02 January 2009

Arnold Kling's Sheriff

I've been thinking about Arnold Kling's "Stern Sheriff" idea for regulatory management of financial crisis. In brief, he suggests that when there's a rush for collateral from an endangered institution, regulators should immediately step in and "penalize liquidity preference" - i.e. tell everyone to wait.

What that really amounts to is declaring bankruptcy earlier. After all, if you are demanding payment which you are due, and someone is telling you you can't have it, the debtor is officially not creditworthy.

Put that way, it seems a very good idea. After all, my layman's understanding of insolvency is that a party is insolvent not when it fails to make a payment, but when it knows that it is not going to be able to make a payment, and that to take on new obligations while insolvent is not allowed. Of course, in real life, that is presumably wrapped up in a whole lot of very necessary, very complicated accountancy. But the principle is that bankruptcy happens not when the money runs out, but before the money runs out, so it can be shared out fairly without chaos and panic. And that's all that Professor Kling is asking for.

It seems a good idea, but of course the next problem is that no real financial institution can pay all its debts on time without access to more borrowing. If I accept the stern sheriff, I'm likely to end up at the Moldbug position, that all maturity transformation is wrong, that a borrower that will not have cash on hand to pay every debt as it comes due is insolvent. I've argued against that view, largely on the basis that it's too easy, and too profitable, to do secretly. If you stop financial institutions from doing it, the result will be that everybody else does it.

There is, to be fair, some room for action between a run on a borrower's credit being possible and it actually happening. But it's very small. And the earlier you are expected to step in and prevent withdrawals, the more incentive you create to withdraw (or call collateral, or whatever) even sooner, before the sheriff arrives, so that window gets even smaller.

The more of a "hair trigger" you put on bankruptcy, the easier it is for the creditors to expropriate the equity-holders at any time. That conflict of interest becomes much sharper and more problematic for maturity-transforming financial institutions than for other enterprises - perhaps those institutions should avoid having two tiers of financing in that way.

Hey! I just invented the investment-banking partnership and the mutual building society! Maybe I'm onto something...

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