The current crisis is a brutal reminder of the fragility of banks (Greenlaw et al. 2008, Pagano 2008, Shin 2008, and Hellwig 2008). It will be the most costly ever and has triggered loud calls for draconian re-regulation to protect taxpayers from the next crisis. Before joining the chorus, it makes good sense to take a close look at the alternatives.
There is a strong argument that banks should be required to hold more equity capital as a buffer against insolvency risk in downturns. A potentially promising supplementary measure is private insurance against systemic crises. This proposal hinges on the observation that contractual arrangements in banking expose banks to macroeconomic shocks, and that this may lead to crises. Such shocks may be exogenous, but they may also occur when many banks undertake correlated investments, thereby increasing economy-wide aggregate risk. If it were possible to induce banks to buy insurance contracts contingent on macroeconomic events closely correlated with the financial health of the banking sector, banking crises might become less likely, and if they did occur, they would be less devastating.
In a CEPR discussion paper, I investigate the potential and limitations of this approach for the banking sector (Gersbach, 2009).1 I suggest two main insights:
Insight 1: Insurance is possible
Mandatory insurance means that a bank has to obtain a sufficient number of insurance contracts. With such insurance contracts, banks pay a premium per contract to private investors. The contract holders have to recapitalise banks in the event of a macroeconomic downturn that would trigger large-scale defaults in the banking industry. In principle, such mandatory insurance can fully insure an economy against banking crises. The crucial condition, called the “insurance capacity” of an economy, is that there be a sufficient amount of wealth for contract holders to be able to honour their obligations in a downturn.
Insurance contracts can be conditioned on contractible macroeconomic indicators such as GDP growth or an index of real estate prices.2 An alternative would be conditioning insurance contracts on average bank equity, as average bank equity in relation to assets is an indicator of the financial health of the banking sector.
Insight 2: Many drawbacks
However, there are a number of serious drawbacks. Most importantly, if insurance is allowed to remain voluntary, banks will not make use of it because it would decrease their return on equity. Moreover, if banks avail themselves of new, risky investment opportunities and gamble, then even mandatory insurance will not be a complete safeguard. A further serious concern is that in a crisis, investors selling insurance contracts may go bankrupt, which decreases the insurance capacity of the economy. Furthermore, managers may not be interested in obtaining the maximum amount of equity they could attract, as lower equity may yield higher monetary or non-monetary benefits. This would increase the number of contracts required to insure against systemic crises, which would very likely exceed the insurance capacity of the economy.
Insurance contracts for bank managers
A sensible way of addressing the drawbacks of private insurance against banking crises is to require bank managers to act as insurers and to hold a specified amount of insurance contracts, perhaps as part of their remuneration package.
One might even envisage making the amount of insurance per bank manager risk-sensitive, i.e. a bank manager opting for risky investments would have to have a larger amount of insurance. In such cases, this scheme would directly counteract excessive risk-taking.
But even without risk-sensitive insurance requirements, such a scheme has positive side effects. It internalises externalities and creates collective responsibility. Moreover, it provides incentives for discovering systemic risk and tends to make bank managers prudent, which lowers the likelihood of banking crises. Suppose, for example, that such contracts are based on average bank capital. While individual incentives for limiting bank equity or gambling may still exist, bank managers engaging in such activities might face severe career barriers as they are harming their colleagues. This would encourage concern for the public good of "system stability".
Collective responsibility on the part of bank managers and the need to contribute to the recapitalisation of banks in a crisis is also useful from a fairness perspective, as citizens will perceive it as even-handed burden-sharing. As a consequence, citizens may be more inclined to support policy measures using taxpayers’ money to resolve banking crises occurring despite the insurance scheme.
Of course, in practical terms, only managers of large banks and large insurance companies would need to hold crisis-insurance contracts, as these are the only institutions that can affect the stability of the whole system.
The current crisis is a painful reminder that sophisticated banking systems are vulnerable to systemic crises. Insurance schemes against systemic crises are a promising way of tackling this problem. However, they are not an all-purpose panacea, as they have serious drawbacks and involve practical problems. But by requiring managers to hold such systemic insurance contracts, our scheme might have a number of beneficial effects, even if it were not necessarily implemented on a large scale.
1 Another paper on private insurance against systemic risk is Gersbach (2004).
2 Ways of making contracts dependent on macroeconomic risk by defining and maintaining standardised macro-indices have been widely discussed in the literature (Shiller, 2003 and Gersbach, 2004).
Dewatripont, M. and Tirole, J. (1994), The Prudential Regulation of Banks, MIT Press.
Gersbach, H. (2004), Financial Intermediation with Contingent Contracts and Macroeconomic Risks, CEPR Discussion Paper Nr. 4735.
Gersbach, H. (2009), Private Insurance Against Systemic Crises?, CEPR Discussion Paper No. 7342.
Gersbach, H. and Uhlig, H. (2006), "Debt Contracts, Collapse and Regulation as Competition Phenomena", Journal of Financial Intermediation 15(4), 556-574.
Greenlaw, D., Hatzius, J., Kashyap, A.K., and Shin, H.S. (2008), “Leveraged Losses: Lessons from the Mortgage Market Meltdown”, US Monetary Policy Forum Report 2, Rosenberg Institute, Brandeis International Business School and Initiative on Global Markets, University of Chicago Graduate School of Business, p. 34.
Hellwig, M. (1998), “Banks, Markets, and the Allocation of Risks in an Economy”, Journal of Institutional and Theoretical Economics 154(1), 328-345.
Hellwig, M. F. (2008), "Systemic Risk in the Financial Sector", Jelle Zijstra Lecture 6.
Pagano, M. (2008), “The Subprime Lending Crisis: Lessons for Policy and Regulation”, in Unicredit Group Finance Monitor June 2008.
Shiller, R.J. (2003), “Social Security and Individual Accounts as Elements of Overall Risk-sharing”, American Economic Review 93, 343-347
Shin, H.S. (2008), “Securitisation and Financial Stability”, Economic Journal, forthcoming.