Tuesday, September 2, 2014
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Why Target Big Banks?

LONDON – It seemed that a new model for global governance had been forged in the white heat of the financial crisis. But now that the ashes are cooling, different perspectives on bank regulation are emerging on either side of the Atlantic.

The emphasis in Europe has been on regulating financial markets with a view to moderating future crises. Credit mistakes are made during the boom, not during the crash, so the argument goes. Better regulation and monetary policy during the boom years, therefore, could limit the scale of any bust.

By contrast, the emphasis in the United States has been on finding market-friendly ways to contain spillovers from bank failure. Policy debates in the US are chiefly preoccupied with ensuring that banks are never “too big to fail”; that private investors rather than taxpayers hold “contingent capital,” which in a crash can be converted into equity; and that “over-the-counter” markets’ functioning be improved through greater reliance on centralized trading, clearing, and settlements.

The chief point of intersection between the European and US approaches is major banks. This convergence has less to do with regulatory thinking on bank size or function than with a common need to play to the political gallery and raise more tax revenue.

Banks’ balance sheets are systemically dangerous when bloated by leverage, and it is this that regulatory or fiscal policy should address through liquidity buffers and leverage ratios. After all, it is the contagiousness of financial crises, not banks’ size, that matters. Any list conjured up in 2006 of institutions that were “too big to fail” would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns, or even Lehman Brothers.

Banks lend to banks, so while some are more illiquid than others, they are all intrinsically illiquid institutions. Small failures can give birth to large panics, which means that in a crisis almost everyone is “too big to fail.” The reality is that we can have as large a financial boom and subsequent bust as we just experienced, resulting in the same economic misery, in a world made up only of small banks.

Many argue that bankers’ belief that their institutions are too big to fail and that their jobs are safe encourages them to underestimate the risks that they assume. But if that belief dominated bankers’ thinking, they would still worry about their savings. In other words, they would not wrap themselves up in their institutions’ equity and the leveraged products they were selling.

Yet they did. The revealed preference of banks’ and bankers’ behavior is that they did not lend more because they thought they could get away with it, but because they thought it was safe. They were fools more than knaves.

The main driver of excessive lending and leverage is a mistaken view of risk that is shared by everyone. The riskiest institutions were not the largest: firms like J. P. Morgan and HSBC proved safer than others, and neither sought nor needed state funding. Those that failed were relatively small, like IKB, Bear Sterns, and so on.

Big banks like the idea that regulation should care less about banks’ size and more about their riskiness, and so champion a “risk-sensitive” approach – not least because they have the bigger risk-management operations and databases, so risk-sensitive regulation is more onerous for their smaller competitors. But this approach suffers from a fatal fallacy: if booms are fueled by underestimation of risks, and regulation is made more sensitive to the estimation of risks, booms will be bigger and busts deeper.

A better argument for curbing bank size is the excessive influence of big banks on policy.What policymakers should therefore be looking for is regulation that makes the financial system less sensitive to error in markets’ estimation of risk, not more so. There are two ways to do this.

The first is to observe that this error is correlated with the boom-bust cycle. Booms have similar characteristics – strong growth in banks’ balance sheets and credit, and therefore a rise in leverage. These trends imply an increased probability that the market is underestimating risk, so systemic risk regulators should raise minimum capital requirements as soon as they spot them.

Counter-cyclical capital requirements fit with this idea, and a range of indicators could be used to calibrate the increase in capital requirements, coupled perhaps with some discretion. There are many reasons why the market fails to correct systemic error, including that booms are always founded on a belief by both regulators and bankers that “this time it is different.” Let’s not forget the essays in central banks’ stability reports on how credit derivatives were benefiting the financial sector.

The second way to reduce the financial system’s sensitivity to risk-estimation errors is to limit the flow of risks to institutions with a structural, rather than a statistical, capacity for holding that risk. That way, when the risk modelers get it wrong, we will be in less trouble.

Credit risk is best hedged through diversification across uncorrelated credits. Liquidity risk is best hedged through diversification across time. Market risk is best hedged through a combination of diversification across assets and enough time to decide when to sell. In the past, risks with volatility of similar statistical magnitudes were considered to be fungible, and,could flow to whomever was prepared to bear them.

But, while banks with short-term funding and many branches originating loans have a deep capacity for holding credit risks, they have a limited capacity for holding market risks, and little capacity for holding liquidity risk. Insurance companies and pension funds, on the other hand, have limited capacity for credit risk, but more for market and liquidity risks.

The lesson for regulators is simple: capacity for risk is related to the maturity of funding, not to what an institution is called.

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