John Cochrane vs. Financial Intermediation

He writes,

demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.

I suppose Murray Rothbard would have liked this.

My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.

I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.

Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.

Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.

8 thoughts on “John Cochrane vs. Financial Intermediation

  1. Deposit insurance, for example, was supposed to Pigouvian in nature, wasn’t it? The guarantee was supposed to be covered by the taxes/fees assessed on the amounts covered by the guarantee.

  2. Financial intermediation is not the same as maturity and risk transformation. A financial intermediary obtains funds from savers, lends them to borrowers (consumers or investors), and charges an intemediation fee or margin. A financial intermediary does not have to perform maturity and risk mismatch. A prudent financial intermediary does not perform maturity or risk mismatch or does it minimally.

    Maturity and risk mismatch (or transformation) happens when the assets of an entity are longer term and riskier than its liabilities. It is the fundamental cause of financial crises. Some financial intermediaries perform maturity and risk mismatch because shorter less risky debt has a lower interest rate than longer riskier debt. Economics is about tradeoffs: an agent cannot perform maturity and risk mismatch and earn higher benefits without becoming more fragile.

    Some banks and shadow banks tend to perform maturity and risk mismatch because of cheap central bank refinancing, clumsy regulation and supervision, implicit or explicit guarantees (systemic risk, too big to fail), and deposit insurance (depositors don’t control the banks).

    Economic agents prefer to issue long term and risky debt, and hold riskless, short-term assets. This is a particular case of sellers wanting to give low quality at high price and buyers wanting to receive high quality at low price. If
    sellers sell at high prices and buyers buy at low prices, quality is probably compromised without at least one of the parties knowing it. But the true quality of the product (in this case credit) will show itself with time.

    Banks are not only financial intermediaries: they are also payment managers that issue their own liabilities as monetary substitutes; this is the reason why banks can be very leveraged. Maturity and risk matching is performed by prudent fractional reserve banks. It makes no sense for 100% banks.

  3. “Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests.”

    What a remarkable elixir “taxation” has become. It now seems to have applications to all manners of human conduct, though never quite sufficient in form or substance to serve as the source of revenues for the functions of governments.

  4. Professor:

    You quote John Cochrane as saying, “demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries,” then observe that “I suppose Murray Rothbard would have liked this.”

    One of the things I learned from Rothbard’s books was that banking systems that require banks to buy government assets to back whatever form of financial instruments they issue tend to go bad. So, I doubt that he would have liked that part of the proposal.


  5. yes, Murray Rothbard would be rising from his grave to shake Cochrane’s hand.

    Ed Prescott is making similar proposals.

    This type of banking reform is pie in the sky as is free banking

    The old question I was asked when working in a Prime Minister’s Department in Canberra was “That is not going to happen so what are you going to do now.”

  6. Could we not make a decent impact on the margin by (in the U.S., at least) eliminating the tax advantages of interest on debts? Businesses can treat interest as an expense, while the cost of equity capital (e.g. dividends) generally cannot be treated that way. Individuals can deduct mortgage or student loan debts in most cases.

    If too much aggregate debt is a problem for the relative leverage and fragility of the system, the means to raise debt’s price, and hence decrease its quantity, seems obvious. If it impacts the financial sector more than others, perhaps banks will raise more equity of their own accord.

    • Sisyphus: “Could we not make a decent impact on the margin by (in the U.S., at least) eliminating the tax advantages of interest on debts?”

      In the post AK does point to the “tax advantages of leverage” as part of the problem. (I missed it on the first read, because it’s buried under deposit insurance and TBTF guarantees!)

      I too think we must reduce the demand for loans by eliminating tax deductions for interest expense. It’s a good way to reduce the size of the financial sector, which would help to solve the problem Cochrane is trying to solve.

      But given that finance is now so large it makes the economy crisis-prone, eliminating those tax deductions “cold turkey” would be too big a shock to the system. We need a way to ease it into place. Rather than just eliminating the mortgage interest deduction, for example, we should replace it with a tax credit that rewards the accelerated repayment of debt.

      Rather than punishing credit use, we can (and at this late date we must) reward the paydown of accumulated debt. This is a gentler way to get the benefit of a smaller financial sector.