Tell Me the Rules and I'll Tell You What to Expect

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In economics, we often make liberal use of the “all else equal” assumption. If I am discussing the market for apples and the supply of apples declines due to bad weather, I will often say that the price of apples rises. What I really mean is that, holding everything else constant, the relative price of apples rises. Furthermore, when I say that the relative price of apples rises, I am saying that the relative price rises in comparison to the counterfactual world in which there was no bad weather. In reality, of course, a lot of other things might be happening. All else might not be equal. The price of apples might be falling relative to oranges because of what is going on in the market for oranges. The job of the applied economist is to disentangle everything and construct the right counterfactual.

This supply and demand example isn’t just holding constant what is going on in other markets. The entire institutional environment is being held constant and pushed to the background of the analysis. This is understandable. The institutional environment is just a fancy way of saying the “rules of the game” in society. Thus, assuming that the institutional environment does not change certainly seems like a reasonable assumption for most examples. Nonetheless, changes in the institutional environment can happen and can be important.

The UCLA tradition of price theory focuses a lot on institutions. How do institutions emerge? What is the purpose of a particular institution? What happens when institutions change? These are all important questions. Although price theory typically holds the institutional environment constant, the economists at UCLA demonstrated that price theory could answer these questions. In fact, people often describe Armen Alchian’s approach to studying property rights as “you tell me the rules and I’ll tell you what outcomes to expect.” That is just another way of saying that the institutional environment shapes the choice people make.

I’ve been thinking about this a lot recently, largely as a response to feedback that I received on a previous post about using multiple liability to align the interests of bank shareholders and depositors.

For those who might have missed the previous post, a quick summary of multiple liability is as follows. Currently, bank shareholders are subject to limited liability. This means that a shareholder who buys $10,000 of Citibank’s stock can only lose this $10,000 in the event that Citibank becomes insolvent. Under multiple liability, the most the same shareholder can lose is some multiple of this initial investment. For example, under double liability, the most the shareholder can lose from this investment is $20,000 because the shareholder would not only lose the money originally invested but could owe as much as $10,000 to depositors in the event the bank becomes insolvent.

My argument in the previous post was that multiple liability helps to align shareholder incentives with depositor incentives since shareholders are financially responsible for depositor losses. (For those interested, I’ve also written about this more extensively here.)

In response, some readers were skeptical that this could work. The following is fairly representative of that feedback:

• This might have worked in the “old days” when banking was simple. But bank operations are more complicated now.

• If multiple liability is used as an alternative to deposit insurance, wouldn’t depositors need to monitor the bank? Is the average depositor capable of evaluating the safety of a bank’s balance sheet?

• Why not leave bank evaluation to the experts and just have the government regulate the banks?

None of these are unreasonable responses. However, I would contend that the underlying premises of these responses seem to be based on the wrong counterfactual or holding things constant that shouldn’t be held constant when the rules of the game change.

The first claim is that banks are more complex now than they used to be. The implicit assumption in this statement is that the complexity of banking is independent of the institutional environment. Banks have become more complex and would have regardless of whether we had multiple liability or the current system of limited liability with deposit insurance.

An alternative hypothesis is that the shift from multiple liability to limited liability and deposit insurance gave both shareholders and depositors less of an incentive to monitor the bank. In a world in which shareholders and depositors try to monitor the bank closely, complexity can be a problem. If the bank seems too complex shareholders will invest their money elsewhere and depositors will deposit their money elsewhere. Thus, a change to the rules of the game that reduces monitoring should also be expected to increase the complexity of banking since it makes it less costly to be complex. If this hypothesis is correct, banking would get less complex with a return to multiple liability.

Natural questions emerge. Is complexity always good? What is the optimal level of complexity? How do we decide?

The second claim is one of my least favorite arguments. This is the idea that depositors either aren’t smart enough or aren’t capable of reading bank balance sheets in order to effectively monitor the bank.

The idea that neither shareholders nor depositors are capable of reading balance sheets or evaluating the stability of the bank seems a bit odd. There are many goods and services that consumers have little knowledge of or experience with. Yet, somehow consumers learn how to discern the quality of these goods and services. I’m willing to bet that many consumers could not explain how a microwave works and certainly wouldn’t know how to build one. Nonetheless, somehow consumers are able to figure out which microwaves are “good” and which ones are “bad.” They are able to do so because of the reputations, brand names, trial-and-error, and word-of-mouth.

Also, when information problems exist, specialist middlemen tend to emerge. These middlemen specialize in having the necessary information and providing it to consumers at a cost. For ordinary household goods an obvious example is an organization like Consumer Reports, which tests out products and offers reports of their findings. In an earlier era of banking, in scenarios in which bank notes didn’t trade at par, there were firms that published books with the relevant discounts on particular notes. Clearinghouse associations provided information about bank balance sheets to the public as a way of disciplining its member banks, thereby reducing the risk of the association.

In a world with limited liability and deposit insurance, there is no need for specialist middlemen because people lack the same incentive to monitor banks.

This role of specialist middlemen gives rise to a comparison with modern regulators. Critics of multiple liability point to the specialist middlemen and ask why government regulators aren’t just a substitute for these specialist middlemen. What is the difference between the middleman and the regulator? Aren’t they both just specialists?

In a sense, this is true that both middlemen and regulators are specialists. Again, this is about the relevant counterfactual. A call for regulation begs the question: regulated by whom? Both the middleman and the regulator are providing a form of regulation.

The middleman provides information to shareholders and depositors. This information then informs decisions about whether to invest in the bank or deposit money in the bank. Banks that are risky or complex will be reported as such by the specialist middleman. Shareholders and depositors then decide what to do. Market forces then lead banks that are struggling to attract investors and depositors to change the way they operate. Otherwise, the bank will continue to struggle.

The government regulator creates rules for the banks to follow. If the banks do not follow the rules, they will be subject to penalties from the government. To avoid fines, banks will attempt to follow the rules.

Whether the middlemen or the government regulator produces better outcomes depends on the incentives provided to banks, shareholders, and depositors in each scenario. Furthermore, it is not necessarily an either/or scenario. It’s possible for middlemen and regulators to be mutually exclusive. However, there is no requirement that they are.

Regardless, the important point to remember here is that when the institutional environment changes, incentives change. People optimize on different margins. The proper counterfactual matters. Tell me the rules and I’ll tell you what to expect.