In the wake of the government’s decision to bail out Silicon Valley Bank earlier this year, questions emerged about what institutions should (and shouldn’t) be given help when things go awry. What factors should be considered when designing policy and regulation around these issues?
Speakers discussed these questions in September at the MIT Golub Center for Finance and Policy’s 10th annual conference, one of several events commemorating the 50th anniversary of the Black-Scholes-Merton derivatives pricing model.
Presenters included an MIT Sloan professor of finance, who in 1997 received the Nobel Memorial Prize in Economic Sciences for his work in applying Black-Scholes to financial matters such as mortgages and student loans.
In a fireside chat, Golub Center director asked Merton three timely questions regarding government financial policy.
“Who should (and shouldn’t) get a bailout?”
It’s a timely question, but not an easy one: Which types of corporate liabilities deserve financial support from the government?
“Every case is different” — even for companies in the same industry — and should be examined on its own merits, Merton said. But across the board, it’s important to accurately assess the costs and benefits of each situation.
“Every case needs to be analyzed seriously on the basis of that case,” Merton said. “It all has to be done, in my view, by systematic analysis design in the 21st century and not dealing with 20th century institutional designs to do it.”
“What are your thoughts on the government’s action toward Silicon Valley Bank?”
Earlier this year, the bank collapsed amid exposure to rising interest rates and required a federal rescue plan. Merton took issue with the company’s decision to bear any interest rate risk at all.
“Why should [SVB] be taking interest rate risk?” he said. “I see no reason for them to take interest rate risk. That’s not part of banking. I know no evidence [showing] that banks are superior forecasters of interest rates.”
Merton said that the job of a bank is “intermediating [and] providing what depositors want and what borrowers want.”
In terms of policy changes, Merton suggested that banks set up a separate subsidiary if they plan to take interest rate risk. But otherwise, interest rate risk “really isn’t part of banking.”
“What are we missing when it comes to policy and regulation?”
Merton said that it’s important to consider the ways in which policy can have ripple effects.
For example, if the Federal Reserve lowers interest rates with the goal of stimulating the economy, that would affect baby boomers who thought they had saved enough for retirement.
If interest rates track the price of annuities and “take down” the pension system, baby boomers are unlikely to increase their consumption, Merton said, which isn’t good for insurance companies who are writing annuities.
Merton has done extensive work in this space to come up with new ways to protect retirement when annuities aren’t sufficient. One of his ideas aims to improve retirement security by creating and issuing a new bond called SeLFIES (Standard-of-Living indexed, Forward-starting, Income-only Securities).
“A time has come where we need to actually put risk and uncertainty in the structure when we think about how we use it,” Merton said. “There has to be communication to understand the consequences of a proposed policy on the other silos.”