Sunday, November 23, 2014

Banking Reform’s Fear Factor

WASHINGTON, DC – Nearly five years after the worst financial crisis since the 1930’s, and three years after the enactment of the Dodd-Frank financial reforms in the United States, one question is on everyone’s mind: Why have we made so little progress?

New rules have been promised, but very few have actually been implemented. There is not yet a “Volcker Rule” (limiting proprietary trading by banks), the rules for derivatives are still a work-in-progress, and money-market funds remain unreformed. Even worse, our biggest banks have become even larger. There is no sign that they have abandoned the incentive structure that encourages excessive risk-taking. And the great distortions from being “too big to fail” loom large over many economies.

There are three possible explanations for what has gone wrong. One is that financial reform is inherently complicated. But, though many technical details need to be fleshed out, some of the world’s smartest people work in the relevant regulatory agencies. They are more than capable of writing and enforcing rules – that is, when this is what they are really asked to do.

The second explanation focuses on conflict among agencies with overlapping jurisdictions, both within and across countries. Again, there is an element of truth to this; but we have also seen a great deal of coordination even on the most complex topics – such as how much equity big banks should have, or how the potential failure of such a firm should be handled.

That leaves the final explanation: those in charge of financial reform really did not want to make rapid progress. In both the US and Europe, government leaders are gripped by one overriding fear: that their economies will slip back into recession – or worse. The big banks play on this fear, arguing that financial reform will cause them to become unprofitable and make them unable to lend, or that there will be some other dire unintended consequence. There has been a veritable avalanche of lobbying on this point, which has resulted in top officials moving slowly, for fear of damaging the economy.

But this is a grave mistake – based on a failure to understand how big banks can damage the economy. Higher equity-capital requirements, for example, require banks to fund themselves with relatively more equity and relatively less debt. This makes them safer, because they are more able to absorb losses, and less likely to become zombie banks (which do not make sensible loans).

The banks claim that higher capital requirements and other regulations will drive up the cost of credit. But there is no sign of any such effect – a point made, rather belatedly, in the Federal Reserve’s monetary policy report to the US Congress last week. On the contrary, the biggest US banks are reporting very healthy profits for the last quarter.

Unfortunately, a big part of these banks’ profits stems from trading securities – exactly the sort of high-risk activity that got them into trouble in the run-up to the 2008 global financial crisis. These are highly leveraged businesses, typically funding their balance sheets with no more than 5% equity (and thus 95% debt).

To understand why this is a problem, consider what happens when you buy a house with just 5% down (or less than 3% down, which is a better analogy for some European banks). If house prices go up, you make a good return on your equity (and a better return than if you had put 20% down). But if house prices go down, your equity may well be wiped out (which is what it means to be underwater on your mortgage).

Higher equity-capital requirements for banks are good for the broader economy – they make financial crises (and the zombie-syndrome) less likely, less severe, or both. US banks are currently funded with more equity than was the case before the financial crisis, and they are doing fine.

Nonetheless, we should still worry about their ability to blow themselves up in a novel and creative fashion – hence the need for the Volcker Rule, derivatives reform, and new rules for money-market funds. And equity-capital requirements for large, systemically important financial institutions remain too low.

The latest indications are that US policymakers are finally starting to focus on this point. Many European banks, however, have less equity than their US counterparts, which creates an important source of vulnerability going forward. If there is to be a broad-based European recovery, the banks must raise more equity, thereby strengthening their ability to absorb potential losses. Unfortunately, there is little sign that European policymakers understand this point.

Instead, senior officials in Europe think and talk like US policymakers did three years ago. They are wary of rocking the financial boat, so they go easy on financial reform and refuse to insist on more equity capital for banks. This is a mistake that they – and possibly all of us – may come to regret.

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    1. CommentedAhmed Souktani

      Logically, the higher capital requirements WILL drive up the cost of capital, correct me if i am wrong but I see no counter argument in the monetary policy report cited.

    2. CommentedProcyon Mukherjee

      Systemic folly actually pervades the Banking system the world over. Are we saying that the problem of calibrating a tail risk and designing a capital buffer adequate enough by the regulator is a good enough riposte by the regulatory body and that through this instrument banks need not then have to be bailed out by the tax-payer? So it is finally the naïve regulator who is to be blamed for the delay?

      The crucial question is: What transpires between investors and bankers in a regime where risk-pricing is left to the interpretation of tail distributions, where mis-pricing is bound to happen due to inherent externalities that have been vitiated by the whole banking-financial system?

      Haldane in his seminal analysis gives us some answers in his paper ‘Risk Reallocation’, “As important as these potential pricing errors were the incentives they generated for originators and end-investors. Given the
      apparent levels of excess return, it is easy to see why less sophisticated investors would
      have had a voracious appetite for tail risk instruments during the boom years. Meanwhile, on the supply side, the originators of these products (the banks) will have had equally strong incentives to manufacture them for onward sale. Yet lurking beneath those market developments was a market failure. Mispricing resulted in incentives to redistribute risk to those least able to price, manage and, hence, potentially bear it. In other words, non-bank investors were attracted by the high returns and seemingly low risk, particularly of the
      super-senior tranches, but did not have the capability to measure and model the true risk of these products, nor in some cases the balance sheets to weather the subsequent mark-to-market volatility.”

      Banking reform is still at the tip of the iceberg and the larger polity must find a broad solution to these problems where bankers, the shadow banking system and the investors (speculators included) are intertwined in risk-linkages that do not bode well as the system lacks the ability to model the pricing of risks.

    3. CommentedFrank O'Callaghan

      What has happened during this "crisis"? Those with the greatest power have become wealthier than could have been imagined. A great mass of people have lost their wealth, futures and security. The gap between the few and the many has widened.

      Why so little progress? Because the wealthy greedy want this.

    4. CommentedLiz Banker

      "Why have we made so little progress?" Because psychoanalysis isn't applied to quant(er)s. Liberal thinking on economic matters rarely wins over the conservative thought process. It has been suggested the best way to “win over” an opposing view is to “argue” in the mode of the opposing person(s) you’re trying to convince into thinking otherwise. This theory, however, would not be applicable to policymakers in Congress since the bipartisan clap-trap from those talking heads, only reflects the legislative objectives to be more similar, than they are to be different.