People don’t like it when banks default on their obligations, because lots of people use those obligations as money. Think of deposits, or commercial paper sold to money-market mutual funds. The problem is that, absent offsetting regulations, government guarantees preserve the value of these forms of money at the cost of transferring wealth to bankers and — to a much lesser extent — bank shareholders, while also encouraging excessive lending.
The $50 trillion question is: how can governments protect the savings of their citizens without creating new problems?
We want to revisit this question because of two events from last week. The big US banks managed to roll back a provision of the Dodd-Frank financial reforms by entangling their policy change in a government funding bill. (Citi lobbyists literally wrote the key passage of the law.) And we got to attend a fascinating discussion on the regulatory value of stress tests.
Bank regulation basically comes in two forms:
- Supervise what banks are doing with their assets so that the expected size of the worst possible losses they will endure won’t be too big
- Force the banks to get the right mix of people funding them so that the government safety net never needs to be used
In theory, the more heavily regulators use one of those two approaches, the less they need to rely on the other. If the only asset on a bank’s balance sheet are reserves at the central bank, regulators shouldn’t need to worry too much about short-term borrowing, for example.
We tend to be sympathetic to the view that what banks put in their box of assets is their own business and that regulators should focus on who is standing where in line. However, the two events from last week mentioned above are making us reconsider. While simple rules about capital and short-term debt still have tremendous appeal, there is value in having a regulatory regime that is onerous precisely because of its complexity and its unpredictability.
The adversarial relationship between bankers and regulators is an inevitable feature of the system we have. (If you don’t like it, we recommend outlawing privately-issued money and replacing it with deposits sold directly by the government. Until then, though…) Regulators have powerful tools at their disposal, but they are limited by their lack of knowledge, their small numbers, and the yawning chasm between the rewards bankers receive for gaming the rules and the rewards that regulators get for preventing blowups.
In other words, even though the best regulatory regime, from a purely theoretical perspective, looks a lot like what John Cochrane has recommended, the political economy suggests something that, on the surface, looks a lot less efficient and a lot more arbitrary.
Let’s first look at the example of the so-called “swaps pushout”, which died last week.
From a straightforward financial stability perspective, the original rule was mostly pointless, so the impact of the change should be small. However, as John Carney noted, it helps the big banks (except Morgan Stanley) game differences in credit ratings within their subsidiaries to marginally reduce their capital requirements, and possibly the amount of collateral needed for derivative transactions. Since the higher-rated subsidiaries are protected by the government’s safety net, the immediate net effect is to increase the taxpayer subsidy for the banking industry by a (very) small amount.
More substantially, the rule change matters because of the political economy. As Matt Yglesias notes, the value of having lots of pointless but annoying rules is that they distract the bank lobbyists from the really important stuff. The swap pushout was the first in what is hopefully a long line of defence. We’re tempted to say that crafty policymakers should immediately propose several new and even more annoying rules for the banks.
Fortunately, regulators have other means of harassing their adversaries, hopefully keeping them busy enough to avoid exploiting the system too much. One of these is the “stress test”. Strictly speaking, stress tests are supposed to be formal exercises where regulators dig into bank books, create a simulation of a severe economic downturn and financial stress, and then see if banks remain sufficiently capitalised at the end of it.
In the teeth of a crisis, the most important thing a stress test can do is demonstrate that the government is willing to pump in as much equity on its own as necessary, although it would also be nice if supervisors could actually figure out the size of the hole they need to fill.
During periods of relative calm, well-run stress tests can be used to prevent banks from getting too comfortable with a given set of rules. The goal should be to inflict as many different kinds of harsh scenarios as possible. This matters because both capital requirements and liquidity requirements encourage banks to lever up government-approved exposures rather than make independent judgments about which assets offer the best risk-adjusted returns. In India, the joke used to be that bank liquidity requirements meant that a quarter of every rupee deposited in the banking system directly funded the government budget deficit.
Perhaps the most egregious case was Dexia. It’s business model was optimised to exploit the flaws in the prevailing method of capital regulation. Unfortunately, that meant loading up on Greek sovereign debt right before a lot of it got written down. That explains how, in mid-2011, the lender could pass the European Banking Authority’s badly-run stress test near the top of the class only to blow up a few months later. Its equity to asset ratio was barely 1 per cent even though its regulatory capital ratio in the “stressed” scenario was greater than 10 per cent. Guess which measure proved to be more relevant?
So how can regulators do better? The consensus from the discussion we attended was that they should use a “belt and suspenders” approach that applies several different standards at the same time, making it harder to game any particular set of rules. The US does a little bit of this by making its banks comply with the internationally-approved Basel system of risk-weights and a supplementary leverage ratio requirement that treats every asset as equally risky. Both of these measures are deeply flawed but their errors ought to cancel out.
Regulators could also incorporate the wisdom of the financial markets. A bank’s equity can be counted by subtracting whatever is owed to creditors from its box of assets. Whatever is left, by definition, must belong to shareholders. The problem is that it’s hard to know what a bank’s assets are really worth, so there may be a lot less protection available than an official report would suggest.
Equity can also be counted by multiplying the bank’s share price by the number of shares. One warning sign is if this price/book ratio is a lot less than 1. For example, Deutsche Bank has a price/book ratio of less than half, as of pixel time. So while regulators and Deutsche Bank’s own accounts imply that there is almost €70 billion worth of human shields to protect creditors from losses, the market thinks there is only about €33 billion. Presumably Deutsche Bank would have fared much worse on the recent ECB/EBA stress test if regulators had relied on the market’s estimates of its loss-absorbing capacity.
Relative share price movements also contain useful information. Viral Acharya and his colleagues at NYU’s Volatility Institute have convincingly argued that the extent to which a given bank’s share price falls on days when the broader stock market declines is a decent proxy for the riskiness of the bank’s specific business model and mix of assets. On down days, safer banks should fall less than fragile ones.
This insight provides an elegant way to check the assumptions baked into the risk weights and internal models favoured by the Basel capital regime. If Bank Z’s assets are a lot less risky than Bank A’s assets according to formal regulatory models, but Bank Z’s share price consistently drops by a lot more than Bank A’s when the broader stock market goes down, supervisors would have good reason to dig into Bank Z’s books and demand that it raise or retain additional capital as a precaution.
Careful use of share price data can also be used to calculate the amount of capital needed to protect creditors in the event of a “stressful” scenario, which makes it a helpful way to check the formal tests run by regulators. (You can play around with their results here.)
The first step is to calculate the implied market value of each bank’s equity in a world where the stock market as a whole has lost a lot of value — perhaps 40 per cent — in a relatively short time, say, six months. This effectively measures what would happen in a severe recession. Then you look at the effective leverage ratio implied by this lower equity value and compare it to the minimum leverage ratio you think is appropriate for safety and soundness. The gap, which they call SRISK, is the amount of additional equity a bank should raise or retain.
In principle, this market-based measure should produce similar sorts of results as the bottom-up regulatory assessments, at least in terms of rank order. And in the US, this is broadly true. The riskiest US bank according to this methodology is JPMorgan, which happens to be the sole American lender that Federal Reserve Vice Chairmain Stanley Fischer singled out as being short $22 billion of equity.
Intriguingly, the reverse is true in Europe. When Acharya and his colleagues ran the numbers, they found that the banks deemed safest by the ECB were the ones facing the biggest absolute capital shortfalls using their market-based measure. The capital deficits at BNP Paribas, Deutsche Bank, and Credit Agricole together accounted for a little more than half of the total for the entire euro area banking system.
You could dismiss these results as unsophisticated compared to the “line-by-line review” by the regulators, except that Acharya’s measure of which banks need the most capital closely corresponds to the ECB’s own assessment of which banks would have to endure the biggest losses in the “adverse scenario”:
SRISK is positively correlated with total losses incurred by banks in the adverse scenario. This result is reassuring given that regulatory losses are estimated with bottom-up asset-level loss calculations applied to book value of equity whereas VLAB losses that feature in SRISK calculation are estimated using a measure of downside risk of market value of equity in a market-wide equity downturn.
This suggests that it is not the actual losses but rather different ways of specifying prudential capital requirements that must be driving the negative correlation between SRISK and the results of the ECB. An important difference between the leverage ratio used in SRISK and the regulatory leverage ratio is the use of risk weights in the latter. These are static for banks using the standardized approach. But most banks, especially the large banks, use the internal ratings based approach (IRB) and calculate risk weights themselves.
Tellingly, the big French and German banks benefit the most from the use of risk weights when calculating their minimum capital needs and have some of the lowest price-to-book ratios on continent. That makes us think that markets are just as sceptical of the regulatory measures as the academics.
This isn’t to say that SRISK should replace existing measures of leverage and indebtedness. For example, any indicator that says the risk of the US banking system didn’t go up from 2002-2007 is clearly missing something important:
The takeaway of all this is that a purely rule-based approach to regulation and supervision is bound to let excessive risks fall through the cracks. One way around that problem is to employ several different rule-based measures at the same time. Another is to embrace the doctrine of regulatory discretion. Uncertainty about future penalties should make bankers more cautious about using too much leverage and taking risks they don’t fully understand. Arbitrariness in government is normally a bad thing, but if it keeps excessive risk-takers on their toes then it’s worthwhile. Finally, regulators should be willing to enforce — and defend — seemingly pointless rules that make life difficult for banks that enjoy the protections of the regulatory safety net.
In other words, the way to regulate banks is to act a bit crazy. Crazy like a fox.
Related reading:
Alternative stress tests find French banks are weakest in Europe — Financial Times
Regulators want banks to rescue themselves next time — Matt Levine
Putting finance into macro: the microfoundations of banking — Free exchange
Equity capital requirements: the people versus the bankers — Free exchange
Addendum:
We sometimes like to think of the capital structure as a line of people who pay for the privilege of standing in front of a cannon. (The money goes into a box called “assets” and people can only get their money out if they line up one at a time.) Common equity holders, bless them, are out in front, nobly willing to sacrifice themselves to save the lives of everyone behind them — from the relatively brave preferred shareholders all the way to the skittish short-term secured creditors fidgeting at the back.
Every once in a while, the cannon fires “losses” at this massed crowd, of varying size. A small one might wipe out a few unlucky people in the front row, but aside from the blood spatter, the rest of the group would be unharmed. If most of the “losses” are small, it doesn’t really matter what sorts of people you get to participate in this bizarre activity. All that are needed are a few thrill-seekers standing in the front of the cowardly creditors.
The problem is when a really big loss comes along and there aren’t enough shareholders serving as human shields for the meek lenders, although in practice it’s just as bad if lenders think that a large loss is likely and start running away from the cannon, demanding they get their money back all at once. Putting more tough guys in the front of the line obviously wouldn’t do anything to reduce the overall destructiveness of the cannon but it would protect the weak-willed souls at the back. Importantly, that safety should also prevent them from panicking in the first place.
Unlike other industries, banks and other financial firms actively pitch themselves as places where people who are afraid of the “losses” cannon can find shelter. Safe spots near the front of the cannon are one of banks’ staple products. As a result, no other industry is remotely as reliant on short-term debt, or debt of any kind.
How do they make this work?
Part of the trick is that banks tend to do less exciting things than other companies. An oil explorer has to buy a lot of specialist technology and scour the earth for a resource that is sometimes very valuable, and sometimes isn’t. Pharmaceutical companies spend billions researching new drugs that may never work. By comparison, lending against a diversified portfolio and earning fee income on everything from IPOs to debit card overdrafts looks like a comparatively safe business.
So the shots from the cannon are smaller, but this is more than offset by the dearth of shareholders willing to stand in front of the creditors. In addition to the (relatively) low risk of their business model, banks have a government-provided blast shield in the middle of the line that blocks the banks’ cannons from hurting any of its creditors. This is deposit insurance, implicit guarantees, and the lender of last resort.
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