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‘Creditors "sign up" to a certain degree of risk-taking by equity holders when they agree to lend to a firm. The firm presents its business plan. Firms must take some degree of risk to generate the operating profits from which interest will be paid. But once the contracts are signed and the money is lent, what is to prevent shareholders from changing their business plan and adopting a much riskier strategy that effectively loots their creditors? Well, when the lenders are private, they insist upon "debt covenants" in the lending contracts. These give creditors leverage to usurp shareholders' control rights as soon as it seems like shareholder risktaking may be putting repayment in jeopardy.’ https://drafts.interfluidity.com/2023/03/24/financial-regulation-is-just-debt-covenants/index.html

This discussion was crystal clear and transparently obvious, thanks for this @interfluidity! While banking could be a lot better than it is, it’s not as bad as it could be. The analogy between private debt covenants enforcing “lender’s rights” and regulation enforcing the public’s rights is fascinating.

For others like me not fluent in the jargon of debt (trying “explain it like I’m five” ELI5 like @SexyCyborg) a company can go to a bank and borrow money promising to use it for something reasonable. But once the bank transfers the money, the owners of the firm can of course decide to have a bonfire and burn it. To ameliorate the risk of the borrower being reckless with the bank’s loan, the bank and borrower agree on a contract (a covenant) that says the bank is allowed to demand all their money back instantly under certain conditions. This works, keeps things safe.

Now consider the case of the government. It doesn’t seem to make home loans or college loans but it effectively does: it promises lenders that if they make loans that the government wants to encourage (home ownership, college attendance, etc.), the government will guarantee those loans and repay the lender if the home buyer or college grad becomes unable to pay. The government would like to make sure the lenders do a good job extending loans to people likely to repay them. It does this via financial regulation, which is the same mechanism that non-governmental banks use when creating covenants.

Cool! Meta!

Maybe I should spell it out a bit more to make sure I understand .

The owners of a firm deciding on a bonfire is maybe overstretching the analogy because that sounds unrealistically silly but a real firm’s owners do have a sound reason to do riskier things with borrowed money to get a bigger return (the “call option” Steve refers to). So instead of a bakery using its loan to buy a bigger oven like it promised the bank, it maybe decides to buy Bitcoin and change its name to CryptoFunLand and try to cash in on some passing mania. The bank, wisely having negotiated a covenant, would be able to prevent the owners of the firm from doing this. That’s an unusual inversion of power!

Similarly, banks in turn may lend overly freely to people knowing the government has guaranteed it will repay the banks if a lot of homebuyers or college grads or whatever stop paying their loans. The government needs to do the same thing to banks that banks do to bakeries: invert control and have some mechanism of controlling what banks do with government guarantees. Governments do this with financial regulation of banks—it’s exactly the same outcomes.