Nov 26th 2009
From The Economist print edition
Two new papers explore how to regulate the financial system as a whole
BANKS mimic other banks. They expose themselves to similar risks by making the same sorts of loans. Each bank’s appetite for lending rises and falls in sync. What is safe for one institution becomes dangerous if they all do the same, which is often how financial trouble starts. The scope for nasty spillovers is increased by direct linkages. Banks lend to each other as well as to customers, so one firm’s failure can quickly cause others to fall over, too.
Because of these connections, rules to ensure the soundness of each bank are not enough to keep the banking system safe. Hence the calls for “macroprudential” regulation to prevent failures of the financial system as a whole. Although there is wide agreement that macroprudential policy is needed to limit systemic risk, there has been very little detail about how it might work. Two new reports help fill this gap. One is a discussion paper from the Bank of England, which sketches out the elements of a macroprudential regime and identifies what needs to be decided before it is put into practice*. The other paper, by the Warwick Commission, a group of academics and experts on finance from around the world, advocates specific reforms**.
The first step is to decide an objective for macroprudential policy. A broad aim is to keep the financial system working well at all times. The bank’s report suggests a more precise goal: to limit the chance of bank failure to its “social optimum”. Tempering the boom-bust credit cycle and taking some air out of asset-price bubbles may be necessary to meet these aims, but both reports agree that should not be the main purpose of regulation. Making finance safer is ambitious enough.
Policymakers then have to decide on how they might achieve their goal. The financial system is too willing to provide credit in good times and too shy to do so in bad times. In upswings banks are keen to extend loans because write-offs seem unlikely. The willingness of other banks to do the same only reinforces the trend. Borrowers seem less likely to default because with lots of credit around, the value of their assets is rising. As the boom gathers pace, even banks that are wary of making fresh loans carry on for fear of ceding ground to rivals. When recession hits, each bank becomes fearful of making loans partly because other banks are also reluctant. Scarce credit hurts asset prices and leaves borrowers prey to the cash-flow troubles of customers and suppliers.
Since the cycle is such an influence on banks, macroprudential regulation should make it harder for all banks to lend so freely in booms and easier for them to lend in recessions. It can do this by tailoring capital requirements to the credit cycle. Whenever overall credit growth looks too frothy, the macroprudential body could increase the minimum capital buffer that supervisors make each bank hold. Equity capital is relatively dear for banks, which benefit from an implicit state guarantee on their debt finance as well as the tax breaks on interest payments enjoyed by all firms. Forcing banks to hold more capital when exuberance reigns would make it costlier for them to supply credit. It would also provide society with an extra cushion against bank failures.
Each report adds its own twist to this prescription. The Bank of England thinks extra capital may be needed for certain sorts of credit. If capital penalties are not targeted, it argues, banks may simply cut back on routine loans to free up capital for more exotic lending. The Warwick report says each bank’s capital should also vary with how long-lived its assets are relative to its funding. Firms with big maturity mismatches are more likely to cause systemic problems and should be penalised. The ease of raising cash against assets and of rolling over debt varies over the cycle, and capital rules need to reflect this. Regulators should also find ways to match different risks with the firms which can best bear them. Banks are the natural bearers of credit risk since they know about evaluating borrowers. Pension funds are less prone to sudden withdrawals of cash and are the best homes for illiquid assets.
The Warwick group is keen that macroprudential policy should be guided by rules. If credit, asset prices and GDP were all growing above their long-run average rates, say, the regulator would be forced to step in or explain why it is not doing so. Finance is a powerful lobby. Without such a trigger for intervention, regulators may be swayed by arguments that the next credit boom is somehow different and poses few dangers. The bank frets about regulatory capture, too, but doubts that any rule would be right for all circumstances. It favours other approaches, such as frequent public scrutiny, to keep regulators honest.
When banks attack
No regulatory system is likely to be fail-safe. That is why Bank of England officials stress that efforts to make bank failures less costly for society must be part of regulatory reform. That includes making banks’ capital structures more flexible, so that some kinds of debt turn into loss-bearing equity in a crisis. Both reports favour making systemically important banks hold extra capital, as they pose bigger risks when they fail.
The Warwick group also thinks cross-border banks should abide by the rules of their host countries, so that macroprudential regulation fits local credit conditions. That would require that foreign subsidiaries be independently capitalised, which may also be necessary for a cross-border bank to have a credible “living will”, a guide to its orderly resolution. This advice will chafe most in the European Union, where standard rules are the basis of the single market. But varying rules on capital could also be used as a macroeconomic tool in the euro area, where monetary policy cannot be tailored to each country’s needs. Regulation to address negative spillovers that hurt financial stability might then have a positive spillover for economic stability.
* “The role of macroprudential policy”, Bank of England, November 2009
** The Warwick Commission on International Financial Reform, November 2009
Boomtime politicians will not rein in the bankers
By Avinash Persaud
Published, Financial Times: November 26 2009 21:09
One of the features that singles out the Warwick Commission on International Financial Reform, which publishes its final report on Friday, is that while other expert groups tiptoe around it, we have been able to point to the true source of the worst financial crisis since the 1930s: regulatory capture and boomtime politics.
Today regulators are working conscientiously to address the issue of banks being too big to fail; the lack of responsibility that can follow securitisation; imperfections in credit ratings; capital requirements which accentuate boom and bust; regulators which were global champions for their local banks; and more. But we should not forget that just a few years ago, regulators, with few exceptions, wanted big banks to have lower capital requirements if they had sophisticated risk models; they were cheerleaders for securitisation and asset sales by banks because, they said, this spread risks; they hard-wired credit ratings into bank risk assessment; they promoted home country regulation over host country control; and they dismissed the idea that regulation was dangerously pro-cyclical.
These and other regulatory mistakes all pushed financial institutions in the same direction. Large international banks compete better on “process” and “models” than credit assessment, and reap economies of scale when rules that segment finance within and between countries are liberalised. As I wrote here in 2002, financial regulation had all the hallmarks of being captured by banks, to the detriment of financial stability.
Separate but related to regulatory capture is the politics of booms. A boom persists because no one wants to stop it. The government of the day wants it to last until the next election. The early phase of a boom brings extra growth, low inflation and falling defaults. Governments tout this as a sign of their superior performance. Bankers argue such alchemy justifies their golden handshakes and excuses their golden handcuffs. Booms spread cheer by providing finance to the previously unbanked. Donations to worthy causes and universities temper traditional channels of criticism. How easily can the underpaid regulator stick his hand up and say it is all an unsustainable boom?
The capture and influence is subtle and there is always a genuine reason, if a wrong one, for why it is different this time. Indeed, one of the key challenges not yet seriously addressed is why the universities and press, falling over themselves to kick bankers today, did not play a more effective counterveiling force to this capture.
One indirect consequence of capture is the mistaken treatment of risk that lies at the heart of regulation. Many politicians and watchdogs think of risk as a single fixed thing inherent in instruments. As a result they put faith in processes that link capital to measures of risk, or in committees charged with determining what is safe and what is risky and banning the risky. But risk is a chameleon: it changes depending on who is holding it. Declaring something safe can make it risky and vice versa. Investment scams are attracted to booms, but booms are in fact built on the belief that some new thing has increased the return or reduced the risk of the world: motor cars, railroads, electricity, the internet or financial innovation. There is often a large element of truth about the original proposition – the world will be different – but the over-investment creates new risks.
In a world in which risk is poorly measured and regulators are vulner-able to political influence, we cannot rely as a defence against a crisis on the regulation of financial instruments, statistical measures of risk, systemic risk committees or the foreign “home country” regulator.
It is not financial instruments but behaviour we need to change. A better defence will come from increasing capital buffers at financial institutions, making these buffers counter-cyclical, and focusing on structural – not statistical – measures of risk capacity. Liquidity risk is best held by institutions that do not require liquidity, such as pension funds, life insurers or private equity. Credit risk is best held by institutions that have plenty of credit risks to diversify, such as banks and hedge funds. No amount of extra capital will save a system that, because measured risks in a boom are low, sends risk where there is no capacity for it.
The writer is chair of the Warwick Commission, chairman of Intelligence Capital and an emeritus professor of Gresham College