Taming the Two 800 Pound Gorillas in the Room

Abstract

The protection of bank debt and the targeting of risk-promoting mortgage subsidies are the primary sources of systemic risk in banking systems around the world. These two threats are related. Deposit insurance and other bank protection creates rents outside the normal budgetary process that funds and encourages risk taking. Governments create these rents not just to reward bankers, but also to target credit subsidies to preferred groups of borrowers. In recent decades worldwide real estate lending has been increasingly favored. Tackling the twin problems of excessive protection of banks and subsidization of housing finance risk with macro-prudential regulation is difficult because the agencies charged with regulatory oversight are subject to the political influences that give rise to these two gorillas in the first place. Furthermore, the incentives of economists tend to make them accomplices in the drama that underestimates the importance of these primary threats to systemic stability.