We need to change the way we do financial regulation
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.