Should we use market indicators for bank capital regulation?
Kenneth Rogoff makes an interesting point on the ‘Too Big To Fail’ problem:
There is this view that if we can just break up the big banks into smaller ones, we won’t have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, I’m not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing.
Rogoff is absolutely right to say that solving TBTF is not a sufficient condition for a robust financial regulatory system. I would however contend it is a necessary condition – if we could find a way to ameliorate the incentive to herd, then ten smaller banks would be less systemically risky than one. If we can’t think of a way of doing this, then it is probably the case that the battle to rid ourselves of TBTF would be a waste of political capital.
However, I have a germ of an idea for how we might be able to make the incentive issue substantially better. There is (to my mind) an enormous flaw in the way we regulate financial institutions, which is that in order to calculate bank capital ratios, we compare bank capital to risk-weighted assets. Now, there were excellent reasons why this was introduced in Basel II and it is of course completely correct to look at the riskiness of the asset portfolio when considering the appropriate amount of capital to hold. But the problem is that if a particular asset class has its risk underestimated by whatever mechanism is used to determine regulatory risk-weighting (e.g. ratings agencies) then you essentially end up incentivising banks to load up their balance sheet with that asset class. Therefore, a regulatory system that uses risk-weighted assets is going to lend itself to the kind of herd behaviour that Rogoff is referring to.
Thankfully, there may be an alternative. As I was discussing all manners monetary and regulatory over lunch with a colleague (as one does), I recalled a fascinating speech by Andrew Haldane – Executive Director for Financial Stability at the Bank of England – that I first read a while ago. Specifically, I remembered the following charts. The first is a chart of the regulatory Tier-I capital ratios of “crisis” and “no-crisis” banks* over time. In celebration of the fact I just figured out how to put images on my blog, here it is:
What this graph shows is that a banks regulatory capital ratio was not a predictor of whether or not it would be a ‘crisis’ or ‘no-crisis’ bank. However, what was really interesting was how market indications of bank’s capital positions appear to have been somewhat predictive of problems before 2008:
This strongly suggests to me that a simple market-based ratio is superior to the highly complex regulatory calculations required by Basel III. And I think it would be a good step towards solving the herd problem, as it would encourage banks to form their own individual views about which risks are priced appropriately in the market, rather than all crowding towards a regulatory-induced mispricing.
Of course, in these situations one must always be wary of Goodhart’s Law, and it may be the case that adopting a rule of this kind would change the relationship between the variables (it may require extra vigilance on the topic of bank disclosure, given the relative increase in importance of them for regulatory purposes). This is certainly worthy of further investigation, and I would also be very keen to see the variation within the two average lines on the charts. Haldane’s proposal in the speech, to mandate bank issuance of ‘CoCo’ bonds which would convert from debt to equity upon passing a market trigger based on an indicator such as those in the above charts, is the best idea I’ve come across so far for a ‘bail-in’ rather than ‘bail-out’ strategy.
However, the bottom line is that a regulatory mechanism that relies on market indicators rather than regulatory risk-weighting should go some way towards reducing the herd effect, and would help make TBTF a problem worth solving.
*’Crisis banks’ are RBS, HBOS, LLoyds TSB, Bradford & Bingley, Alliance & Leicester, Citigroup, WaMu, Wachovia, Merrill Lynch, Freddie Mac, Fannie Mae, Goldman Sachs, ING Group, Dexia and Commerzbank. ‘No-crisis banks’ are HSBC, Barclays, Wells Fargo, JP Morgan, Santander, BNP Paribas, Deutsche Bank, Credit Agricole, Societe Generale, BBVA, Banco Popular, Banco Sabadell, Unicredit, Banca Popolare di Milano, Royal Bank of Canada, National Australia Bank, Commonwealth Bank of Australia and ANZ Banking Group.