2014-11-11 07:09:47
Nov 7th 2014, 14:25 by Buttonwood
HOW do we make the system safer? That was the third question raised by the Hoover Institution's fascinating new book referred to in yesterday's post (which dealt with the build-up to, and immediate aftermath of, the crisis).
There is a very useful essay from Martin Neil Baily and Douglas Elliott on the various (and complex) provisions of the new regime, combining Basel rules and the Dodd-Frank Act. To sum up; banks have more capital, the capital they have is higher quality; they have to hold more capital against trading positions; and they need to conform to an overall leverage ratio (the relationship of tier 1 capital to total assets). If this seems a belt and braces approach, that is because the old rules allowed banks to game the system; either by holding lots of risky assets or by having core capital that could not be relied upon in a crisis. The effect of all this has been to make banks much safer; common equity was 11.6% of risk-weighted assets in the third quarter of 2013, up from 4.6% in 2007.
But, of course, there has been a cost. Critics say the effect of the changes has been to restrict access to credit and reduce market-making, and thus liquidity in the asset markets. As Kevin Warsh points out
policies that seek to reduce the likelihood of systemic crises may do so only by reducing the costs of intermediation in non-crisis periods
Can a banking system ever be truly safe? The nature of banking is the combination of short-term funding (deposits) and long-term assets (loans to business). The problem, as John Cochrane points out, but Jimmy Stewart made real in "It's a Wonderful Life", is "runs" - the stampede for the exit that occurs as investors scramble to retrieve their money before it vanishes.
Runs are a pathology of specific contracts, such as deposits and overnight debt, issued by specific kinds of intermediaries. Among other features, run-prone contracts promise fixed values and first-come first-served payment. There was no run in the tech stock bust because tech companies were funded by stock, and stock does not have these run-prone features.
The answer to this problem, some say, is "narrow banking". Cochrane again
demand deposits, fixed-value money-market funds or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, this means mostly common equity, though some long-term or other non-runnable debt can exist as well.
This, he argues, would be a great improvement on the current system where
In order to stop runs, our government guarantees debts, implicitly or explicitly, and often ex-post, with credit guarantees, bailouts, last-resort lending and other crisis-fighting efforts.
To try to reduce the moral hazards associated with this approach
our government tries to regulate the riskiness of bank assets and imposes capital requirements to limit banks' debt funding. Then banks game their way around regulations, take on more risk, and skirt capital requirements; shadow banks grow up around regulations; and another crisis happens. The government guarantees more debts, expands its regulatory reach, and intensifies asset regulation.
Each new step follows naturally to clean up the unintended consequences of the last one. The expansion is nonetheless breathtaking. Beyond massively ramping up the intensity, scope and detail of financial institutions and markets regulation, central banks are now trying to control the underlying market prices of assets, to keep banks from losing money in the first place.
Cochrane is not the only one to worry about the sheer complexity of the system, as symbolised by the 848 pages of the Dodd-Frank Act. As Bair and Delfin write
there has been too little focus on writing strong, simple rules that are difficult to game and easy to understand, implement and enforce, and too much reliance on "stress testing" which, while helpful, is a discretionary process heavily reliant on supervisory judgment
adding that
Governments have a weakness for making exceptions and carve-outs that contribute to complexity and often lead to asymmetries and abuse. They are also terrible at admitting mistakes, setting or determining asset prices, fostering market discipline, and recognizing the inherent difficulties in the consolidated supervision of large, complex financial institutions.
Cochrane argues that his narrow banking approach is much simpler.
Rather than dream up a financial system so tightly controlled that no important institution ever loses money in the first place, we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs.
He adds that, luckily enough, there is no shortage of Treasury securities available for banks to own as security against their deposits.
While this all sounds good, one does have to wonder how we get there from here. For banks to own virtually all short-term Treasury debt would increase the odd symbiosis under which the government stands behind the banks and the banks behind the government. Even if that is not a problem., will the banks issue enough equity to stand behind their risky assets, or would they simply shrink their balance sheets by reducing the number of risky loans they make? And might that not produce a terrible credit squeeze for the small business sector?
One further issue stems from another regulatory response to the crisis; a desire to have more transactions cleared through central counterparties (CCPs). This might concentrate risk. As Darrell Duffie writes
Once the capital of a CCP is wiped out, the tail risk is held by clearing members, which are generally themselves systemically important firms...The US bankruptcy code is not currently adapted to safely resolve a failing CCP.
The risk may seem remote, but the collapse of AIG seemed a remote risk at the start of 2008. Stuff happens.
The underlying issue is ages old. Investors and consumers favour liquidity, but liquid assets offer low returns (all the more so today when many European government bonds pay negative rates). For the economy to function and to grow, companies need to issue risky assets. When things are going well, there is a ready market for such assets, and thus apparent liquidity. When things are going badly, prices fall and the liquidity vanishes. Mr Cochrane thinks there can be a rigid divide between the safe and risky assets; history suggests that there will also be a market for products that cross this divide. Many investors may not realise how much risk they are taking. What we tend to do is eliminate risk in one area, only to see it pop up somewhere else. Even narrow banking, one fears, would be subject to this problem.