. An market-friendly alternative would be to reinforce the responsibility of agents to take third party risks (especially bond-holders, for example see Gersbach(2004)). Recent experiences showed us that only the most sophisticated agents were able to master third-party risks and barely. Finally critics should also tell us what should be done with fourth-party risks and nth-party risks.
  5. We have also to be aware that the State can get it all wrong as well and we did not analyze this case here.

So these criticisms help us to understand the context under which the theory of risk externality could be valid. We shall keep them in mind when formulating policy recommendations.

7. First policy recommendations for the present crisis:

In practice the proposed theory is already able to give interesting recommendations, despite the fact that it is in its infancy:

  1. Real estate crisis have never been considered separataly sofar. History shows that this is the only type of crisis which still affects severeraly OCDE countries (FMI(2008)), despite the level of sophistication of their financial market and of their stabilization policies. Normally governments underestimate the level of risk externalities that they generate. This creates a higher level of uncertainty, so that a lasting Knightian uncertainty could appear. In order to fight the emergence of real estate crisis new policy tools have to be developed.
  2. Are nationalizations useful? Yes, if they are necessary for reassuring investors and for withdrawing a lot of uncertainty from the market. Counter-arguments (breaking the taboo of nationalization will create uncertainty, how to know which banks should be nationalized? aso) have a more technical nature and can be circumscribed (setting-up clear rules for nationalization, acting promptly once and for all, giving a call warrant to former banks shareholders, aso).
  3. Creating a bad bank? It is not going to be useful if it is a pure accounting trick in order to help bankruptcy procedures. The value of banks bonds will still be unknown. As nobody knows who owns them, the level of uncertainty and risks externalities in the whole financial market are not going to be lowered. A recapitalization is more effective in reducing the overall risk, as it protect also banks bonds holders. A quick and definitive repricing of banks bonds is also thinkable, but could leave long-term scars if it is not done properly. Selling put-options on potential losses due to systematic risks might be more effective, as it would set a floor on downside risks taken-up by private investors.
  4. Macro-prudential rules? Yes, but it would be better to base it in large parts on “housing affordability”, as real estate crisis are the only type of crisis that OCDE countries need to fear. The “output gap” or auto-corrective rules for loans growth are only marginally interesting, as loans to firms are normally not the problem. In addition when banks reserve ratio are already depleted, Surchat(2009) suggested a rule which would also work, while the rule proposed by Brunnenmeier and al. (2009) works only if banks have been prudent first. The discussion on this topic is by far not closed yet (see Acharya and al. (March 2009)).
  5. Regulating financial innovations? Yes, but only so far as they generate risk externalities by being leveraged and by including some sort of limited liability (or worse a Ponzi scheme). The principle “Silence is forbidding” shall apply only to financial innovations dealing the real estate market. The principle “Silence is allowing” should apply when the financial market is affected alone. No regulation seems necessary yet for financial innovations on the business sector. By the way, why not create a patent for financial innovations, so that its owner will have a strong interest that it works?
  6. Reducing international disequilibrium? Yes, but it is much more effective to develop real estate markets in developing countries. How to justify that, because their financial and real estate markets are not well developed, the excess saving of developing countries help building luxury homes in the developed world while their own people do have proper housing? I didn’t find the answer. In addition the real estate market has proven to be relevant when one tries to reduce the level of mismatch between real local investments and short-term financial flows, in particular in the Asian crisis.
  7. Special regulations for large and complex institutions? May be, but it looks like an overkill. Only the aspect “complex” seems to be relevant, as LTCM was a small financial institution, Enron was a business firm, and the Japanese postal bank might be huge, but is totally safe, while the Saving-and-Loans crisis was due to small banks. Indeed the notion of risk externality has little to do with size and is not limited to the financial market.

So we can see that when risk externalities due to limited liability are taken into consideration, some distinct accents appeared in the formulation of an optimal policy response. This is due to the fact that our contribution to the literature come mostly from the fact that we consider the notion of risk externalities in a more general context, even outside the financial world. Nevertheless not all the details are going to be settle with such concept, but they are mostly very technical contractual details5.

I would like to take this opportunity to thank all the professors who posted a synthetic view of all their reforms proposals on the blogosphere (see for example Goldstein(2009), Buiter(2009), Philippon(2009)). This is really helpful.

Conclusion:

Our analysis shows that the concept of “risk externality” due to limited liability can be a powerful tool for designing optimal policies. With a few assumptions it is able to explain many important financial phenomenon and can give very good advices to policymakers. I encourage everyone to look closely at this promising concept which has been barely studied in the literature.

It is already noticeable that with only two principles (1. limiting “limited liability” on the financial and the real estate markets, but not in the business world, 2. assuring all risk externalities), we found the core of policies that are actually pursued by governments, we were able to cover almost all issues at stake and we were even able to propose missing policies in an original way. I recognize that more market-friendly solutions will be developed in the future and they have already all my intellectual support. Meanwhile today is the time where some politicians can make our heart beat by saying words like “hope”, “reviving our communities”, “affordable homes for all”, “a financial world made for humans”, aso. But words were not so far able to reassure the financial markets. In that regard the notion of risks externalities can reinforce the credibility of a global plan.

The concept or risk externality is also more suited to future crisis. If we accept that everyone of us has a partial knowledge of the world that surround us, we have also to accept that systemic crisis will always be possible (i.e. finding that we were all wrong because we took as granted the opinion of other specialists). In that case it will be important to have the proper toolbox available. The concept of risk externality can help us build a comprehensive one. The aim is that people should keep their confidence that they can specialize themselves where they are the most gifted without fearing that the sky will fall on their head. This ability to specialize oneself has been known to be the best foundation for a sustainable long-term growth since Adam Smith(1776).

Marc SURCHAT

Département fédéral de l'économie
Secrétariat d’Etat à l’économie (SECO)
Secteur Politique de croissance et de concurrence

Effingerstrasse 1
CH-3003 Berne
Phone ++ 41 31 322 21 32
Fax ++ 41 31 323 50 01
E-Mail: [email protected]

Footnotes, bibliography, P.S. and disclaimer:

P.S.: As I am finally ready to do a Ph.D., any professor willing to contact me should think to prepare a yes-or-no answer to a question that might arise naturally. I will answer all comments that I receive.

Disclaimer: The views presented here are purely personal and do not represent necessarily the views of the State Secretariat for Economic Affairs or of the Swiss Federal Department of Economic Affairs.

Footnotes:
1 The panics of 1819 and of 1837 in the US had a monetary nature. Former crisis were often due to States decisions. Finally it is unclear, if the first known bubbles had a systemic character in a mostly agricultural society.
2 It is very rare when the State forces the bearer of the risk to pay the risk producer, even if it would be Pareto-efficient. So we disregard this possibility.
3 An example of a general policy is a minimal income for all whatever the context.
4. A “premium” can take the form of general taxes or an adjustable reserve ratio for banks.
5. I realize Wednesday by reading Rossi(2009) that the question of the optimal mix between nationalization, bankruptcy procedure, eliminating toxic assets, recapitalization is not yet settled. I hope that I will have the time to write a blog article next week on this subject. I solved this problem in October already, by I thought that it was obvious and I really needed some long vacation at the time. The idea is that we shall use the “revelation principle” with a menu of contracts. First the State shall gather the maximum of information of each bank and guess the distribution of possible banks losses depending on the type of their loans. Second it should set some criteria under which banks are nationalized immediately. Third the remaining banks shall face a step-by-step series of menu of contracts, going from almost entire recapitalization(first step), to buying toxic assets at decreasing discount depending on the level of recapitalization(second step), to finally a x*10% tax break for banks that do not accept any State aid, but agree to increase their loans to firms and households by more than x% over the average rate of credit growth(third step). This menu of contracts would be a once-and-for-all take-it-or-leave-it offer. The steps are necessary so that the State can get as much information as possible on how bad banks are and get a chance to revise its a priori distributions of banks losses. It is legitimate to do so when markets are not anymore in shape to value bad assets. Bankers have nevertheless a “gut-feeling” of their real value, which must be over the observed market price, otherwise they would have sold them. This scheme tries to extract this “gut feeling” by minimizing inevitable losses for the State acting as a principal. Obviously the first best can never be reached.

Bibliography:
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