Central bank digital currencies
13 January 2021
Erasmus and Turing
11 January 2021
Brexit and Marxism
3 January 2021
What to do about the Covid financial system bailouts?
22 December 2020
The crypto-technical response to the Covid-19 bailouts
13 December 2020
The libertarian response to the Covid-19 financial turmoil
9 December 2020
The socialist response to the Covid-19 financial turmoil
4 December 2020
On the response of the financial authorities to Covid-19
2 December 2020
The Covid-19 bailouts and the future of the capitalist banking system
26 November 2020
Which programming language is best for economic research: Julia, Matlab, Python or R?
20 August 2020
ARM on AWS for R
15 June 2020
Low vol strategies
8 May 2020
Of Julia and R
8 May 2020
How to manipulate risk forecasts 101
30 April 2020
The five principles of correct riskometer use
27 April 2020
The problem with Backtesting
25 April 2020
The magic of riskometers
24 April 2020
Risk and scientific socialism
23 April 2020
Financial crises and epidemics
19 April 2020
Hayek and Corona
17 April 2020
Hayek et Corona
17 April 2020
Ignoring the Corona analysis
15 April 2020
The coronavirus crisis is no 2008
26 March 2020
Artificial intelligence as a central banker
6 March 2020
Systemic consequences of outsourcing to the cloud
2 December 2019
The dissonance of the short and long term
12 August 2019
Central banks and reputation risk
6 August 2019
The Brexit culture war
5 May 2019
All about BoB — The Bank of England Bot
29 April 2019
My tiny, tiny contribution to Apple's fall in profits
6 January 2019
The 2018 market in a 250 year context
1 January 2019
Short and long-term risk
3 December 2018
Perceived and actual risk
2 December 2018
Cryptocurrencies: Financial stability and fairness
9 November 2018
The October 2018 stock market in a historical context
1 November 2018
The hierarchy of financial policies
12 September 2018
Which numerical computing language is best: Julia, MATLAB, Python or R?
9 July 2018
26 June 2018
What are risk models good for?
3 June 2018
The McNamara fallacy in financial policymaking
1 June 2018
VIX, CISS and all the political uncertainty
20 May 2018
Here be dragons
30 March 2018
Low risk as a predictor of financial crises
26 March 2018
Cryptocurrencies don't make sense
13 February 2018
Yesterday's mini crash in a historical context
6 February 2018
Artificial intelligence and the stability of markets
15 November 2017
European bank-sovereign doom loop
30 September 2017
Do the new financial regulations favour the largest banks?
27 September 2017
The ECB Systemic Risk Indicator
24 September 2017
Finance is not engineering
22 September 2017
University of Iceland seminar
14 June 2017
Brexit and systemic risk
31 May 2017
Should macroprudential policy target real estate prices?
12 May 2017
Learning from history at LQG
13 April 2017
Is Julia ready for prime time?
12 March 2017
With capital controls gone, Iceland must prioritise investing abroad
12 March 2017
Competing Brexit visions
25 February 2017
Systemic consequences of Brexit
23 February 2017
Why macropru can end up being procyclical
15 December 2016
The fatal flaw in macropru: It ignores political risk
8 December 2016
Why it doesn't make sense to hold bonds
27 June 2016
On the financial market consequences of Brexit
24 June 2016
Cyber risk as systemic risk
10 June 2016
Big Banks' Risk Does Not Compute
24 May 2016
Interview on þjóðbraut on Hringbraut
21 May 2016
Farewell CoCos
26 April 2016
Will Brexit give us the 1950s or Hong Kong?
18 April 2016
Of Brexit and regulations
16 April 2016
IMF and Iceland
12 April 2016
Stability in Iceland
7 April 2016
Everybody right, everybody wrong: Plural rationalities in macroprudential regulation
18 March 2016
Of tail risk
12 March 2016
Models and regulations and the political leadership
26 February 2016
Why do we rely so much on models when we know they can't be trusted?
25 February 2016
Does a true model exist and does it matter?
25 February 2016
The point of central banks
25 January 2016
Volatility, financial crises and Minsky's hypothesis
2 October 2015
Impact of the recent market turmoil on risk measures
28 August 2015
Iceland, Greece and political hectoring
13 August 2015
A proposed research and policy agenda for systemic risk
7 August 2015
Are asset managers systemically important?
5 August 2015
Objective function of macro-prudential regulations
24 July 2015
Risky business: Finding the balance between financial stability and risk
24 July 2015
Regulators could be responsible for next financial crash
21 July 2015
How Iceland is falling behind. On Sprengisandur
12 July 2015
Greece on Sprengisandur
12 July 2015
Why Iceland can now remove capital controls
11 June 2015
Market moves that are supposed to happen every half-decade keep happening
14 May 2015
Capital controls
12 May 2015
What do ES and VaR say about the tails
25 April 2015
Why risk is hard to measure
25 April 2015
Post-Crisis banking regulation: Evolution of economic thinking as it happened on Vox
2 March 2015
The Danish FX event
24 February 2015
On the Swiss FX shock
24 February 2015
Europe's proposed capital markets union
23 February 2015
What the Swiss FX shock says about risk models
18 January 2015
Model risk: Risk measures when models may be wrong
8 June 2014
The new market-risk regulations
28 November 2013
Solvency II: Three principles to respect
21 October 2013
Political challenges of the macroprudential agenda
6 September 2013
Iceland's post-Crisis economy: A myth or a miracle?
21 May 2013
The capital controls in Cyprus and the Icelandic experience
28 March 2013
Towards a more procyclical financial system
6 March 2013
Europe's pre-Eurozone debt crisis: Faroe Islands in the 1990s
11 September 2012
Countercyclical regulation in Solvency II: Merits and flaws
23 June 2012
The Greek crisis: When political desire triumphs economic reality
2 March 2012
Iceland and the IMF: Why the capital controls are entirely wrong
14 November 2011
Iceland: Was the IMF programme successful?
27 October 2011
How not to resolve a banking crisis: Learning from Iceland's mistakes
26 October 2011
Capital, politics and bank weaknesses
27 June 2011
The appropriate use of risk models: Part II
17 June 2011
The appropriate use of risk models: Part I
16 June 2011
Lessons from the Icesave rejection
27 April 2011
A prudential regulatory issue at the heart of Solvency II
31 March 2011
Valuing insurers' liabilities during crises: What EU policymakers should not do
18 March 2011
Risk and crises: How the models failed and are failing
18 February 2011
The saga of Icesave: A new CEPR Policy Insight
26 January 2010
Iceland applies for EU membership, the outcome is uncertain
21 July 2009
Bonus incensed
25 May 2009
Not so fast! There's no reason to regulate everything
25 March 2009
Modelling financial turmoil through endogenous risk
11 March 2009
Financial regulation built on sand: The myth of the riskometer
1 March 2009
Government failures in Iceland: Entranced by banking
9 February 2009
How bad could the crisis get? Lessons from Iceland
12 November 2008
Regulation and financial models: Complexity kills
29 September 2008
Blame the models
8 May 2008

What to do about the Covid financial system bailouts?

22 December 2020

Financial crises and bailouts of financial institutions are inevitable and can’t be prevented without paying too high a price. Diversity is the best way to minimise the frequency and severity of crises and ensure sustainable high economic growth.

I have been discussing what can be learned from the Covid-19 financial market turmoil, already covering the official view, the socialist take, the libertarian conclusion and the crypto-technical utopia. I disagree with all. So what do I suggest?

We bail the financial system out every decade. The reason is simple: we want the banks and other financial institutions to take risk since the economy won’t grow without risk, and we don’t like that. We want the banks to make risky loans to small and medium-sized enterprises and take on the very maturity mismatches that allow us to make demand deposits that allow the banks to make 30-year loans. Meanwhile, safety is expensive, and we don’t want banking services to be even more expensive than they are now — the spread between deposit rates and lending rates should be as low as possible.

The end result is a financial system composed of levered intermediaries with a lot of liquidity and credit risk. And we like it that way.

With all of that risk comes a chance of things going pear-shaped, as they did with gusto in 2008. And, then the government has no choice but to step in and bail the system out.

It is not easy to do something about all these crises and bailouts because of the tradeoff between crises and growth. We can certainly make the system supersafe and prevent all financial crises, but that will make financial services prohibitively expensive and curtail growth. Risk will either be driven into the shadow sector or pushed out of the official sector altogether.

We can debate where the safety-growth tradeoff is, not that there is one.

I show the tradeoff in the following figure, what I call the regulation intensity pendulum:

In the years before the crisis in 2008, we generally opted for growth, not stability. The pendulum swung back after the crisis, but now with Covid-19 is yet again moving back.

Bailouts and regulations are inevitable. The taxpayer will be called on to assist, no matter how good the system is. We just have to find the best way to manage the cost.

To do that, the best place to start is asking the question of what are we trying to accomplish.

In a good system, the accumulated economic benefit should outweigh the cost of crisis intervention. In other words, a good policy goal is to maximise:

\[\frac{\text{cumulative long run economic growth}}{\text{cumulative cost of crises}}\]

And that means thinking both about the numerator and the denominator. The political leadership usually cares about the numerator, but the financial authorities seem to focus on the denominator. The FSB holistic document certainly does. All about reducing risk and reducing the need for intervention, more regulations and nothing about what we need the financial system for — growth.

Despite what one often reads in research papers and punditry on financial stability, the political power is very firmly on the side of growth, not stability.

The purpose of financial policy is to maximise that ratio, and if that entails accepting crisis, so be it.

And that takes me to what to do about crises. There are several competing narratives, as I discussed in my earlier pieces. To start with the three most political. I don’t think the laissez-faire view of no bailouts is credible, the politicians will be forced to bail out the middle class when things go wrong. Similarly, the socialist vision of a government run financial system will hold back growth, but crises will still happen. And the crypto-technical vision of either a cryptocurrency monetary system or a central bank digital currency is both inherently authoritarian and unstable, and hence undesirable.

And that leaves the current set up, and what to do with it.

There is a need for a central bank ready with liquidity injections and a regulator preventing the worst abuses in today’s financial system with its levered intermediaries and high liquidity risk.

And straying firmly into controversy, unlike so many other commentators, I think a key purpose of central banks is to help the financial system operate at higher risk levels than it otherwise could do. That is the best way to maximise the policy objective function.

How should we do that? One vision is expressed by the financial authorities in their FSB holistic document, and as I already covered that in an earlier piece, I don’t want to rehash it here, but to summarise the authorities’ view, at least as expressed in the holistic document, is:

  1. Bring everybody under the same regulatory umbrella;

  2. Every time a crisis happens, ratchet up regulations to close the loopholes;

The reason I don’t find this the best way forward is that:

  1. Risk is progressively reduced — hampering growth;

  2. Diversity is squeezed out of the financial system — increasing systemic risk;

  3. The state is increasingly responsible for the financial system — asymptotically taking us to either a nationalised or lobotomised state-controlled private system.

So what to do?

I do have a whole book coming out on the subject, but to summarise.

1. Aim for diversity

The most important way to achieve the financial system that helps driving growth without too many costly crises is diversity.

The more similar financial institutions become, the higher systemic risk is since then the financial institutions behave in the same way, amplifying the same shocks and inflating the same bubbles.

The antidote is diversity. To paraphrase Minsky,

Diversity is stabilising.

Unfortunately, diversity is steadily being eroded. Competitive forces drive mergers, and the financial authorities use mergers to contain financial crises. Regulations have an ever-increasing fixed cost and level playing fields, favouring the largest market participants, driving mergers and concentration.

So what can the authorities do? To begin with, don’t let the number of banks drop. A system with a handful of very large banks is not only much less diverse in a system with many small banks, these huge banks have a lot of lobbying power they can use to prevent competition.

It would be much better if the authorities actively encouraged different types of financial institutions. Do everything in their power to get new entrants in the markets. Create multiple categories of financial institutions, all with different types of regulations. Encourage alternative ways of financial intermediation that are not banks.

About a third of financial intermediation in the United States is made by banks, over 80% in the United Kingdom, 92% in Germany and 96% in Spain. The rest of the world is very much like Europe in this regard. The result is much less financing for innovative and risky companies. The cost of finance is very high, and it is very hard to regulate the banks without imposing significant economic costs. The stillborn European Capital Markets Union was meant to help, but the power of the incumbent interests was just too high.

OK, I suspect almost every policy authority would agree with the principle of institutional diversity, but most, if not all, don’t back that up in action. It is so incredibly hard to get the authorisation to create a new bank, and even harder to be allowed to set up a different type of financial institution, one that does financial intermediation but differently than banks.

The reason is an unholy alliance between incumbent banks and policymakers. The banks don’t want competition, and the financial authorities don’t want the extra work.

2. Avoid regulating by riskometer

A few years ago, I came up with the concept of the riskometer, a device that when plunged into the bowels of the financial system pops out an accurate measurement of risk.

The riskometer is then a device akin to the thermometer that keeps the risk manager’s office at steady 22°C. I don’t want to go over the issues here, I did that in earlier pieces, for example, how easy it is to manipulate risk forecasts, and I did make recommendations on how riskometers should be used.

As I argued, the riskometer is a myth. There is simply no way of accurately measuring risk, and it is too easy to game the outcomes.

And, riskometers only measure the most visible risk. The risk we know about is the least dangerous type. If the stock market goes down by $200 billion today, nobody will care very much because it’s a known-unknown. Subprime losses were less than $200 billion in 2008, and it was almost like the world had come to an end — Unknown-unknown. We prepare for known-unknowns because that is the risk directly in front of us, while nobody knows about unknown-unknowns until it’s too late, so we can’t build resilience for what matters. By 2007, we become experts in managing the known-unknowns, which gave us the false sense of resilience that allowed the excesses that culminated in the crisis in 2008.

Modern financial regulations are founded on the riskometer. Measure all the risk that is possible to measure and sets rules to keep that in check. The problem is, along the way the policymakers may have fallen for the the McNamara fallacy.

3. Don’t focus on de-risking

I have seen a lot of financial research where the author makes claims like: “The financial system is dangerous, I have identified the most important risks, and this is how you measure and control them. If you follow my suggestion, we meet our objective, which is to reduce risk.” In other words, they see the objective of financial regulations as — de-risking.

No. That misses the point The objective of financial regulations is not to de-risk, it is to help us meet our economic objectives: growth, savings, the environment, and the like. Risk, or the absence thereof, should only be judged in the context of whether those two objectives are met. We may even want instead to increase risk, just like after Covid-19, where economic recovery depends on the banks being willing to increase their levels of risk.

4. Break up the silos

We should consider the entirety of government policies towards the financial system together. We don’t do that today. Policymakers live in silos. They care deeply about their corner of the world but are instructed to ignore the rest of the universe. They optimise locally, not globally, solving the problem inside their silos, not society’s overall objective.

To overcome the silo mentality, financial policy should be done globally, and the only authority who can make that happen is the government. It can mandate the necessary interagency and intersilo cooperation. The task is difficult. How do we allocate responsibility without setting boundaries, and then how to prevent these from creating silos?

And, perhaps most importantly, how do we avoid ending up with a single regulator with one rulebook that is anti-diversity in practice?

There are examples to follow, most importantly, Singapore, and there is no inherent reason why such global optimisation can’t be done elsewhere.

And, diversity makes the silos less damaging.

5. Worry about the fundamentals, not the triggers

The number of fundamental factors causing financial crises is very small. Excessive leverage. The belief that liquidity infinite. Good control of visible risk while the hidden risk is ignored. Deep understanding and control of silos and ignorance of anything else.

There is an almost infinite number of triggers that push on these fundamentals. The same trigger one day could result in a crisis, and the next whimper out into nothing. Focusing on the triggers is counterproductive, leading to resources being wasted on irrelevance while we miss out on the more dangerous ones.


There are no silver bullets when it comes to the financial system, as the Covid-19 financial turmoil illustrates so well. The very thing that brings all the benefits, all the risk and maturity mismatches and leverage is also what creates all the danger.

No matter what some think, it is not only impossible to prevent crises, trying too hard causes real damage. Crises will happen, and the only way to prevent them is not to have a financial system, but that means not having economic growth. It is much better to acknowledge that crises will happen, not try too hard to prevent them, but instead have the appropriate contingency measures. Hence, when the inevitable happens, we are prepared.

The strongest force of financial stability is diversity. When financial institutions are all different, seeing the world in their own way and reacting individually, then the aggregate behaviour is like random noise.



Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.

© All rights reserved, Jon Danielsson, 2021