It seemed that a new model for global governance had been forged in the white heat of the financial crisis. When the G7 gave way to the G20, leaders representing 80% of the world’s population began to call for a global policy response to the crisis. After governments opened the fiscal sluice gates, interest rates were slashed and the IMF was given additional resources. But now the ashes are cooling and senior U.S. officials are saying “nobody is going to tell us how to regulate our banks.” Different national perspectives are emerging in the area of international bank regulation.
The emphasis in Europe has been on how to regulate financial markets to moderate future crises. The argument runs that credit mistakes are made during the boom, not during the crash, so better regulation and monetary policy during the boom years could limit the scale of any bust. They add that in a crash, moreover, markets are not very discerning, and it is hard to strike a balance between those to be saved and those to be thrown to the wolves. Europeans now focus therefore on how to limit financial crashes by introducing new macro-prudential regulations, for instance counter-cyclical charges levied by systemic risk committees, and by creating minimum liquidity buffers.
In the U.S. the approach is somewhat different, reflecting perhaps Americans' greater belief in markets and their stronger mistrust of regulation. The emphasis across the Atlantic has been on finding market-friendly ways to contain spillovers from bank failure. Policy debates in the U.S. are chiefly preoccupied with concerns that banks should never be “too big to fail”; that private investors rather than taxpayers should hold “contingent capital” which in a crash can be converted into equity and that improvements to the functioning of “over-the-counter” markets must be made through the greater use of centralised trading, clearing and settlements. These proposals are less about modifying capital requirements and more about prohibitions and taxation. In the case of the Volcker Plan, banks would not be allowed to do “risky” things, and in that of the Obama Levy large balance sheets will be taxed to repay bail-out funds.
The chief point of intersection between the different U.S. and European approaches concerns the major banks. This has less to do with a convergence of regulatory thinking on bank size or function than it has to do with a common need to play to the political gallery as well as to raise more tax revenue. This shared desire to increase the tax yield from bankers sits well with the idea that in future policy should act as a disincentive for banks from becoming systemically more important. I myself have long argued in favour of this point, but I have also come to realise that the whole idea of making sure banks are not “too big to fail” is partly based on an illusion.
Banks’ balance sheets bloated by leverage are systemically dangerous, and it is this regulatory or fiscal policy should address through liquidity buffers and leverage ratios. But given the contagiousness of financial crises, it is likely that what is “too big to fail” is actually small. Any list of institutions that were “too big to fail” conjured up in 2006 would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns or even Lehman Brothers. Banks lend to banks, so while some are more illiquid than others, they are all intrinsically illiquid institutions. Small failures can give birth to large panics, which means that in a crisis almost everyone is “too big to fail”.
The reality is that we can have as large a financial boom with its subsequent crash, resulting in the same economic misery, in a world made up only of small banks. It is worth recalling the 1973-1975 secondary banking crisis in the UK, in which the collapse of a property boom meant that some 30 relatively small financial institutions had to be supported by the Bank of England. The impact on the UK economy of that crisis rivals, and by some measures even exceeds, the effects of the current financial crisis. It was one of the reasons that bank supervisors began to take a more benign view of large banks snapping up smaller ones. The argument at that time was that smaller financial institutions were less efficient than larger and more profitable banks and had little “franchise value”, and would therefore under-invest in their own longevity by employing less conservative lending practices that would make them more competitive.
Crashes follow booms, and booms are themselves fuelled by some new dawn – normally the arrival of new technology – that makes bankers feel that the world is becoming a brighter place, that risks have fallen and that they are therefore justified in lending and leveraging more. This behaviour is even more acute today in the age of “risk-sensitive” regulation than it was in the old-fashioned world of credit and concentration limits and lending by rule of thumb. The systemic effect of having one large bank engaged in rapid lending growth is no different than having several small banks doing so. Indeed, it may even be easier to head-off a crisis when there is just one large bank.
It can be argued that underestimating the risks run by bankers is encouraged by the belief that if it all goes “belly up”, their institutions are too big to fail and so their jobs will be safe. But if that latter belief dominated bankers’ thinking, they might not worry about their job but would still worry about their savings. In other words, they would not wrap themselves up in the equity of their institutions and the leveraged products they were selling. Yet in the event they did. The revealed preference of banks’ and bankers’ behaviour is that they did not lend more because they thought they could get away with it, but because they thought it was safe. They were fools more than knaves.
The main driver of excessive lending and leverage is a mistaken view of risks – shared by everyone. The riskiest institutions were not the largest, for large institutions like J. P. Morgan and HSBC proved safer than others and neither sought nor needed state funding. Those that failed were relatively small like IKB, Bear Sterns and so on. There is an all-too-narrow dividing line between this argument and the one that got us into this mess. Big banks like the idea that regulation should care less about the size of banks and more about their riskiness, and so champion the “risk-sensitive” approach to bank regulation, not least because they have the bigger risk models and databases, so risk-sensitive regulation is more onerous for their smaller competitors. The problem is that if booms are fuelled by an underestimation of risks, and regulation is made more sensitive to the estimation of risks, then the booms will be bigger and the busts deeper. This is the fallacy of the “risk-sensitive” approach to risk management, regulation, and auditing. A better argument for curbing bank size is the excessive influence of big banks on policy.
What policymakers should therefore be looking for is regulation that makes the financial system less sensitive to the error in the markets’ estimate of risk, not more so. There are two ways to do this. The first is to observe that this error is strongly correlated to the boom-bust cycle. Booms have similar characteristics – strong growth in bank balance sheets and credit, and therefore a rise in leverage. The appearance of these implies an increased probability of the market underestimating risk, so systemic risk regulators should raise minimum capital requirements as soon as they spot these trends. Counter-cyclical capital requirements fit in with this idea, and a range of indicators could be used to calibrate the rise in the capital requirements, coupled perhaps with some discretion although not too much. There are many reasons why the market fails to correct systemic error, the least rigorous being that booms are always founded on a good story that takes in both regulators and bankers of why “this time it is different”. Let’s not forget the essays in central bank stability reports on how credit derivatives were bringing new stability to the financial sector.
The second way to reduce the sensitivity of the financial system to the errors of estimating risk is to limit the flow of risks to institutions with a structural capacity for holding that risk rather than a statistical capacity. That way when the risk modellers get it wrong we will be in less trouble. Credit risk is best hedged through diversification across uncorrelated credits. Liquidity risk is best hedged through diversification across time. Market risk is best hedged through a combination of diversification across assets and having enough time to decide when to sell. In the past, volatility of similar statistical magnitudes were considered to be fungible risks and they could flow to whoever was prepared to pay for that level of risk. But while banks with short-term funding and many branches originating different loans have a deep capacity for holding credit risks, they have a limited capacity for holding market risks and little capacity for holding liquidity risk. Insurance companies and pension funds on the other hand have limited capacity for credit risk, but more for market and liquidity risks. Capacity for risk is related to the maturity of funding, not to what an institution is called.
Although responses to the global financial crisis are becoming more national and less global, some current proposals for reforming banking regulation have promise. This is especially the case in the area of the counter-cyclical measures being championed by Europeans, and also in the emerging ideas on how to fragment financial institutions that are being put forward in the U.S. by former Fed Chairman Paul Volcker, although I personally think that fragmentation should be along the lines of risk-capacity and not according to legal entities or names. We should nevertheless be careful, however tempting it may be, to expect too much from simply bashing big banks.
by Avinash Persaud - Chairman of Intelligence Capital Limited and Emeritus Professor of Gresham College, London. He also chaired the regulatory sub-committee of the UN Commission ("Stiglitz Commission") on Financial Reform.
