Saturday, October 24, 2009

How to Improve Regulation

. Saturday, October 24, 2009

Martin Wolf has a good column on the difficulties of crafting an appropriate regulatory structure. Basically, he says, in order to get a truly safe system we have to abolish banking. Despite recent difficulties, that isn't desirable. So he offers an outline for how improve the system without destroying it:

First, create a set of laws and institutions that make it possible to bankrupt any and all institutions, even in a crisis. Second, make financial institutions safer, with much higher capital requirements, against all activities. Third, prevent off-balance-sheet activities. Fourth, impose dynamic provisioning. Fifth, require huge cushions of contingent capital. Finally, cease to favour debt-finance, throughout the economy.

Kevin Drum is on board:

This is very sensible sounding: the first item is a backstop in case the others don't work, and four of the remaining five items are aimed at reducing leverage throughout the banking system. (Dynamic provisioning is the exception. It might be a good idea, but it's not directly related to reducing leverage.) Now extend this to the rest of the financial system and make sure to write the rules with no wiggle room, and you're done. Piece of cake, really. Any other problems you'd like solved?

But Matthew Yglesias sees trouble:

I’m not sure how much of this can stick in an industry where the product and the inputs (just money, really) can cross international borders so easily. Shut down some antics in London and they move to Zurich.

I'm on board with some of Wolf's ideas. The first is a clear priority; indeed, one of the reasons why the financial crisis was so bad that it threatened to kill the entire global economy is because Paulson and Geithner had no way to wind down troubled firms in an orderly fashion. Markets panicked as half the financial industry was in a state of flux, and an old-fashioned bank run was on. (For a good description of this, see this excerpt from Andrew Ross Sorkin's new book.) It wasn't that banks were too big too fail per se. It was that there was no legal way for them to fail in a timely, ordered fashion. So Paulson and Geithner had to try to find buyers for the troubled firms, transform investment banks into bank-holding corporations to get access to loans from the Fed, and try other ad hoc "fixes" to prevent total collapse.

I am similarly in agreement with Wolf that all bank activities should be "on balance sheet". A lack of transparency was a major problem in this crisis, and part of the reason was that nobody knew what obligations what banks actually had. And this includes the bankers themselves, not to mention traders, hedge funds, short sellers, etc. Any regulation that improves transparency in the financial system is a good one, if you ask me.

But contra Drum, I'm not sure what good the other provisions would have done in this crisis. All of the banks were more than well-capitalized, even Lehman. Merrill Lynch had $140bn in cash that dissipated in about a week because of withdrawals when they were fundamentally solvent. Most banks had Tier 1 ratios more than double their Basel requirements and overall capital ratios were similarly high. Bank runs caused illiquid firms to become insolvent, and chaos ensued because there was no way to wind them down.

There were two primary problems in this crisis: mispriced risk, and massive amounts of uncertainty that led to a panic. Wolf's proposals don't address the risk part, and once a panic sets in a bank is doomed no matter how much capital they hold in reserve. Moreover, one reason why banks were levered up so high was because of the risk-weighting scheme in Basel that, combined with the Recourse Rule, encouraged banks to invest in asset-backed securities. If we require higher capital requirements under a similar risk-weighting rule we'll be essentially encouraging even more leverage.

Yglesias' response is similarly misguided. The problem wasn't regulatory competition. Indeed, the U.S. has higher capital requirements than many other Western countries, yet that didn't matter to anyone. (Additionally, whatever the U.S. does generally becomes a widely-adopted international industry "best practice" standard.)

I would add one thing to Wolf's list: make it easier to declare "bank holidays" on part or all of the banking system. It now seems clear that excessive short-selling made the crisis much worse than it needed to be. Also, most of the work by Paulson, Bernanke, Geithner, and private firms had to be done over weekends while the markets were closed. If Bernanke and Paulson could have declared a week-long holiday + ban on short-selling the day that Lehman collapsed, and used that time to come up with permanent solutions, much agony might have been avoided. Same if they could have conducted "stress tests" or determined which banks could survive and which couldn't without markets reacting to every drop of sweat on Paulson's brow.


How to Improve Regulation
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