Home > Economics, Policy > We need to change the way we do financial regulation

We need to change the way we do financial regulation

November 9, 2011 Leave a comment Go to comments

In between pondering the potentially disastrous consequences of Italy entering the ‘Danger Zone‘ on their debt yields, I have been thinking more about what I wrote on Monday about financial regulation. There is a kind of basic dilemma that is very difficult to avoid; we tell banks that they must have this much capital or this many liquid assets, but what are the consequences if they don’t? Well, the whole point of a rule is that it needs to be enforced. The banks must be induced to have at least x% Tier-1 capital, or a y% liquidity coverage ratio, by creating consequences if they don’t. But in order for the consequences to be an incentive against breaking the ratio, they must be bad consequences for the bank (otherwise there is no inducement). Regulatory rules such as capital ratios may increase stability during normal times, but can end up destabilising financial institutions when they are at their most fragile.

Simply put, if you have a rule then there have to repurcussions for breaking it (otherwise, why not break it?). But the times when the banks are put under pressure by the rule is exactly the time you least want them to have to take some kind of prompt corrective action. Financial markets in a world with leverage and maturity transformation have some inherently unstable features, and we need to come up with regulatory mechanisms that counteract  rather than compound those instabilities.

As I said on Monday, I do think a CoCo-type plan has promise (more on that here) because the mechanism that kicks in when the rule is broken looks to be stabilising whilst also punishing the bank’s shareholders. I shall continue to ponder.

Categories: Economics, Policy
  1. Mariolia
    January 29, 2012 at 8:36 am

    I believe that a risk sensitive deposit insurance scheme could do the job ex-ante.
    Deposit insurance should account for systemic risk. Factors that lead to systemic risk are correlation among banks’ returns, bank size, and bank interconnectedness.
    The incentive-efficient premium that discourages banks from excessive correlation in their investments features a higher charge for joint bank failure risk than the actuarially fair premium. This premium should be charged according to bank capitalization level and its interconnectedness with other banks. Such a design of deposit insurance may be a first step to prevent ‘too-many-to-fail or too-big-to-fail’ which often results in ‘too-much-to-bail’ or capital injections, resulting in fiscal costs.

    • January 29, 2012 at 9:40 am

      Mariolia,

      My issue with deposit insurance is you are going to have to enormously extend the scheme to cover things like money market funds as well as normal retail deposits (see Gorton’s argument that the crisis began as a bank run in the ‘shadow banking’ sector). Since £100,000 means pretty much nothing to these sorts of investors, the government is going to have to provide a substantial guarantee. Furthermore, if (say) money market fund were guaranteed but other wholesale bank funding channels were not, then I would expect funding to move towards the guaranteed asset class, increasing the contingent liabilities of the insurance scheme. My worry is that the government cannot plausibly assume this level of contingent liability (especially in current fiscal conditions) and therefore the insurance is not credible. I think this would be true even if the government acted like a proper insurance company with the float, as the circumstance under which they would need to draw on the fund would be when the assets are most likely to be distressed.

      However, if the government actually acted like a proper insurance company with the float, here’s an idea: create a national ‘Taleb-style’ Black Swan fund, which will provide outsized returns in unusual market conditions (such as a systemic event). However, you may have some counterparty risk issues and I’m not sure whether that investment strategy will work at the scale necessary.

  1. April 12, 2012 at 10:35 am

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