Could a "Crisis Insurance" Wrinkle Make Banks Managers More Prudent?

One of my (many) pet peeves is the lousy incentives that investment bank top brass and staff have had for some time. In particular, the advent of the “other people’s money” model has meant that everyone has reason to be cavalier. The industry has a proud tradition of people failing upwards, or at least sideways, so being at an organization, or even, say, running a desk that blew up was not as damaging to one’s earning power as it ought to be.

It was pretty different in the days of partnerships. The big reason was the leadership of the firm was highly motivated to contain risk. Partnerships have unlimited liability, which tends to focus the mind. Another contributing factor was that the partnership model greatly reduced mobility at anything beyond the junior levels. Let’s face it, if you are a lateral hire, you will be at a disadvantage in making partner, all things being equal. Clubs tend to admit people they know well and feel comfortable with. People with shorter tenures are at a disadvantage.

Now in some cases, “all things being equal” is less relevant because things are not all that equal. If you are a trader, people can look at your bottom line, But judging the risks you take (personally and professionally) is a more subjective assessment. For instance, a partnership has good reason to be concerned about risk of exposure to a sexual harassment suit (all the partners will pay for any damages) than in the OPM model, so around the margin, conduct does matter. Goldman in the old days made a point of making the solid rather tame but highly profitable types partner more rapidly than their fast living peers. They made it clear what posture they preferred.

And we and others have wailed ad ad nauseum that the incentive problem has gotten worse now that everyone that is part of crucial capital markets infrastructure or is just plain big (as in losses on CDS written against their debt could prove traumatic) now gets a backstop, which only worsens the already dangerous OPM dynamic.

We are not going back to the partnership model, but a post at VoxEU suggests a clever new wrinkle. In all candor, it gave the impression out as one of those abstract economist exercise, “Well if we just create a market for X, everything will be hunky dory.”

The idea, from Hans Gersbach, is to create insurance for banks. You groan. I did too. Look, we have FDIC insurance, the risks on these big banks is huge, only the government can effectively insure them, and this is really problematic (as in how you set the policy rate is a thorny problem, to put it mildly). But Gersbach has a wrinkle that makes the setting of the exact rate less important. You put the executives on the hook, meaning they have to pay out when the bank incurs big enough losses to trigger the insurance. You get a fair bit of the way back to the partnership model of having the top management have their assets on the line.

Of course, it will never happen. No one with money in the US is willing to eat liability; that’s why we have D&O insurance, for instance. But it is a clever idea nevertheless.

From VoxEU:

The crisis is a brutal reminder of the fragility of banks. This column suggests that managers of large banks be obliged to purchase insurance against systemic crises. This would create incentives for them to be concerned about the stability of the banking system as a whole.

The crisis is a brutal reminder of the fragility of banks. The only way to enable banks to absorb more losses in downturns is to force them to hold more equity capital (Greenlaw et al. 2008, Pagano 2008, Shin 2008, and Hellwig 2008).

The current crisis 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. 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 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.

Conclusion

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.