Capital markets regulation 2.0?
Although catastrophe is a precondition to fundamental financial reform, one shouldn’t waste a good catastrophe, and now that we’ve had ours, let’s start on the reform. A recent guest article in the Economist by Raghuram Rajan, former chief economist for the IMF, now a finance professor a U Chicago’s Booth school, “argues for a regulatory system that is immune to boom and bust,” with several ideas that have merit:
Rajan wants immunity
As the G20 summit showed, we typically regulate in the midst of a bust.
Actually, that’s when we make brave noises about regulating … but it’s a start.
I am regulator, hear me roar!
That is when righteous politicians feel the need to do something, bankers’ frail balance-sheets and vivid memories make them eschew risk, and regulators have their backbones stiffened by public disapproval of past laxity.
But we reform under the delusion that the regulated, and the markets they operate in, are static and passive, and that the regulatory environment will not vary with the cycle.
True ever since Heraclitus observed that you cannot step into the same river twice, for you’re not the same person, and it’s not the same river.
You cannot regulate the same market twice …
Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system.
Actually, both of these beliefs contribute to their own collapse. First we get drunk on risk-taking, then we get hung over on regulation.
No more regulation, please
We need to acknowledge these differences and enact cycle-proof regulation.
If we don’t, there are many dangers. Recent reports have argued for “counter-cyclical” capital—raising bank capital requirements a lot in good times, while allowing them to fall somewhat in bad times. While sensible prima facie, these proposals may be far less effective than intended.
That is because in boom times, the market requires banks to hold very low levels of capital, in part because euphoria makes losses seem remote. So when regulated firms are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated operators, as banks did with structured investment vehicles and conduits during the current crisis.
Markets constantly prove two paradoxical truths:
· Risk migrates to those best able to bear it.
· Risk migrates away from those best able to regulate it.
The post on the other side of this blog is false …
Even if regulators are strengthened to prevent this shift in activity, banks can subvert capital requirements by taking on risk the regulators do not see or do not penalise adequately.
Thus, every regulatory cycle expands the universe of regulated entities and increases transparency, so that every entity is the Bank of Glass.
“If a problem cannot be solved, enlarge it.”
– Dwight D. Eisenhower
Shrewder than he got credit for: Eisenhower
To have a better chance of creating stability through the cycle—of being cycle-proof—new regulations should be comprehensive, contingent and cost-effective.
Those that apply comprehensively to all leveraged financial firms are likely to discourage the drift from heavily regulated to lightly regulated institutions during the boom.
In the Bank of Glass, every financial institution will be seen as a bank, every entity will be regulated – as to capital and risk disclosure, and capital adequacy.
Regulation as to capital adequacy isn’t about protecting the bank’s investors, but about systemic risk. Government shouldn’t be in the business of preventing individual banks from going bust – that way lies moral hazard – but it should be in the business of preventing individual banks from becoming so large and intertwined into the financial system that their failure risks toppling the whole edifice.
No place for Superman to change
As we’ve seen with Collateral Default Swaps – unlicensed insurance – if there’s no regulation of capital adequacy, and no disclosure of contingent liability, it’s possible to make bets that are hundreds of times larger than the entities on whose failure they are betting. So much concentrated risk can verge on a scam – or at least, risk moonshine – since it’s head I win, tails everybody goes bust.
We don’t like risk Prohibition
Regulations should also be contingent so that they have most force when the private sector is most likely to do itself harm, but impose fewer restrictions at other times.
This will make regulations more cost-effective and so less prone to arbitrage or dilution.
Okay, that all sounds fine. How you gonna do it?
[1. Equity-infusion insurance.] Instead of asking institutions to raise permanent capital, ask them to arrange for capital to be infused when they or the system is in trouble.
This appears to be simply a form of ‘recapitalization insurance.’
Because these “contingent-capital” arrangements will be entered into in good times when the chances of a downturn seem remote, they will be cheap (compared with raising new capital in the midst of a recession) and thus easier to enforce.
Certainly they’ll be cheap. But will they be easy to enforce? Don’t you have counterparty risk?
There’s a risk you’ll be so many plastic men
Who insures the insurers? With everybody up through Berkshire Hathaway on the downgrade, how can you insure you’ll have the credit you need?
I took your premiums and I spent them!
Because the infusion is seen as an unlikely possibility, firms cannot raise their risk profile, using the future capital as backing.
That seems naïve.
And since it comes at bad times, when capital is scarce, it protects the system and the taxpayer.
If it works, it’s great. Much better is to have the money already in the entity, as in Mr. Rajan’s next suggestion:
[2. Equity-convertible debt.] One version of contingent capital is for banks to issue debt which would automatically convert to equity when both of two conditions are met:
[a] The system is in crisis, either based on an assessment by regulators or based on objective indicators; and
[b] second, the bank’s capital ratio falls below a certain value.
This is a really good idea.
I have many good ideas …
Such capital could be expensive – it’s like a reverse-convertible preferred stock, one that converts from debt into equity at the company’s option, not the shareholder’s – but that’s all right, it’s something to which the market could adjust.
The first condition [a] ensures that banks that do badly because of their idiosyncratic errors, rather than because the system is in trouble, don’t avoid the disciplinary effects of debt.
The second condition [b] rewards well-capitalised banks by allowing them to avoid the dilutive effect of the forced conversion (the number of shares the debt converts to will be set at a level so as to dilute the value of old equity substantially). It will also give banks that anticipate losses an incentive to raise new equity.
The debt does not bend into equity. There is no debt, there is no equity.
If banks were required, for instance, to issue ‘equity-convertible debt’ equal to a stipulated percentage of their core capital, they would have the benefit of leverage but we would have the cushion of equity convertibility.
A collateral benefit is that, anticipating forced conversion, banks will raise new capital expeditiously when they make losses, thus protecting taxpayers.
Yes, the existence of equity-convertible debt would be a substantial complicating factor. These dynamics are similar to those experienced by TARP recipients, and by Citi, which has received several large capital injections from the
But complications are okay. We want the common shareholders to be preoccupied with their bank’s capital ratios. We want the market to do the stress-testing for us.
Of course, learning from the recent experience of foreign investors who put in money just before American banks declared more losses, new equity investors will need to be convinced that banks have disclosed fully all potential losses they know about.
Yet more reason to build the Bank of Glass.
Glass bank, ready for capital … any takers?
[3. Collateralized recapitalization insurance.] Another version of contingent capital is the requirement that systemically important, and leveraged, financial firms buy fully collateralised insurance policies (from unleveraged firms, foreigners, or the government) that will capitalise these institutions when the system is in trouble. [Described in a paper by Anil Kashyap, Raghuram Rajan and Jeremy Stein.]
As with Mr. Rajan’s equity infusion insurance (mentioned above), this one has counterparty risk galore. Foreigners are intrinsically non-collectible. Firms unleveraged at issuance can lever ten seconds later, and no amount of leverage-prohibitions can outwit companies’ capacity to create new Enron-like off-balance-sheet entities. And having the insurance derive from the government is no comfort at all for systemic risk – indeed, it shifts al the systemic risk directly onto the government, which is part of why we got into this trouble in the first place.
Yet other versions would require banks to issue capital to top up losses based on public signal (idea by Oliver Hart and Luigi Zingales).
Foreign Policy’s image introducing the article describing the top-up concept
[4. Self-designed suicide pills.] There could also be regulations aimed at institutions regarded as “too big to fail”. Imposing limits on their size and activities will become very onerous when they are growing fast, thus increasing the incentive to water down any curbs. Perhaps, instead, a more cyclically sustainable approach would be to make them easier to close. What if firms big enough to pose a threat to the stability of the financial system were required to develop a plan that would enable them to be resolved over a weekend?
As readers can gather from the name I’ve bestowed on this one, I have my doubts that any rational entity would put its heart and soul into designing its own cyanide pill.
Now, you can take the Chapter 11 pill, or you can … believe whatever you want to believe
Such a “shelf-bankruptcy” plan would require banks to track, and document, their exposures much more carefully, probably through better use of technology.
As we’ve seen, technology is a tool – it’s a shovel for moving large mounds of data. Tracking and documenting are possible; interpretation is harder.
The mechanism would need to be stress-tested by regulators periodically and supported by legislation—such as one to facilitate an orderly transfer of the institution’s swap books to third parties. Not only would the need to develop a plan give these institutions the incentive to reduce needless complexity and improve management –
Actually, I think it would give them the incentive to invent a plan that looks good on paper and is utterly unenforceable in practice. Imagine what the evil AIG guys (not the good AIG guys) could have come up with!
– it would not be particularly onerous in the boom, and might force management to think the unthinkable.
In the boom, it would be ignored, just as all risk-management protocols are ignored and stomped upon in boom times. If you want something like this, it has to be imposed from without, and the imposers will be less clever than the imposees.
Still, we have to start somewhere:
A crisis offers us a rare opportunity to implement reforms. The temptation will be to over-regulate, as we have done in the past, only to liberalise excessively over time. It would be better to think of regulation that is immune to the cycle.
Which form of regulation will you swallow?
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