There were some other very interesting presentations at the conference hosted by the Federal Reserve Bank of Boston last week. Fed Chair Ben Bernanke spoke on Financial Regulation and Supervision after the Crisis while Princeton Professor Alan Blinder’s message was It’s Broke, Let’s Fix It: Rethinking Financial Regulation. Here I summarize four key reforms these speakers addressed.
(1) Capital adequacy. The key principle for preventing the “bank run” dynamics of the recent financial turmoil is to make sure that financial institutions have a sufficient cushion of equity capital to be able to absorb liquidation and delinquency losses on assets without sacrificing the institution’s ability to repay short-term creditors. Equity capital is also a critical tool for addressing the core incentive problems arising from gambling with other people’s money. As Chair Bernanke observed:
Through the course of the crisis, it became increasingly clear that many firms lacked adequate capital and liquidity to protect themselves as well as the financial system as a whole.
the real leverage problems arose with (a) investment banks that operated (under a different regulatory regime [from commercial banks]) with 30 times leverage and more, and (b) gimmicks such as thinly-capitalized SIVs and conduits that (legally) avoided capital requirements…
Both Bernanke and Blinder further called attention to the problems with procyclical capital requirements. Standard capital requirements become looser when times are good, but that is exactly when it’s most feasible and desirable for them to strengthen the equity cushion. Blinder advocated reverse convertible debentures proposed by Mark Flannery and the Squam Lake Working Group on Financial Regulation as a way to implement countercyclical capital requirements.
Though a conceptually different issue from equity capital, Blinder also favored requiring both mortgage originators and mortgage securitizers to retain 5% of any assets they create.
(2) Compensation. Blinder observed: “Pay plans that are structured in such a ‘heads I win, tails I don’t lose’ way create powerful incentives for traders to go for broke gambling with OPM (‘other people’s money’).” In his spoken remarks he added, “They did go for broke, and a lot of them achieved that objective.”
Here were Bernanke’s observations on the subject:
flawed compensation practices at financial institutions also contributed to the crisis. Compensation, not only at the top but throughout a banking organization, should appropriately link pay to performance and provide sound incentives. In particular, compensation plans that encourage, even inadvertently, excessive risk-taking can pose a threat to safety and soundness. The Federal Reserve has just issued proposed guidance that would require banking organizations to review their compensation practices to ensure they do not encourage excessive risk-taking, are subject to effective controls and risk management, and are supported by strong corporate governance including board-level oversight.
(3) Derivatives. Though Bernanke did not say much about the explosion of financial instruments such as credit default swaps and their role in propagating the crisis, Blinder highlighted the desirability of changes:
While the regulation of derivatives is fraught with peril, it is not hard to improve upon what we have now– which is practically nothing. I have argued for years that the most important step the government could take would be to push as much derivatives trading as possible into organized exchanges….The Treasury White Paper (p. 48) proposes to subject OTC derivatives to a “robust regime” of regulation that includes “conservative capital requirements,” margins, reporting requirements, and “business conduct standards.”
(4) Resolution mechanism. Finally, both Bernanke and Blinder stressed the need for a mechanism to supervise the liquidation of failing systemically important financial institutions. Blinder advocated:
we could develop a new resolution mechanism, perhaps patterned on what the FDIC now does with small banks (often before the bank’s net worth goes negative), that would enable the authorities to wind down a systemically-important financial institution (including a non-bank) in an orderly fashion– rather than just throwing it to the Chapter 11 wolves. This last idea is among the key ingredients of the Treasury’s reform plan, has substantial support in Congress, and may well become law. If so, it would have several desirable effects.
- The TBTF doctrine would morph into “too big to be put into Chapter 11,” but not “too big to be seized and its management thrown out.” That change alone would go a long way toward reducing moral hazard.
- Taxpayers would (mostly) be relieved of the burdens of costly bailouts….
- Regulators would no longer have to keep large “zombie banks” (and non-banks) on life support for fear of the systemic consequences of shutting them down.
Bernanke endorsed this reform as well:
the Congress should create a new set of authorities to facilitate the orderly resolution of failing, systemically important financial firms…. In light of the experience of the past year, it is clear that we need an option other than bankruptcy or bailout for such firms.
A new resolution regime for nonbanks, analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks, would permit the government to wind down a failing systemically important firm in a way that reduces the risks to financial stability and the economy. Importantly, to restore a meaningful degree of market discipline and to address the too-big-to-fail problem, it is essential that there be a credible process for imposing losses on the shareholders and creditors of the firm. Any resolution costs incurred by the government should be paid through an assessment on the financial industry and not borne by the taxpayers.
One detail I’d stress is the need for integration of the approaches to items (3) and (4) above. One of the problems that makes bankruptcy messy for these institutions is that outstanding derivatives contracts can assume a life of their own, sucking assets out of the firm as the market moves against the firm’s bets and in practice giving these contracts seniority over conventional debt. From the perspective of society’s best interests I don’t think such seniority can be justified. I agree with the assertion in Blinder’s spoken remarks that the economic costs of the latest recession exceed the cumulative potential efficiency benefits of what he referred to as “fancy finance.”
I would propose that instruments such as the credit default swaps entered into by any systemically important financial institution should be subject to a regulatory stop-loss provision. In a standard clearinghouse mechanism, each party delivers collateral against the possibility of the market moving against their original bet. If the market moves too much, the loser either must add collateral or their position is wiped out. If the institution continues to deliver new margin capital, it can become like the compulsive gambler doubling down as the firm’s equity cushion essential for financial stability bleeds away. Like the referee protecting a staggering boxer, the regulator needs the authority to declare “no mas” on an institution’s commitment of new capital to such positions.
Bernanke concluded with the following:
we cannot lose sight of the need to reorient our supervisory approach and to strengthen our regulatory and legal framework to help prevent a recurrence of the events of the past two years.
To which I would only add, Amen!
I think that the net benefit of additional regulation is negative. Actually it has been negative for a long time, after (1) large investors believed that ex post they could transfer losses to taxpayers, and (2) small investors believed that government would prevent intermediaries to take excessive risks. Large investors assumed that politicians and government officials were corrupt–and they were right. Small investors assumed that government officials were inept–and they were right. If you want to reform financial regulation (and the same is true for health “insurance” reform), please tell me first how you are going to check government corruption and inefficiency.
Is this the same Boston Fed that Stan Liebowitz suggests was the cause of the sub-prime crisis?
I also don’t buy the argument that large international corporations need TBTF holding companies.
It’s amazing that Merrill, Shearson, Bear Stearns, Lehman and Goldman Sachs–not to mention BofA, JP Morgan and Citi–seemed to have serviced these large orgs prior to the 1999 dissolution of Glass-Steagall.
The idea that these orgs in their previous forms couldn’t compete today is pure BS.
Additional concerns may be worth to add:
Banks have outsized their countries GDP through external growth, their rescues hampered the public finance and their countries further borrowing capacity. That means no more leeway available should further deterioration of the world economy occur. This hurdle is not addressed.
The same cause (oversized banks) will drive the same effect, they are difficult to manage, no CEO no board members can thouroughly grasp the risk magnitude on assets,on contingent liabilities (derivatives)
The Value at Risk is a difficult proposition when the sample is restricted to 5 banks in the USA (sharing 85 % of the derivatives markets), and Gaussian probalities applied on a sample that is not representative of the risk spread. The subprime derivatives implosion is confirming the ill fated probalities when associated to four major players in the field (downfall of 25 STD)
PS May be worth looking at P18 Fig 14 before calling the big Lebowsky
http://www.bos.frb.org/economic/smr/smr2007/smr0807.pdf
I still think the mea culpa,mea culpa,mea maxi culpa needs to be addressed and thouroughly before Amen.
The Fed’s call for more regulation is a bit like the pot calling the kettle black. Bloomberg News has reported that the NY Fed, under Geithner, refused to negotiate AIG’s payouts for CDSs, despite widespread industry practice to do so, and they refused to make the term sheets public despite it being public money. US taxpayers got stung for over $13 billion that unnecessarily went to large banks to bail them out of capital shortages. Since this was a back-door rescue, not authorized by either Congress or the Treasury, it is a violation of the Constitutional principle that disbursement of taxpayer funds starts in the House of Representatives. More details are on Bloomberg’s site at http://www.bloomberg.com/apps/news?pid=20601109&sid=a7T5HaOgYHpE
The Fed’s call for regulation is hypocritical. Since the Fed has not acted legally, they do not deserve to be independent. The Fed needs closer supervision by a Congressional appointed group, and the Fed needs to make all their transactions open to public inspection. We can debate the schedule for openness, but after a few months (less than 3), all Fed transactions should be public. It is after all the public’s money, and the Fed has shown that they are not good financial stewards of the public’s money.
Regarding CDS and stop-loss: these sorts of regs would have to be very carefully constructed to avoid impairing the use of CDS to hedge/shift risk! By creating an asymetry between a CDS (or other derivative) and the underlying, it may well make it impossible (or very, very expensive) to use the CDS to hedge/transfer risk in a position in the underlying, while at the same time making ‘naked’ CDS positions more attractive. With thin secondary markets (e.g.: MBS/ABS securities), the use of CDS to enter/exit long/short positions is essential, and would likely be greatly impaired by a ‘stop-loss’ reg provision: this would require a great deal of careful analysis to get these regs right!
Note that the poster child for most egregious use of CDS was AIG, which took on ‘naked’ positions, but the counterparties to AIG were using the CDS to hedge a position in the underlying….
that’s not all that needs to be improved http://www.interfluidity.com/posts/1256656346.shtml – “The great moderation made aggregate GDP and employment numbers look good, and central bankers sincerely believed they were doing a good job. They were wrong. We need to build a system where changes in asset prices reflect the quality of real economic decisions, and where the playing field isn’t tilted against the poor and disorganized in the name of promoting price stability.”
“Third, we could recognize the inevitability of having some TBTF institutions…”
“The TBTF doctrine would morph into too big to be put into Chapter 11,”
“I have long advocated the middle approach: providing strong regulatory incentives to move trading onto organized exchanges.”
“Once again purity should not be our goal. There are cases in which customized (bespoke) derivatives really are appropriate, and those arrangements will never be sufficiently standardized to be traded on exchanges.”
“But the biggest gains, especially from a systemic-risk standpoint, come from moving from the status quo to clearinghouses.”
So the Volker-Mervyn approach of breaking up TBTF institutions and banning leveraged speculation by banks was not even taken seriously. The FED and the coterie of inbred economists that influence its policies are completely captured.
There will be a reckoning!
Sure. Close the barn door now that all the horses are gone. Good idea. Let’s make it a first priority. Better to get a rigorous system in place to make ‘TBTF’ an obsolete acronym by making sure there will be swift and sure destruction of equity and debt values in the event of a failure of any sized institution.
The problem going forward is really simple. Debt is too high relative to income. Either saving will have to accrue for some time to get debt loads down (or to let income grow), or a lot of debt has to be destroyed (with the attendant fall in (perceived) asset values). Preventing debt destruction is counterproductive in the longer run. Short-term solutions that prevent the collapse of debt and of asset values will prolong the period of adjustment. The current tactic of deny and delay that is the main support of equity values for most financial institutions will help ensure that we will have a very slow, drawn-out recovery.
I believe Charles Calomiris already had this insight a week or two in a WSJ editorial, but I think it is important to stress the international nature of the web of counterparties both in preventing and unwinding failures or “too big to fail” institutions.
This means that not only do we want instruments trading on exchanges, but we want to make particularly sure than they can do so seamlessly across borders given that sources of liquidity and investment targets are often in different countries.
Robert Bartley in THE SEVEN FAT YEARS calls attention to Nobel Laurette economist Merton Miller’s comments on regulations creating more problems than they ever solve. Bartley then goes on to attribute the regulation fever that gripped the country after the Savings and Loan Crisis as being the single most powerful event to end the prosperity of “seven fat years” and bring on the recession during the GHW Bush administration. He makes the point that regulations in the hands of politicians, or would be politicians, such as Rudy Guiliani, allow them to abuse their offices in an attempt to gain political notoriety. It allows indictments without convictions that ruin reputations and destroy thriving companies. Finally it destroys the entrepreneural spirit and punishes risk-taking to the extent that business innovation declines.
As I read Bartley, over and over I saw those same political and economic mistakes being repeated today. The headlines today also scream about the chilling effect our government regulations are having on new business.
October 17, 2009
U.S. Venture Capital Recovery Stalls as 3Q Investment Slumps; Trends Point to a Prolonged Correction, Shakeout
Excerpt:
This quarter’s total is down 38% from the $8.2 billion invested in 663 deals during the third quarter of 2008.
What happens when the governmental actions that stalled a thriving economy hit a declining economy? Those like Bernanke and Blinder (who is at times pretty good) who encourage over-regulation, lowering of executive compensation moving the best and brightest to new venture (abroad?), and the criminalization of risk-taking are sowing today what we will reaping for years to come. Think about it as we enter the era of stagnation.
Debt is too high relative to income.
i think you have to be a little careful on balance sheet to income statement (stock/flow) comparisons. debt may be too high relative to equity and debt _service_ may also be too high relative to income, but as paul mcculley asserts,* is that really true when the fed is expanding its balance sheet, rates are zero and the treasury can borrow under 4% for 10-years?
now, whether and how long the fed can run an ultra-loose monetary policy is a different question, but i think it gets at a crisis in central banking itself and global monetary structure, BWII/IMF/BIS or otherwise…
high interest/debt to income/equity is only a symptom of the disease that SRW describes in that interfluidity post mentioned above. to amend delong,** central banking is false in theory, so is it worth preserving “the running code for limited, strategic interventions that will make [central banking] roughly true in practice?”
i think not, but if we are to scrap the whole enterprise, what institutions (that are ostensibly true in theory) would we put in their place? + i’m not sure, paul romer excluded, what a (true) theory of (macro)economics is or would be, much less (more) technologically equipped human being.
anyway, i feel like i can confidently predict that it won’t be until central banking is wholly discredited that *something else* takes its place 😛 after all it has had an amazing 315 year run!
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*Global Central Bank Focus By Paul McCulley, November 2009
**Brad DeLong speaks at a Cato event