Cycle-proof regulation

IF YOU FIND IT TOO LONG READ FROM THE 7 PARAGRAPH DOWN. THANKS

AS THE G20 summit showed, we typically regulate in the midst of a bust. That is when righteous politicians feel the need to do something, bankers’ frail balance-sheets and vivid memories make them eschew risk, and regulators have their backbones stiffened by public disapproval of past laxity.

But we reform under the delusion that the regulated, and the markets they operate in, are static and passive, and that the regulatory environment will not vary with the cycle. Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system. We need to acknowledge these differences and enact cycle-proof regulation.

If we don’t, there are many dangers. Recent reports have argued for “counter-cyclical” capital—raising bank capital requirements a lot in good times, while allowing them to fall somewhat in bad times. While sensible prima facie, these proposals may be far less effective than intended.

That is because in boom times, the market requires banks to hold very low levels of capital, in part because euphoria makes losses seem remote. So when regulated firms are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated operators, as banks did with structured investment vehicles and conduits during the current crisis. Even if regulators are strengthened to prevent this shift in activity, banks can subvert capital requirements by taking on risk the regulators do not see or do not penalise adequately.

Attempts to reduce capital requirements in busts are equally fraught. The risk-averse market wants banks to hold a lot more capital than regulators require, and its will naturally prevails. Even the requirements themselves may not be immune to the cycle. Once memories of the current crisis fade and the ideological tide turns, there will be enormous political pressure to soften capital requirements or their enforcement.
The three Cs

To have a better chance of creating stability through the cycle—of being cycle-proof—new regulations should be comprehensive, contingent and cost-effective. Those that apply comprehensively to all leveraged financial firms are likely to discourage the drift from heavily regulated to lightly regulated institutions during the boom. This drift is a source of instability since the activities that heavily regulated banks hive off often return to haunt them in the bust, through unforeseen channels. Regulations should also be contingent so that they have most force when the private sector is most likely to do itself harm, but impose fewer restrictions at other times. This will make regulations more cost-effective and so less prone to arbitrage or dilution.

What form could such regulations take? First, instead of asking institutions to raise permanent capital, ask them to arrange for capital to be infused when they or the system is in trouble. Because these “contingent-capital” arrangements will be entered into in good times when the chances of a downturn seem remote, they will be cheap (compared with raising new capital in the midst of a recession) and thus easier to enforce. Because the infusion is seen as an unlikely possibility, firms cannot raise their risk profile, using the future capital as backing. And since it comes at bad times, when capital is scarce, it protects the system and the taxpayer.

One version of contingent capital is for banks to issue debt which would automatically convert to equity when both of two conditions are met: first, the system is in crisis, either based on an assessment by regulators or based on objective indicators; and second, the bank’s capital ratio falls below a certain value*. The first condition ensures that banks that do badly because of their idiosyncratic errors, rather than because the system is in trouble, don’t avoid the disciplinary effects of debt. The second condition rewards well-capitalised banks by allowing them to avoid the dilutive effect of the forced conversion (the number of shares the debt converts to will be set at a level so as to dilute the value of old equity substantially). It will also give banks that anticipate losses an incentive to raise new equity.

A collateral benefit is that, anticipating forced conversion, banks will raise new capital expeditiously when they make losses, thus protecting taxpayers. Of course, learning from the recent experience of foreign investors who put in money just before American banks declared more losses, new equity investors will need to be convinced that banks have disclosed fully all potential losses they know about.

Another version of contingent capital is the requirement that systemically important, and leveraged, financial firms buy fully collateralised insurance policies (from unleveraged firms, foreigners, or the government) that will capitalise these institutions when the system is in trouble**. Yet other versions would require banks to issue capital to top up losses based on public signal†.
Got any weekend plans?

There could also be regulations aimed at institutions regarded as “too big to fail”. Imposing limits on their size and activities will become very onerous when they are growing fast, thus increasing the incentive to water down any curbs. Perhaps, instead, a more cyclically sustainable approach would be to make them easier to close. What if firms big enough to pose a threat to the stability of the financial system were required to develop a plan that would enable them to be resolved over a weekend?

Such a “shelf-bankruptcy” plan would require banks to track, and document, their exposures much more carefully, probably through better use of technology. The mechanism would need to be stress-tested by regulators periodically and supported by legislation—such as one to facilitate an orderly transfer of the institution’s swap books to third parties. Not only would the need to develop a plan give these institutions the incentive to reduce needless complexity and improve management, it would not be particularly onerous in the boom, and might force management to think the unthinkable.

A crisis offers us a rare opportunity to implement reforms. The temptation will be to over-regulate, as we have done in the past, only to liberalise excessively over time. It would be better to think of regulation that is immune to the cycle.

IT LOOKS LIKE ASKING BANKS TO HOLD A BIGGER % OF RESERVES. NOT BAD PHILOSOPHICALLY SPEAKING.....WE HAVE TO SEE IN PRACTICE.