Update on FinReg Politics

Awhile back Thomas and I wrote a chapter for a Research Handbook summarizing positive theory in political economy on global financial regulation. (The book is here; an ungated draft version of our chapter is here.) As we were writing many governments were revising their regulatory standards in response to the global financial crisis, and the international standards created by the Basel Committee were undergoing revision as well. We were pleased that most of our speculations -- which came directly from a variety of researchers in the IPE literature -- were borne out by later developments. It was one of the few validations of IPE work that emerged from the crisis. But things can change, and the politics of financial regulation doesn't stay still for long.

One of the key arguments that we made was that the revisions to the Basel accords were highly likely to benefit banks in the US. Indeed, the U.S. government left capital regulation out of the Dodd-Frank Act almost entirely, choosing the international forum. Previous IPE research suggests that this is done in order to advantage domestic US firms, which should only be expected since all regulations involve redistribution, and thus creates both winners and losers. It's seemed pretty obvious that the winners would be US firms, and the losers would be firms in Continental Europe and Japan. (I've blogged about this before.) In the chapter Thomas and I wrote we explained how this was just a continuation of a dynamic going back to the creation of the first Basel accord in the mid-1980s.

Fast-forward a few years and the same dynamics appear to be in force:

THE European Banking Authority (EBA) released its second report monitoring compliance with Basel III regulations on September 27. The big finding is that the aggregate European banking sector needs about 338 billion euros of additional equity capital to comply with the rules. While firms have several more years to adjust their balance sheets and raise funds, this seems like a tall order, especially given what has happened to bank share prices [wkw: which have declined dramatically since 2008].

In the US, which are generally better-capitalized than their European and Japanese competitors, the new international rules are likely to harm small banks more than big banks, as the new standards increasing the complexity involved in compliance. Perhaps this is why large US banks have remained relatively quiet about their new Basel obligations, unlike many of the provisions in Dodd-Frank, while smaller banks have screamed bloody murder. The increase in complexity rewards large firms with the technical capacity to navigate the system. The new Basel demands for more capital hurt firms with less capital, and for whom it is more expensive to acquire it. On both dimensions, large US banks are in a better position than their smaller domestic rivals or competitors in other jurisdictions.

On these points it is interesting to read Felix Salmon's take on Sheila Bair's new book (which I've not read), in which we find:

Tim Geithner involved himself quite deeply in Basel III negotiations. Bair can’t stand Geithner, and ascribes malign intent to everything he does. Geithner asks questions about Basel III without explicitly saying what his own opinion is? “It wasn’t clear whether Tim was trying to build consensus among the U.S. regulators or trying to stir the pot.” Geithner agrees to push for higher capital standards — exactly what Bair wanted all along? Well, that’s just his way of trying to marginalize her:

Bair sees the entire episode as a power play by Geithner. She argues he was trying to blow up the meeting between international regulators so that the issue would be kicked higher to the Group of 20 finance ministers who were set to meet in November. If the G-20 took over negotiations, Geithner would be leading the U.S., not Bernanke. The FDIC would have little say in the final number.

I'm more sensitive to the idea that Geithner's involvement was a power play than Salmon, although more likely Bair was less Geithner's target than Bernanke. And I doubt that Geithner ever wanted to leave the Fed out of the process -- that would be absurd and it didn't happen -- rather than ensure that he remained actively involved in the process. Geithner is routinely accused of pushing for policies that benefit the US banking sector, both in his time at Treasury and before when he was at the US Fed. I think many of the more moralistic of these criticisms are a bit much -- after all, shouldn't a healthy banking sector should be a goal for regulators? -- but the general drift seems to fit the data fairly well. There's no doubt that things would look a bit different if Bair, or Elizabeth Warren, was in charge.  And this fits in with the general tenor of the story I'm trying to tell: US policymakers have the well-being of US firms in mind when they go into international negotiations. Or, as Salmon puts it:

[I]t’s entirely natural that Geithner, who moved straight to Treasury from the presidency of the New York Fed, would take an interest in Basel III: after all, the New York Fed generally provided most of the frontline negotiators hammering out details far from the view of principals like Bair. And, it’s worth noting, the New York Fed was actually very aggressive in the Basel negotiations — much more aggressive, actually, than the higher-level negotiators from Washington. That was the culture Geithner came from, and if he was more sympathetic to Citi and BofA than Bair was, he was also well aware that the tougher the capital-adequacy standards, the better the competitive position of US banks in general, vis-a-vis their woefully undercapitalized European counterparts.

In this particular case this is good from the perspective of those hoping for a stricter regulatory state, since the US (along with the UK and Switzerland) were the ones pushing for tighter capital and liquidity requirements, while the Germans, French, and Japanese resisted. Needless to say the Americans won on most points, with the major concession being a longer phase-in period to give European banks a chance to play catch-up. Many major US banks are already in compliance.

This narrative complicates usual regulatory capture stories. For example, if US firms push US regulatory authorities to impose stricter regulations in order to lock in an advantaged market position, should those who favor the regulatory state approve? Well, that's a tricky one isn't it. But this tends to happen following regulatory innovations: incumbents are advantaged, while new entrants and possible competitors are disadvantaged. And indeed, the Too Big To Fail banks have only gotten bigger since the crisis.

This is something that a political economy approach can, and does, help us understand.

Annals of Silly(?) Policymaking: Procyclical Financial Regulations During a Bank Run Edition

This (via @dandrezer) does not seem smart:

Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench.  

The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario".

That is only within the European Union, and it came about due to panic over Greece last month. Basically, this means that EU banks have to increase their capital cushions by over 200% by the end of this month. What does that mean?

The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery.

Note that this just in Europe. But it made me wonder (on Twitter): why do this now? After all, it was Germany that insisted on a longer phase-in period for Basel III during negotiations, while the US/UK/Switzerland wanted that stricter capital requirements. Now the EU is doing a rapid phase-in and tougher capital limits years before they are required to by Basel. And they're doing it in the middle of a bank run during a continent-wide recession. What gives? A few things.

1. Banks do have to get to 9% tier 1 capital by the end of the month, but they don't have to come fully into compliance yet. That is, a lot of junk capital that is prohibited by Basel III -- but was allowed under Basels I and II -- will still be allowed. (ht to @Procyclicality for this point)

2. Nevertheless, this is still a big boost to minimum capital standards. So how will banks come into compliance? Two quick and easy ways are to:

a. Hold more cash.

b. Buy more sovereign debt.

The first of these is contractionary -- it's basically hoarding more cash rather than lending it out -- although the ECB can facilitate it if they want to pump eurozone banks full of cash. Non-euro EU central banks, such as the Bank of England, can do the same thing if they want and the US Federal Reserve has injected a bunch of liquidity into foreign banks when needed in the past as well. As a zero-risk instrument, cash has a zero risk weight, so adding more of it to your portfolio brings your overall capital ratio up.

The second of these is expansionary. OECD sovereign debt also carries a zero risk weight under Basel III, as it did under Basels I and II. This might seem bizarre at first, but remember who's making these rules: OECD governments. And OECD governments want to pay low interest on their debt. To do that, they rig the regulatory rules to make it more attractive for financial institutions to buy that debt. Hence, a zero risk weight in Basel.

So what does that mean? If banks need to boost their capital stock, there are two ways to do it: by raising more capital (e.g. by selling equity) or by shifting their risk portfolio. The former latter will be often preferred to the latter former, so banks are essentially being encouraged to buy sovereign debt (and other zero risk weight instruments) in order to come into regulatory compliance.

Was this the point of this policy? I don't know. Probably it was mostly a freak-out after runs started on Greece and then Spain. But I imagine it was part of the calculus, or at least has become so since. In practice this will likely be a transfer of private funding for public funding. Given that the ECB cannot provide liquidity directly to eurozone governments, but can accept sovereign debt as collateral when lending to banks, this could be part of a stealth bailout program that began when Mario Draghi took over as ECB chief from Jean-Claude Trichet last year. Call it "bailout by regulatory arbitrage".

Will it work? I don't know.

Moral Hazard FOTD

Banks that took bailout money acted more riskily.

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. ... 

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand. 

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find? ... 

Moving from this granular level to a bank-wide basis, the authors found that the CPP banks increased asset risk (using ROA & earnings volatility as proxies) while decreasing their leverage (perhaps because they knew that regulators would be keeping an eye on this metric in addition to the capitalization ratio.)

Here's the paper. This part of the abstract is very important:

Our difference-in-difference analysis indicates that after the bailout, bailed banks approve riskier loans and shift investment portfolios toward riskier securities. However, this shift in risk occurs mostly within the same asset class and, therefore, has little effect on the closely-monitored capitalization levels. Consequently, bailed banks appear safer according to the capitalization requirements, but show a significant increase in market-based measures of risk. Overall, our evidence suggests that banks’ response to capital requirements may erode their efficacy in risk regulation.

So of course global -- and many domestic -- regulations focus on capital and leverage ratios.

There Is No Technocracy QOTD

Felix Salmon nails it in a post titled "All bank regulators are captured":

The fact of the matter, however, is that all regulators are captured by banks. Or, to be a little more precise, all legislatures are captured by banks, and all regulators do what the government tells them to do. 

In countries like Canada and India, there’s a very small number of strong, well-capitalized banks with a vested interest in maximizing barriers to entry. So they’re happy with very tough standards. In Europe, national banking systems are also concentrated, so in theory they could go the same way. But European banks are more likely to have cross-border and global ambitions, and in any case as a matter of contingent fact they’re not very well capitalized. So they get the regulation they want — which allows them to grow fast without having to raise lots of expensive new equity capital.

And then there’s the US, which is pretty much unique among major economies in having thousands of pretty vibrant small banks. Those small banks have a lot of political clout in Congress, and they hated Basel II, because they’re not nearly sophisticated enough to take advantage of it. So they essentially bullied Congress into keeping the old Basel I standards, for fear that otherwise they would be at a massive competitive disadvantage with respect to the big US banks like JP Morgan Chase. Congress obliged, and used the FDIC as its chosen mechanism for blocking the adoption of Basel II in the US.  

Does that make the FDIC particularly virtuous? No: it makes the FDIC just as beholden to the banks as any European regulator. Look at the banks’ contributions to the FDIC insurance fund, for instance: they fell to zero, for no good reason, just because the banks didn’t like making those payments.

Cross-national differences in regulations are not due to one country's regulators being somehow wiser than the rest. It has to do with different organizations of domestic interests within (and across) countries. These lead to different policy outcomes.

Paul Krugman does not in a post titled "Crats, Maybe, But Not Much Techno":

But it’s more than that: these alleged technocrats have in fact systematically ignored both textbook macroeconomics and the lessons of history in favor of fantasies. The European Central Bank has placed its faith in the confidence fairy, while imagining that it can run policy in a way that has never worked in several centuries of central bank experience. Meanwhile, the European policy elite has simply wished away the clear evidence that the euro zone needs to make an adjustment that is virtually impossible unless inflation targets are raised.

The point is that I know technocrats, and these people aren’t — they’re faith healers who are making stuff up to suit their prejudices.

I contend that Paul Krugman does not know technocrats. He knows people who have different priorities than those he dislikes in the government and punditocracy. He claims that his side are the true technocrats -- untainted by avarice or bias -- because that gives them a moral authority that they would not otherwise have. But Krugman's preferred "technocrats" are just those who prioritize labor over capital, to use a short-hand, while those he decries have the opposite preference. As Salmon notes, capital generally wins, but in varying ways that reflect their varying preferences in disparate places.

"Textbook macroeconomics" presupposes a political system that is dedicated to the pursuit of utilitarian aims, a "socially optimal" mix of outcomes. But there is no universally agreed upon social optimum. There are only different, competing interest groups with different, competing preferences. Rousseau was wrong about this. There is no General Will, only the Sum of Private Wills. Some interests are narrower than others, as OWS has figured out, but that's really the only difference.

Links

Some of these I may blog properly later, but time is scarce these days.

-- Ikenberry responds to Walt.

-- Good discussion of Herbert Simon and complex social systems.

-- Bernanke on how central banking has changed post-crisis, including on the interplay between regulatory and monetary policies.

-- Problems with Basel III implementation. This is what Jamie Dimon is referring to when he says Basel is "anti-American".

-- Vladislav Surkov, "Putin's Rasputin".

-- Interactive description of the eurozone crisis, as a series of weighted, directed networks. (ht Alex)

-- US attacks China's "Great Firewall" at WTO.

-- Ambrose Evans-Pritchard says world power is swinging back to the US. I hadn't realized it had gone.

Quibble

Vikash Yadav supports the Occupy Wall Street, but wants to see more protests directed at international institutions like the Basel Committee on Banking Supervision. Although he doesn't say this, I suspect that he is not aware that the BCBS is nothing more than a talk shop. Its members are the (domestic) central bankers and finance ministers from industrial economies. As such, it doesn't make a whole lot of sense to protest against the administrative staff, which are the only ones actually located in Basel. It makes a lot more sense to protest against the domestic authorities that meet under the auspices of the BCBS to set international regulatory policy. Which is pretty much what the #OWS movement is doing.

What Do Regulations Do?

I believe I wrote about this year-old post by John Hempton awhile ago, but it's worth revisiting. I like the way he thinks about the effect of financial regulation:

In the UK banks were allowed to lever themselves to a silly extent (similar over-leverage occurs in their life insurance companies). Overleverage as a policy was the defining character of Northern Rock. 

Individually it makes sense for banks to lever up. However competition was intense - and collectively it was insane. Northern Rock was levered 60 times or so - but to mortgages that were really thin margin. Their spreads were about 40bps.   

What I suspect is happening is all the banks are standing on tippy-toes. It is individually rational - collectively insane because competition kills the benefit of all that extra leverage. Margins in the UK - the most over-levered market on the planet - fell further than anywhere else.  

Of course competition was good for borrowers - at least for a while. Lower spreads meant cheaper finance - but not dramatically cheaper. Spreads of 150bps on mortgages levered 15 times is about as profitable as spreads of 40bps levered 60 times. Competition might drive spreads down by 110bps - at the risk to the whole banking system.

In most of the popular discourse and academic literature banks are presumed to be opposed to regulation, because it corrects market inefficiencies by forcing firms to internalize negative externalities*. The public choice school** argues that there are times when this is not the case -- when incumbent firms can use regulatory structures to collect rents -- so there is no reason to start from the assumption that regulations will be welfare-enhancing.

Hempton is proposing something else: thinking of financial markets as creating a prisoner's dilemma for banks. In this case, banks would be better off if they were able to collude. They'd be able to maintain fairly large spreads, and thus profits, without taking on inordinate risk. The "cooperative" outcome is Pareto-optimal (for the banks at least). But it isn't individually rational. If all the other banks are maintaining higher standards, you can capture quite a lot of market share by "defecting" -- levering up, in this example. To do this you will have to accept lower margins, but profits will still increase if you increase volume enough.

Of course what is individually rational for one firm is individually rational for all firms, so just like in a prisoner's dilemma everyone "defects", driving down margins without capturing any more market share. In this scenario, bankers would prefer regulations like minimum capital adequacy and limits on leverage,  not because it bestows rents (at least not only for that reason), but because it changes the structure of the strategic interaction. Firms can now attain Pareto-improving outcomes where they can achieve a decent profit at fatter margins without taking on so much risk. So, ceteris paribus, in this situation firms should actually prefer to be regulated so long as everyone else is regulated too.

And, in fact, in the wake of the financial crisis every banker said they supported re-regulation of the financial sector so long as it affected everybody. But here's the kicker: the same dynamic that makes regulation Pareto-improving also makes regulatory avoidance very lucrative. If you can figure out a way to arbitrage the regulation, you can capture more market share at a slightly lower margin, thus boosting profits. In terms of the prisoner's dilemma, you can profit by defecting while everyone else cooperates. The rise of the shadow banking system is best understood in this light.

Meanwhile, I'm not as perplexed as Drezner is by recent developments in domestic and international regulatory regimes. First, Basel III went basically the way previous rounds went. This process isn't as simple as "bank preferences are communicated to national governments, and also includes the preferences of voters and policy elites. Second, the majority of the Dodd-Frank rules haven't been written yet, must less implemented so it's far too soon to say that bankers have "lost" in any meaningful way. Third, there are very real concerns that the EU won't be able to begin enforcing Basel III any time soon, which could potentially affect the competitiveness of US banks (this is what Jamie Dimon was talking about when he called Basel III "anti-American"). Fourth, Dodd-Frank contains dozens of provisions on top of Basel III, some of which could effect international competitiveness (although most won't).

Lastly, I think Drezner is making too much of the fact that the banks aren't getting everything they want. They are still getting quite a lot -- Dodd-Frank implementation is slow, underfunded, and every GOP candidate vows to repeal or otherwise castrate it -- but they never get everything they want. Finance is one of the most heavily-regulated industries in the country. They routinely lose political fights. The influence of bankers on politics is real, but it is quite often over-stated.

*A line of thought that began with Pigou, who wrote more about taxation than regulation, but the fundamental principle is the same.

**Notably Stigler and Peltzman, extended onto the international level by Oatley and Nabors.

Sunday Links

-- NYT roundtable on Basel III.

-- Michael Lewis goes to California.

-- Long interview with Daron Acemoglu, on a number of topics.

-- Economist special report on shifting of economic activity from west to east.

-- Opening statement of Firedoglake book salon on Chinn/Frieden's Lost Decades.

-- The attempt to collect and publish in one place accurate data on the graduation and placement rates of poli sci departments. I fully support this, and hope UNC gets on board soon.

Basel Is Not "Anti-American"

I see (via Felix Salmon) that JP Morgan executive Jamie Dimon thinks the Basel bank regulations are "anti-American". I have no idea what he means by that, but my working understanding of the Basel regulations is that from a competitiveness standpoint they are generally beneficial to large American firms (like JP Morgan), and generally harmful to European and Asian firms. As Salmon puts it:

I have no idea what Dimon thinks is anti-American about the Basel standards, which are certainly in the interests of the United States. In fact, by all accounts it was the US which was pushing for stricter rules, and had to compromise with the laxer Europeans, whose banks are much less well capitalized right now. US banks, including JP Morgan with its “fortress balance sheet”, are very well placed to navigate through the Basel rules and come out strong and dominant on the other side.  

European banks, by contrast, will have to raise a lot of very expensive equity. And UK banks, if the Vickers proposals are adopted, will be much less formidable in the international arena than they are right now, with most of their assets ring-fenced and unavailable for merchant-banking misadventures.

There are two basic ways to think about regulations like the Basel accords. The first way is to think in terms of externalities and welfare: regulations restrict the ability of banks to act riskily, which prevents them from generating negative externalities that spill over into the rest of society during financial crises. Thus, new regulations represent a redistribution away from banks to society at large. I think this is the wrong view.

A better approach, in my opinion, is to think of regulation as altering the competitive landscape in ways that benefit some firms and hurt others, and benefit some in the broader society while hurting others. Large incumbent firms often support new regulations that function as a barrier to entry for potential competitors. Regulations can lock in the market dominance of existing firms. This is what Salmon is talking about when he writes that "US banks are well placed to navigate through the Basel rules and come out strong and dominant on the other side".

So why is Dimon opposed to them? It could be that he doesn't appreciate this dynamic, but that sort of ignorance would wreak havoc on the assumptions used to generate the rent-seeking model of regulation. So let's not go there.

My guess is that Dimon recognizes the advantages of Basel rents but think they are smaller than the benefits to his firm of having lower regulations. That is, since JP Morgan is already at a competitive advantage over many of its competitors, and with the European banking sector apparently on the verge of collapse, he may believe that he doesn't need to collect rents for his firm to be profitable. If that's the situation, then the regulations restrict Dimon's flexibility without providing any significant competitive benefit.

That doesn't mean Basel is "anti-American" of course. For one thing, the Basel system could lock in market dominance for large American firms long into the future. For another, US policy makers hope to create a more stable financial system through Basel, not just secure profits for American firms. Of course Dimon may have a shorter time horizon, in which case the long-run benefits of Basel would be enjoyed by someone other than him, while the costs of initiation and compliance are borne by him and his friends.

Banks Too Weak for Basel III?

It looks like many might be, especially in Europe:

Banking regulators are preparing to relax the new rules requiring banks to hold more liquid assets to be prepared for a new funding crisis, writes the Financial Times. ... 

A new report by JPMorgan estimates that 28 European banks showed a liquidity deficit of 493 billion euro billion at the end of last year. 

Only seven of the 28 banks tested comply with the  new standards, French banks being among the least prepared. In fact, JPMorgan analysts concluded that the requirements of liquidity for the banks must hold sufficient assets, easily sold to meet a 30-day-long funding crisis, will affect most sectors, and will cost about 12% of the average European banks earnings of 2012.

We've written a lot about the competitive nature of Basel III, and especially how American banks tend to have higher capital and liquidity ratios than many of their European counterparts. Basel III was really hard on European (and Japanese) banks, and it looks like many of them won't be able to meet their obligations in a timely manner, especially if the European debt situation deteriorates. And, of course, if European banks are allowed to defect from their Basel obligations then pressure will be placed on the US and other governments to allow their banks to do the same.

This is worth keeping an eye on.

Regulatory Politics

The EU is working to implement Basel III:

New European Union rules designed to make the financial system safer would require banks operating in Europe to raise an estimated €460bn in capital by 2019 or substantially reduce their risk and balance sheets.

The draft proposals unveiled on Wednesday – which still need approval from the 27 member states and the European parliament – make the EU the first jurisdiction to start implementing the global Basel III capital and liquidity guidelines that were adopted last year.

The new Basel capital definitions hurt EU banks more than US banks, as they focus on improving capital quality by mandating more equity and less debt. As a result, EU banks -- still suffering from the crisis and recession, and on edge over sovereign debt holdings -- have to raise more capital than many of their foreign competitors. Predictably, they don't like that:

Industry groups in the UK and Germany warned that if the EU moves too far ahead of the rest of the world, its banks could lose out to international competitors and cut lending to the real economy. The projected capital shortfall, equivalent to 2.9 per cent of all the EU banks’ risk weighted assets, goes a long way towards explaining why EU banks are among the fiercest critics of the Basel III proposals.

Banks and some other groups argue that this will have an adverse effect on economic growth at a time when the EU can had afford it; while there might be some truth to that some new research shows that too much finance can actually retard growth, and that this is currently the case in some EU countries.

But the competitiveness argument seems to be undercut by this:

The EU’s draft proposals are likely to unleash months of heated debate, as member states and banking institutions haggle over the details. Some countries – including the UK – are still fighting for the flexibility to introduce national requirements that are higher than the EU minimums.

If competitiveness is such a big worry then why would any states have stricter requirements than required by international agreement? Note that this is nothing new; the US had stricter capital requirements than Basel I and II in order for firms to be considered "well capitalized" by the FDIC. And World Bank surveys conducted in 1999, 2003, and 2006 showed that 40-50% of countries had capital standards stricter than the Basel minima even before the financial crisis. The above heat map shows those results in 2006*. Since the crisis many countries have proposed or enacted new regulations that are tighter than their international obligations.

Most existing literature on regulation in finance, economics, or political science does not expect this type of behavior by governments**. Episodes like this suggest that we need to complicate our expectations about the ways that domestic and international politics interact, and the process by which governments set policy in a competitive global economy. It isn't unidirectional neoliberalism, even before the crisis. This is the focus of my dissertation research, so I'm sure you'll all be hearing plenty more about it in coming months. For now let's just say that this type of behavior follows the precedent of previous periods of crisis and regulatory reform.

*Darker colors indicate higher capital requirements. White is missing data. The Basel minimum of 8% is the light orange, as in the US. Note that much of the variation on this variable is in the developing world.

**Or the equivalent behavior of firms, which "over-comply" with capital regulations as a rule, albeit at different spreads.

Regulatory Regret

Suppose policymakers send a clear signal: banks that are "too big to fail" will be bailed out, so in return they must bear a stricter regulatory burden. Banks that are not too big to fail will not be bailed out, so they have a laxer burden. What incentive does that give to banks... get bigger to capture the guarantee, or get smaller to avoid the stricter regulation? Depends on the regulation. But I don't see any large bank responding to Basel III or Dodd-Frank or any other regulatory change by desperately trying to reduce size. That should provide some indication of what margin we're operating at. And even if the banks are small enough to fail without systemic consequences, that doesn't necessarily mean their creditors are:

Governments across the world are committed to allowing banks to fail in the future. Socialising bank losses is unpopular, and it creates moral hazard. However, when national banking sectors remain fragile, imposing burden-sharing resolution regimes is fraught with danger. Governments and regulators may chose safety first. Witness the ECB’s continuing refusal to allow haircuts for the senior bondholders of Irish banks. They, it seems, are definitely too big to fail.

Also remember 1907. The problem then wasn't too big to fail. It was too small so they failed. Larger institutions gain greater confidence than smaller institutions. The 1907 panic stopped only after JP Morgan (the man) intervened, so says the myth. That strategy repeatedly failed in 1929, as Galbraith's The Great Crash notes, but in 2008 the crisis may have been much worse if huge institutions didn't exist to merge with other huge institutions. Small institutions can't easily take on others' balance sheets in times of trouble, at any price.

The point is that there are downsides to decentralized finance. TBTF is a real problem, but it's not the only problem. Constructing regulations to punish TBTF firms could actually reward them. I can easily imagine Wall Street executives wearing their SIFI ("systemically important financial institution"*) designations as badges of honor. And counting on them as explicit blank checks from governments. Who wouldn't want a SIFI as a counterparty? Almost as good as a GSE.

*Subject to stricter capital requirements under Basel III.

Capital Is Political

Joe Nocera and Bethany McLean, co-authors of financial crisis account All the Devils Are Here, have competing op-eds on the importance of raising capital ratios. Here's how Nocera's starts:

Capital matters. Let me put that another way. The current fight over additional capital requirements for the banking industry, eye-glazing though it is, also happens to be the most important reform moment since the financial crisis broke out three years ago. More important than the wrangling over Dodd-Frank. More important than the ongoing effort to regulate derivatives. More important even than the jousting over the new Consumer Financial Protection Bureau.

And here's McLean:

Think about the past (the financial meltdown in 2008) and the present (the fear that a default by Greece will ignite another financial crisis ). If banks had held more capital, would we have avoided either mess? I'm afraid the answer is no.

Here's how I'd sum up the difference. McLean argues that all bank crises stem from runs on banks, and when a run is on no amount of capital can stop it. Yes, Nocera might respond, but runs are crises of confidence and higher capital requirements can increase confidence in the stability of financial institutions. Both could be right. But as McLean hints, the type of capital restrictions can end up backhandedly make financial institutions less safe:

Not only would higher capital requirements have failed to prevent these crises; conceivably they might have made them worse. The risk weighting that the regulators apply to assets encourages banks to hold more of the assets that are supposed to be low-risk. That's why banks all owned a lot of mortgage-backed securities—they were purportedly low-risk, and banks didn't have to hold much capital against them. Sovereign debt like Greece's was also purportedly low-risk; that why banks owned a lot of it. Subsequent events showed that the risk weightings left something to be desired. Because they were standardized, they incentivized banks engaged in the same risky behavior. If you believe that crises come about because too many banks do too many of the same dumb things, then faulty international capital requirements are arguably worse than no such requirements at all.

This is more-or-less the Friedman hypothesis [1, 2, 3, 4]: the regulatory code rewarded lending to governments and to vehicles for securitization, and no wonder. Regulations are political creations, so they will favor things that political actors want. Cheap access to government debt is one; plenty of cheap housing finance is another.

Nocera hasn't fully internalized this point -- he refers to regulators' decisions as "somewhat absurd" and to political bargaining over regulatory policy as "pathetic" and a "sorry sight" -- but he hones in on one important international dimension:

European banks, to be sure, have fought fiercely against higher capital requirements. It’s not really because they hope to get a leg up on the rest of the world, though. It is because these banks are in far worse shape than the banks in other parts of the world; they can’t afford higher capital requirements. If Europe began insisting that its banks begin holding enough capital to cushion against all the risk on their books — starting with Greek debt — the truth would be out: Their insolvency would suddenly be apparent. If Europe wants to keep kicking the can, by turning its back on the surest measure to increase the safety of its financial system, why on earth would we want to go along?

Tarullo will soon travel to Basel, Switzerland, (yes, that’s why they call them the Basel accords) to push for the highest capital requirements he can get the rest of the world to agree to. He will also try to convince the international standard-setters that a significant surcharge on the most systemically important banks is vitally important.

That surcharge, discussed here, represents just the most recent of several US (and UK and Switzerland) victories in the Basel negotiation process. The delayed phase-in was the main victory of the European contingent. But the takeaway needs to be that we need to understand the political process in order to understand what the purpose of regulations are, and the ways they shape firm behaviors.

Basel Is Political

Wonky technical point with large ramifications:

This year has seen some improvement. Data submitted by banks in May were subject to “peer review” by a committee of experts from the European Banking Authority (EBA), a pan-European college of regulators, which is administering the tests. The committee concluded that some banks had been over-optimistic in their self-assessment. In some cases different banks had estimated very different probabilities of default and losses on similar underlying assets. Results were meant to be out this month, but all banks have now been asked to do their sums again and resubmit by the end of July.

National regulators have not taken kindly to this. Germany’s regulator, BaFin, has been involved in a public war of words with the EBA over its definition of capital. The EBA has adopted the Basel III standard for Tier 1 capital. That excludes “silent capital”, bond-like instruments which Germany used to recapitalise its banks. Germany has pointed out that banks have several years to be Basel-III compliant. But so far the EBA has resisted German demands to recognise silent capital.

Why is this provision in Basel? Because US and UK banks don't use silent capital to pad their ratios, so if US/UK regulators were going to up the statutory capital requirements for their banks, they wanted to make sure those banks weren't competing against firms (esp in Germany and Japan) that were gaming the system, and gaining a competitive advantage from it. Basel III looks the way it does for a reason, and that reason isn't simply technocratic.

Over-Regulation Isn't Surprising

Yves Smith:

Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.

I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?

The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III.

Basically, the point is that some countries' regulators are considering implementing stricter regulations than those agreed in the multilateral Basel accords. How "peculiar" is this? Not very. The above heat map* shows capital-to-asset requirements for about 140 countries in 2006. The data come from this World Bank survey, which was the third of its kind. The darker the color, the higher the minimum ratio required by governments. (White countries are missing data, which means non-respondents to the survey.) At the time, the Basel requirements were 8% capital, of which 4% needed to be equity capital, represented by the beige color of the United States. The interesting thing about this is the number of countries that had tighter restrictions than those minima. It's nearly half of the sample**.

This might surprise some, who believe that absent a tough international standard national governments will "race to the bottom" in order to give their firms a competitive edge. But that doesn't tend to happen. Nor does it happen much in the private sector. Banks routinely over-comply with capital requirements, as doing so signals to investors that they are safe firms, which in turn lowers their borrowing costs. Pre-crisis almost all of the major banks had capital ratios that were not only well above the Basel II requirements, but also above the proposed Basel III requirements as well***. Rather than push up against the regulatory capital minimum, banks tried to signal credibility by maintaining capital ratios that were often twice as large as legally required. In some cases, banks lobbied their governments for stricter regulations, especially if those could also be applied to their foreign competitors or otherwise shield them from competition. Note that the countries with darker colors above, i.e. those with stricter regulations, are most often middle income countries most in need of signaling credibility.

Obviously this over-compliance didn't do much good in 2008, but that doesn't mean it wasn't happening.

I presented some preliminary research on this at this year's International Studies Association meeting. It's not yet in suitable shape for me to post the paper, or to report any firm conclusions, but one thing I think is fairly clear: popular commentators, and most academics, have been thinking about the relationship between firms' and governments' preferences over regulatory policies in some pretty wrong ways. It isn't just a race to the bottom. There's more going on.

*Created using the wonderful, free Open Heat Map web program. Click for larger image.

**43%, if I remember correctly. And that doesn't include other "pseudo-regulations", like the US' requirement of 10% capital to be considered "well-capitalized" by the FDIC, that operated as de facto requirements.

***At least in terms of capital; leverage and liquidity is another thing entirely.

Basel Politics Nothing New

Felix Salmon:

One of the big successes of the Basel III process was that while there were serious disagreements along the way, the governments and central banks concerned were pretty good at keeping the discussions productive and confidential. But just as with Dodd-Frank, it seems, the real difficulty is going to be in implementation, and that’s where there’s a big risk of everything becoming very political.

In the short term, the biggest winners in any fight between regulatory authorities are always going to be the banks, who will happily arbitrage differing regional regulatory regimes and take advantage of their parents’ squabbles to stay out drinking all night. In the long term, however, even the banks would ultimately prefer a single global regulatory regime with clear ground rules and a level playing field — something which lets them concentrate on their main job, of banking, rather than expending enormous effort on lobbying and loopholes.

A few relatively minor quibbles:

1. I would stress that it makes little sense to frame this in terms of "big risk of everything becoming very political". Everything has already been political. The entire Basel negotiation process was political (see also here, here, and here). The time schedule for implementation was political. The terms of implementation (and definitions of implementation) remain political. The political nature of every step in the Basel process is not only in line with the Basel III history, but with previous Basel accords as well, as a paper (no math) Thomas and I co-wrote argues.

2. Saying that banks would prefer a level playing field neglects the very important point that not all level playing fields are the same. Banks in some countries would prefer one type of field, while banks in others would prefer a different field altogether. The battle is not over whether or not there should be a common set of broad standards; it's over what those standards will be. And on this point, not all banks have homogenous preferences. Large, well-established banks would prefer stricter regulations (in some areas at least), as those are likely to reinforce their market position and create barriers to entry. This is why this is a political battle.

3. This is not just an EU v. US battle. The EU is split along some important lines, as one of the FT articles Salmon links hints:

Mr Barnier’s comments were triggered by a Financial Times story based on an unpublished draft of the impending EU legislation, which indicated that there would be more flexibility for banks with insurance subsidiaries than proposed under the Basel III guidelines.

As with the debt crisis, what is good for German banks (say) might not be good for other EU banks. The UK butted heads with other EU members repeatedly during the Basel negotiations.

All to say, the political nature of Basel III has been present all along.

Will Barclays Leave London?

Dealbook plays gossip columnist:

An analyst report has renewed speculation among some investors that the British bank Barclays might leave London for New York.

The report, published by two UBS analysts on Tuesday and titled “The first to leave?”, gives a list of reasons why there apparently is “little option for Barclays but to reconsider domicile.”

Executives of large British banks, including HSBC, Standard Chartered and Barclays, had been threatening to move their headquarters abroad ever since a government-appointed banking commission here hinted it would consider splitting investment and retail banking to make Britain’s financial sector more stable.

The warnings were widely seen as a tactic by the banks to scare the government into abandoning plans for stricter financial regulation.

This is interesting on a number of levels. First of all, the report is by UBS -- not Barclays, who's CEO Bob Diamond has recently said that he is committed to keeping Barclays headquartered in the U.K. UBS is based in Switzerland, but it has major operations internationally (including the U.K.), so perhaps this report really says more about UBS's preferences than Barclays'. What do I mean by that? If the U.K. tightens up its regulations, all firms that operate in that country will have to comply, whether they are based there or not. The effectively functions as a barrier to entry for new firms, since better-established firms will have an easier time complying with stricter regulations. The net effect of this is that firms with a large market share -- like Barclays -- will be in a better competitive position relative to emerging challengers -- like UBS. This is pure speculation on my part, but remember that regulation is about competition first and foremost, and that means that regulatory structures are political creations.

Another interesting aspect is that the U.S. is not necessarily a laxer regulator than the U.K. Prior to the crisis it definitely was not: the U.S. required higher capital ratios to be considered "well-capitalized" than the U.K., which operated under a "light touch" regime. Additionally, the U.S. has already placed some limits on the extent to which commercial banks can engage in investment banking activities under the so-called "Volcker rule". To this point, neither the U.K. nor most continental European countries have similar restrictions. The U.S. has also conducted much more rigorous "stress tests" of systemically-important financial institutions than their European counterparts, and the U.S. (with the U.K.) pushed for stronger capital, liquidity, and leverage requirements in the new Basel accord revision. In other words, relocating to the U.S. isn't necessarily beneficial from the perspective of trying to evade regulations.

But this type of talk also speaks to a process that is not very well understood by political scientists: when and why some national governments regulate their financial systems more strictly than international regulations require, since that would seemingly put their firms at a competitive disadvantage vis-a-vis foreign competitors in internationalized markets. I presented some preliminary research on this question at ISA a few weeks ago. While I've still got quite a bit of work to do on the question, my tentative conclusion is that most official regulations are well below the levels of prudence that markets demand, and function primarily as a way to prevent free-riding behavior by opportunistic firms. Given that, some governments can signal credibility to markets by having stricter rules than the international minima. This can, in turn, benefit firms by reducing their cost of finance. I'll probably post a working version of that paper online pretty soon, but until then interested parties can read some similar work by Thomas Bernauer and Vally Koubi here.

Anyway, I don't think there's a snowball's chance in hell that Barclays is moving to the U.S. But then I don't think that's really the point.

ht: Felix Salmon, who somewhat surprisingly doesn't dwell long on the point.

P.S. Here's your FOTD, from the same Dealbook piece: "Barclays’ gross balance sheet is 100 percent of Britain’s gross domestic product."

Why Optimal FinReg Isn't Even on the Table

Here's a nice little illustration of the difference between technological desires and political realities in financial regulation:

What is the optimal level of capital that a bank should hold? The new Basel III agreement sets a minimum level of 7% core Tier 1 capital, whose definition has been sufficiently tightened to consist almost largely of common equity. Under the Basel II rules, a bank could get away with just 2% common equity. But if Bank of England Monetary Policy Committee member David Miles is to be believed, regulators should really be forcing banks to hold as much as 20% core Tier 1 capital.

Miles, in other words, wants a 500% increase from Basel I and II in the amount of Tier 1 capital banks would have to hold. And maybe he's right: maybe that is the right amount. But that's basically irrelevant:

The Basel Committee calculated that just raising core Tier 1 capital ratios to 7% would require the world's 94 biggest banks to raise €600 billion ($821 billion) of equity, based on December 2009 balance sheets. If U.K. banks had to raise capital ratios to 17%, they would need an extra £757 billion ($1.2 trillion), more than twice their current market capitalization, according to UBS.

That is probably impossible in the current environment. As the article notes, Modigliani-Miller posits equivalence between debt and equity in the long run, but we're very much in the short run.

There's also a nice bit about the relationship between government policy and market expectations, and the political controversies over a supposedly technocratic policy.

As regulators have learned with Basel III, it doesn't matter how long banks are given to transition to higher capital requirements, the market will hold them to the higher standard straight away, a process known as superequivalence.

Still, Mr. Miles's analysis is useful in one respect; it shows the clear direction of thinking in U.K. official circles. British policy makers pushed hard in Basel for a minimum core Tier 1 ratio of 10%, supported by the U.S. and Switzerland. They are now winning support on the Financial Stability Board, which is overseeing the global overhaul effort, that the proposed additional capital buffer for too-big-to-fail banks should take the form of common equity. The U.K.'s Independent Commission on Banking also is considering further capital requirements for British banks over and above anything Basel demands.

Speculative Conjecture on Regulation and Crisis

Finally someone else is writing about the politics of financial regulation, so you know I'm all over this one. Riffing off of Reinhart & Rogoff (R&R) at The Monkey Cage, David Andrew Singer asks how we could know whether this time is different:

Financial crises happen regularly throughout history; indeed, R&R's analysis makes the enduring pattern of boom and bust perfectly clear. However, the book explains very little about the patterns it presents. The authors "select on the dependent variable" by examining only cases of countries in crisis, and as a result they are unable to make causal inferences. Are large capital inflows the root cause of the current financial crisis, and did they cause earlier crises throughout history? With no variation in the dependent variable, we cannot discern whether the alleged macroeconomic triggers are the real culprits, or whether other factors are at work. Examinations of past financial crises tell us little about whether or when current account deficits lead to financial instability, or about the political and institutional factors that might militate against systemic market failures.

The point here is that because R & R only look at crisis periods, and not non-crisis periods, it is impossible to know for sure whether the macro variables are really causing the crisis. For example, even if most crises occur when countries have high current account deficits, there are many periods when countries have high current account deficits and yet do not have financial crises. Looking only at crisis periods, we might conclude that current account deficits cause crises. Looking at all periods, not just crisis periods, we (might) conclude that they do not. Or we might find a conditional effect: rapid depreciations in the current account cause crises, but more gradual depreciations do not. Or maybe levels matter more than changes, or maybe there is an interactive effect between the current account balance and levels of national debt. Etc. This is why research is hard.

But then Singer goes on a harangue:

Despite the challenges of causal inference, many social scientists seem content to attribute the financial crisis to underlying macroeconomic imbalances. In my view, these arguments provide useful cover for financial regulators who might otherwise be held accountable for their rule-making. If systemic failure is the periodic and ineluctable result of global capital cycles, then there is little reason for regulators to enact tougher regulations. Why should central banks and regulatory agencies impose more stringent capital requirements and prohibitions against risky investments? If the roots of the crisis are macro-structural, regulators feel no incentive to alter the rules. How else can we explain why U.S. regulators, when facing the public or their overseers in Congress, speak of recent bank failures as if they were exogenous acts of nature? ...

From a research design perspective, a reasonable way forward is to test hypotheses about the conditional impact of capital inflows on the probability of financial crises in the developed world. The scope and quality of regulation are likely contenders for inclusion in such a model. The cases of Australia and Spain suggest that large capital inflows might be less destabilizing if the banking system faces strict capital requirements and prohibitions against non-traditional banking activities. Other possible conditioning variables include, inter alia, resource endowments, partisanship, and corporate governance.

Singer has done a lot of good research on regulation (as I am trying to do, now), so it makes sense that he thinks it's important. I do too. But as far as I know there is no persuasive research showing that crises are the result of poor or lax regulation either. At least not of the "large-N", quantitative variety. One of the reasons for this is that cross-national time series data on financial regulations are rare and incomplete. But even a cursory look across the past few years of history suggests it's more complicated than that. India was recently regarded as a paragon of financial stability... until it wasn't. In fact, the U.S. had stricter regulations pre-crisis (at least in terms of capital adequacy and leverage) than many other major economies, including Germany and Japan, and it's been the U.S. (and U.K.) pushing for tougher standards in the Basel negotiations.

Despite some harmonization through the Basel Accords, national regulatory standards still vary quite a lot. Nevertheless, the subprime crisis spread throughout the system in ways that make national regulatory standards look largely irrelevant. At least, there's no clear pattern to me. What best predicts exposure to crisis (to me) seems to be how integrated a country is in the international financial system, especially to the U.S. and U.K., and how large the banking sector is relative to GDP. Countries that were very tightly connected and had large financial sectors (e.g. Iceland, Ireland, the U.S. and U.K.) have suffered quite a lot. Those that were less integrated into the system or had smaller financial sectors (e.g. Australia, Brazil) have done better.

Singer mentions Spain as a positive example, which is curious because Spain is in the middle of a banking crisis right now that has already required massive public sector bailouts, and that appears to be intensifying and now is threatening to turn in a sovereign debt crisis. (Which is exactly what R&R would predict, by the bye.) This despite the fact that, as Singer notes, Spain has a relatively strict regulatory structure.

Considering a time series leaves us even more unsure. In the U.S., Glass-Steagall didn't prevent the crises revolving around the Latin American debt, savings and loans, and dot-com bubbles. The Basel Accords obviously didn't do their ostensible job either, either in the 1990s or 2000s. The U.K. had more financial instability before "light touch" than after, until 2008. It's not that crises are exogenous shocks; it's just that the regulatory structure doesn't appear to tell us too much about how susceptible to crisis countries are either. Of course we don't know that for sure, because data limitations have limited our ability to rigorously tests these claims. But it isn't obviously true, even if it is intuitive and intellectually appealing.

I think Singer is correct about his main point: R&R doesn't tell us everything we need to know. There are certainly intervening variables that are important, and strength of regulation may be one of them. In fact, I would be very surprised if regulation had no effect on stability or instability. But we also need to remember that regulations are political creations; there is no ex ante reason to believe that regulatory codes are even primarily intended to promote stability. Regulations affect distribution, and that makes them inherently political rather than technocratic. Indeed, much of the Dodd-Frank reform bill was about either punishing financial institutions, protecting consumers, shuffling regulatory authority, or winding-up failed institutions. Not a whole lot of it really concerned stability, and it didn't say much of anything about capital, liquidity, or leverage.*

Jeffrey Friedman has argued that specific parts of the regulatory code -- those privileging mortgage debt, asset-backed securities, and OECD sovereign debt -- made the system less stable. These parts of the regulatory code had an explicitly political purpose: to encourage home-ownership, especially among the lower classes, and to make access to bond markets incredibly cheap for governments. This ground is ripe for political economists.

Singer concludes with this:

Until we conduct more rigorous tests, social scientists will remain in the uncomfortable position of offering only speculation and conjecture. The availability of hundreds of years of data on previous crises should not give us a false sense of confidence about our capacity to explain. Indeed, we simply do not know whether this time is different or not.

I completely agree. I would argue that this applies equally to claims about the effects of regulation as well which are, as of now, at least as speculative and conjectural.

*Title I concerns financial stability, but mostly reorganizes already-existing regulators and tasks them with monitoring and addressing systemic weaknesses. It doesn't create any substantive new statutory requirements of banks.

Dodd-Frank: The Good Stuff

Economics of Contempt has a wonderful two-post series on the importance of resolution authority for bank regulators. Basically, this means that when a large bank goes under, there needs to be a process in place for dealing with the bank's creditors. Why is this important? He lays it out in part one:

To take one example: Lehman’s holding company (LBHI) filed for bankruptcy, but at the last minute its US broker-dealer (LBI) was kept out of bankruptcy by the NY Fed. The problem was that no one knew about this — most people thought LBI had filed too. Lehman had all sorts of problems getting employees to even show up for work; JPMorgan, which was LBI’s clearing bank, unilaterally shut off LBI’s access to its accounts for several days, and actually started seizing assets of LBI’s prime brokerage clients (a huge no-no); clearinghouses improperly limited LBI’s trading activity; the NSCC mistakenly seized a large amount of LBI’s customer securities; Lehman’s European broker-dealer (LBIE) stopped payments to LBI’s omnibus account even though LBI continued to make payments to LBIE; incoming customer securities to LBI weren’t getting properly segregated; counterparties simply stopped posting collateral they owed on OTC derivatives with LBI; and so on. That first week, the biggest challenge was simply getting someone at Lehman on the phone. (I saw a 63-year-old senior partner do a fist-pump you’d have to see to believe when he finally got an account executive at Lehman on the phone. Unquestionably the highlight of my week.)

You get the picture: it was utter chaos, in no small part due to sheer confusion about what was going on.

He argues that a big reason why Lehman's collapse had such a huge effect on financial markets is that nobody knew what was going on, how much of their money was lost, or even who to call to try to get it back. Given the similar concerns about basically every other Wall Street firm, investors had no idea if their funds were safe, or if/when they'd be repaid if their counterparties went under.

This gets even more complicated when you consider international firms. Which country's creditors get paid, and which get left in the cold? This is part of the ongoing Basel negotiations:

Lehman’s collapse also showed the need for a cross-border mechanism to wind down failing banks that have a global reach. More than 80 proceedings against the firm, involving hundreds of subsidiaries worldwide, have complicated recovery by creditors and destroyed much of the value of its assets.

The Financial Stability Board, which includes most Basel committee members as well as finance ministers from the Group of 20 nations, struggled to come up with such a resolution mechanism this year. The FSB postponed a decision until next year after divisions among nations proved too wide to bridge, members said. The group has been unable to agree on how to distribute losses among countries when a global bank fails and how different legal jurisdictions can recognize a single authority to pay creditors, the members said.

Fortunately, the Dodd-Frank bill gives the U.S. government resolution authority, and there is a similar mechanism in place in the U.K. As Econ of Contempt notes in part two, those are the only two countries that really matter:

What about all those thorny international problems? Well, the truth is that in terms of systemic risk, there’s only one other jurisdiction that really matters: the UK. New York and London are still the two dominant financial centers, and the vast majority of transactions at the major US banks flow through either New York or London. It’s important to understand that it was the UK’s ridiculously backward somewhat dated insolvency regime that forced the liquidators of Lehman’s European broker-dealer to seize so many client assets and assets of affilates. Fortunately, the UK now has their own version of the OLA, which they call the “Special Resolution Regime,” and was enacted as part of the Banking Act of 2009. The Special Resolution Regime is, like the OLA, modeled explicitly on the FDIC resolution authority, and gives the Bank of England the same wide-ranging tools to wind down a London broker-dealer in an orderly fashion — including, significantly, the power to create “bridge banks” to ensure that key functions can continue uninterrupted. Cross-border problems that aren’t identified and dealt with in the resolution plan can, if necessary, be dealt with by bridging the relevant entities until a solution can be fashioned.

I like this line of argument, and I've made the case several times before that basic ignorance was a major problem in the crisis. In my first post on Dodd-Frank I argued that the provisions that increased transparency in the financial system, like resolution authority, were much better than trying to create the perfect regulatory structure that would prevent financial crises from occurring in the first place. The latter approach is sure to fail. The former can do some real good.

I strongly recommend reading both of these posts. They are wonky, but if you are interested at all in what Dodd-Frank did, or why it's important, you'll learn quite a lot.