This column is a lead commentary in the VoxEU Debate "Banking reform: Do we know what has to be done?"
In the decades leading up to the recent banking crisis, regulators and supervisors consistently failed in three key areas:
- They did not measure banks’ risks credibly or accurately, or set sufficient minimum equity capital buffers in accordance with those risks so that banks would be able to absorb potential portfolio losses reliably;
- They failed to enforce the inadequate capital requirements they imposed because supervisors consistently failed to identify bank losses as they continued to mount, thus allowing banks to overstate their levels of capital;
- They failed to design or enforce intervention protocols for timely resolution of the affairs of weakened banks to limit the exposure of taxpayers to protecting the liabilities of feeble, ‘too-big-to-fail’ banks.
The failures of prudential bank regulation have been visible for decades and have motivated many regulatory reform proposals by financial economists (den Haan 2012).
Solutions to regulators’ failures
There are credible solutions to the key policy challenges that the government faces. For the most part, my proposed solutions to those problems are not new; they have been known and advocated by financial economists for some time. The failure to prevent the crisis was not a failure of thinking, but a failure of will on the part of our political system. Our politicians and regulators have found it expedient to offer hidden subsidies for risk taking to bankers through the combination of safety net protection and ineffectual prudential regulation. Attempts to identify and rein in those subsidies have been defeated politically time and time again.
Will proposed reforms in response to the crisis be effective this time round? Will reformers succeed in implementing changes in the rules of the game that would reduce the chance of a repeat of the recent crisis? The experience with post-crisis reforms in financial history offers, at best, a mixed record of responses (see Calomiris 2010, 2011).
Overall, it is fair to say that there is much cause for pessimism for a simple reason: politicians don’t really have strong incentives to solve the problems of banking regulation; they have strong incentives to only pretend to do so.
Keeping up appearances
The typical post-crisis response gives the appearance of diligence, as politicians and regulators assemble a laundry list of the things that went wrong in the crisis – typically defined with reference to the specific symptoms of poor policies and not to the deeper incentive problems that policy errors have produced. That laundry list then gives rise to a new, more complex set of regulatory initiatives, and these laws and rules are advertised as preventing a recurrence of the problems.
Deficiencies are supposedly remedied by ever-more-complex sets of rules for measuring risk, by granting increased supervisory discretion to a variety of new government officials with varying mandates, by scores of new research initiatives pursued by increasingly fragmented research and supervisory divisions at central banks and supervisory agencies, by the creation of new international study groups. Is it too cynical to see this exponential increase in complexity of rules, and of the regulatory and supervisory authorities charged with designing and enforcing them, as deliberately designed to reduce accountability by dividing responsibility and by making the regulatory process less comprehensible to outsiders? I don’t think so.
The implicit theory behind these sorts of initiatives, to the extent that there is a theory, is that the recent crisis happened because regulatory standards were not quite complex enough, because the extensive discretionary authority of bank supervisors was not great enough, and because rules and regulations prohibiting or discouraging specific practices were not sufficiently extensive. That theory is demonstrably false. At the core of the recent financial crisis – and the many that preceded it around the world in the past three decades – have been basic incentive problems in the rules of the game set by the government. The pre-crisis environment was one in which regulatory complexity was unprecedented, supervisory enforcement was virtually non-existent, and private risk taking at public expense was virtually unlimited. And yet this is precisely the environment that has produced the most unstable 30 years in global banking history, and the most severe financial crisis in the US since the Great Depression.
What should the rules look like?
The need is not for more complex rules, and more supervisory discretion, but rather for rules that:
- Are meaningful in measuring and limiting risk;
- Are hard for market participants to circumvent;
- Are credibly enforced by supervisors.
These qualities are best achieved by constructing simpler rules that are grounded in an understanding of the incentives of market participants and supervisors.
The keys to effective reform in all these categories are, first, recognising the core incentive problems that have encouraged excessive risk taking and ineffective prudential regulation and supervision, and, second, designing reforms that are ‘incentive-robust’ – that is, reforms that are likely not to be undermined by the self-seeking regulatory arbitrage of market participants, or the self-seeking avoidance of the recognition of problems by supervisors.
I have developed numerous specific incentive-robust reform proposals (for details see Calomiris 2013, Calomiris and Herring 2012). These include:
- The reform of the regulatory use of ratings that would quantify the meaning of debt ratings and hold Nationally Recognized Statistical Rating Organizations (NRSROs) financially accountable for egregious inaccuracy in forecasting the probability of default of rated debts;
- The use of loan interest rate spreads as forecasts of non-performing loans for purposes of budgeting capital to absorb loan default risk;
- The establishment of a transparent and simple contingent capital (CoCo) requirement that incentivises large banks to replace lost capital in a timely way (rather than disguise losses and avoid replacing lost capital);
- The setting of simple cash requirements for banks (this would not resemble the complicated and poorly conceived new ‘liquidity’ requirements created by the Basel III process);
- The creation of a simple macro prudential rule to govern the variation in capital requirements over time and, which would trigger changes only under extreme circumstances, based on objective, observable criteria;
- A reform of resolution procedures for large financial institutions that would require a pre-specified minimum haircut on unsecured creditors whenever the resolution authority employs taxpayer funds in the resolution (i.e. whenever there is a departure from the enforcement of strict priority in the resolution process);
- The establishment, as part of the ‘living wills’ of global financial institutions that govern their prospective resolution, of clearly demarcated lines of legal and regulatory jurisdiction (‘ring fencing’) over the disposition of all the assets and liabilities within a bank.
This program of reform would be effective in addressing the real challenges that have threatened our financial system for decades, and continue to threaten it. And this approach would avoid much of the collateral damage that comes from the many hundreds of pages of complex, costly and misguided mandates that are typically substitutes for credible reform. Politicians, however, almost universally hate these sorts of simple ideas, based on observable criteria, precisely because they work by removing the discretionary control that politicians, bankers, and regulators enjoy and abuse over the enforcement of regulatory standards. Overcoming that challenge will require more than good economic thinking.
Calomiris, Charles W (2010), “The Political Lessons of Depression Era Banking Reform”, Oxford Review of Economic Policy, 26, Autumn, 540-560.
Calomiris, Charles W (2011), “Banking Crises and the Rules of the Game”, in Nicholas Crafts, Terry Mills, and Geoffrey Wood (eds.), Monetary and Banking History: Essays in Honour of Forrest Capie, Oxford, Routledge.
Calomiris, Charles W, “An Incentive-Robust Programme for Financial Reform”, Journal of Financial Perspectives, forthcoming.
Calomiris, Charles W, and Richard J Herring (2012), “Why and How to Design a Contingent Convertible Debt Requirement”, in Yasuyuki Fuchita, Richard J Herring, and Robert E Litan (eds.) Rocky Times: New Perspectives on Financial Stability, Brookings, 117-62.
Den Haan, Wouter (2012), “Banking reform: Do we know what has to be done?”, VoxEU.org, 30 November.