October 4, 2013

There seems to be almost universal consensus that using public funds to protect large institutions from failure, commonly called “bail-out,” is bad policy. There is nothing like a consensus, however, on what should be done about it, and execution seems to be floundering. Three approaches have emerged, only one of which has much chance of being successful. 

 Alternative Approaches 

Approach 1: Commit That Bail-outs Will Never Happen Again: Under this approach, the Government adopts a policy that it will never again rescue a major bank faced with impending failure, regardless of what the consequences might be. This seems to be the favored policy position of those who have not thought through all the implications.  

The problem with this approach is that so long as we have Government agencies and public officials with responsibilities for promoting economic growth, price level stability and high employment, it cannot be implemented. The public officials who made the bailout decisions during 2007-9 were forced to choose between using public funds to bail out an imprudent institution, or allowing the failure of that institution to destroy hundreds of innocent firms and the jobs of thousands of innocent workers. They properly chose the bailout as the lesser evil. If public officials ever have to face that horrible choice again, we will want them to make the same decision.

Approach 2: Prevent Systemically Important Firms From Failing by Imposing High Capital Requirements. This is the Dodd-Frank approach that Federal agencies and legislators are now attempting to implement. Under this scheme, regulators would tag as “systemically important” (SI) every financial firm that is so large and inter-connected with other firms that its failure would destabilize the world’s financial system. Since failure results from losses that exceed a firm’s capital, SI  firms would be subjected to capital requirements high enough to absorb the losses that might occur under the worst circumstances. Just as the ocean liner Titanic was built to be unsinkable, SI firms would be made unfailurable. The analogy is apt, even if the underlined word doesn’t yet exist.   

The first step in this approach is to identify SI firms, a process that has already started. Under Dodd-Frank, a super-committee of regulatory agencies has been compiling a list of banks and other major firms that are systemically important. While this requires some tough decisions, particularly as it applies to firms other than banks, it is clearly doable.  

What is not doable is using capital requirements to reduce the risk exposure of the SI firms, to the point where these firms could survive any economic shocks to which they might be subjected. The problem is that capital requirements can be gamed by the SI firms subjected to them, and regulators cannot be depended on to prevent it, This will be discussed below.  

Approach 3: Adopt a Better Regulatory System That Shifts the Cost of Bail-outs to Systemically Important Firms:  The major objection to bail-outs is less that the firms affected don’t deserve it but that public funds are used for the purpose. If we had a way to require SI firms as a group to pay the cost of bail-outs, the too-big-to-fail problem becomes manageable.  

A regulatory system that can’t be gamed by SI firms already exists and has been rigorously tested in other markets. This system, discussed below, could be easily modified to shift the cost of any required bail-out to SI firms.  

The Intuitive Appeal of Capital Requirements 

The capital of a firm is the value of its assets less the value of its liabilities. Insolvency occurs when asset values decline to the point where they are smaller than liabilities, meaning that capital is negative.  

The larger a firm’s capital is at any time, the larger the shrinkage in asset values it can suffer before becoming insolvent. It seems intuitively obvious, therefore, that the way to make an SI firm completely safe is to raise its capital requirements to the point where the firm can withstand any shock to the value of its assets. But this view fails to account for the reactions of the firm to higher requirements.   

The Incentive to Evade Capital Requirements 

 Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario, such as the financial crisis in 2007-2008.  For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it.. In a study of international banking crises, Richard Herring and I called this “disaster myopia”.

Disaster myopia is reinforced by “herding”. Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy, and opening itself to a possible takeover.

Even when decision makers are prescient enough to know that a severe shock that will generate large losses is coming, it is not in their interest to hold the capital needed to meet those losses. Because they don’t know when the shock will occur, preparing for it would mean reduced earnings for the firm and reduced personal income for them for what could be a very long period. Better to realize the higher income as long as possible, because if they stay within the law, it won’t be taken away from them if the firm later becomes insolvent.

Gaming Capital Requirements and Out- Smarting Regulators

A capital requirement of, say, 6%, means that a firm will remain solvent in the face of a shock that reduces the value of its assets by 5.99%. How safe that is depends on the size of potential shocks that reduce the value of assets, which in turn depends on the riskiness of the assets the firm holds. SI firms can game the system by shifting into higher-yielding but riskier assets that are subject to larger potential shocks.

Risk-Adjusted Capital Requirements Don’t Help Much

Regulators have tried to shut down this obvious escape valve by adopting risk-adjusted capital ratios, where required capital varies with the type of asset. SI firms must hold more capital against commercial loans, for example, than against home loans that are viewed as less risky. However, this does not prevent the firm from making adjustments within a given asset category. For example, during the years prior to the financial crisis, some mortgage lenders shifted into sub-prime home mortgage loans, which were subject to the same capital requirements as prime loans. 

Market Bubbles Can Also Undermine Capital Requirements

A given set of capital requirements may make SI firms safe in one economic environment, but not in another. In particular, if a bubble emerges in a major segment of the economy, as it did in the home mortgage market during 2003-2007, a massive shock to asset values will occur when the bubble bursts.

Regulatory Corrections Are Unlikely

In principle, regulators can offset a shift toward riskier assets within given asset categories by breaking the categories down into even smaller sub-categories subject to different capital requirements. And they can adjust to emerging bubbles by raising requirements for the sector being impacted by the bubble. But such actions require a degree of intelligence, foresight, and political courage on the part of regulators that history suggests we have no reason to expect.

Banks and other depositories have been subject to capital requirements since the 1980s. During the housing bubble, regulators did not set higher capital requirements for sub-prime mortgages, nor did they increase the ratios overall.

The need is for a regulatory system that can’t be gamed by SI firms; that does not require regulators to be smarter, or more strongly motivated than the firms they regulate; and that in the event that an SI firm nonetheless fails and needs to be bailed out, the cost of bail-out will be imposed on all SI firms rather than taxpayers.

An Alternative to Capital Requirements: Transaction-Based Reserving

Under transaction-based reserving (TBR), financial firms are regulated as if they were insurance companies that are obliged to contribute to a reserve account in connection with every asset they acquire. The portion of the cash inflows generated by the asset that is allocated to the reserve account depends on the potential future outflows associated with the asset.

If the asset is a loan or security, the required allocation to a contingency reserve would be, say, 50% of the portion of the income generated by the asset that is risk-based. If a prime mortgage was priced at 4% and zero points, for example, the reserve allocation for a 6% 2 point mortgage might be ½% plus 1 point.

Contingency reserves can’t be touched for a long period, perhaps 15 years, except in an emergency. Inflows allocated to reserves would not be taxable until they were withdrawn.

Advantages of TBR

The major advantage of TBR is that it applies to every transaction with a risk component, whether it is shown on the firm’s balance sheet or not. It is akin to a capital requirement that is applied to every individual asset and risk-generating activity. The firm cannot game the system by shifting to riskier assets within the asset groups specified by the regulator, or by incurring new types of obligations that are not shown on the balance sheet, as they can with capital requirements. 

Another advantage of TBR is that regulators need not make judgments about the riskiness of different assets – judgments they are not well-equipped to make. Such judgments are made by the firm itself in its pricing.

To some degree, TBR automatically dampens the excessive optimism that feeds bubbles. A shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums. To the degree that a euphoric SI firm underprices risk during such episodes, however, failure is possible, and with it the possible need for a bail-out.

This points up another critical advantage of TBR, which is that it provides a mechanism for shifting the cost of a bailout to the SI firms. Part of the reserve allocation of SI firms (but not other firms) would accrue not to their reserve account, but to that of the FDIC. It would be held by FDIC to cover any losses associated with the bail-out of an SI firm, should that prove necessary.

Experience of Private Mortgage Insurance Companies Is Relevant

Private mortgage insurance companies (PMIs) have been subject to TBR since their inception in the 1950s. They must allocate 50% of their premium income to a contingency reserve for 10 years. The system was not rigorously tested until the recent financial crisis, which devastated the industry and battered their shareholders. Yet  the PMIs have been able to meet all their obligations in connection with the extraordinary losses suffered by lenders during the crisis. TBR allowed the PMIs to do exactly what they were chartered to do: cover losses out of their reserves. There were no bail-outs of PMIs.