This column is a lead commentary in the VoxEU Debate "Banking reform: Do we know what has to be done? "
A financial institution’s capital is defined as the difference between the value of its asset and liability positions. The idea that capital requirements can serve as a stabilisation tool is based on the presumption that, other things being equal, the strength of an institution’s hold on economic solvency can be proxied by the size of its capital position.
This way of crunching the numbers seems simple and reliable, but it is neither.
- It is not simple because accounting principles offer numerous variations in how to decide which positions and cash flows are and are not recorded (so-called itemisation principles), when items may or may not be booked (realisation principles), and how items that are actually booked may or may not be valued (valuation principles).
- It is not a reliable proxy for a firm’s survivability because, as a financial institution slides toward and then into insolvency, its managers are incentivised to manipulate the ways they apply these principles to hide the extent of their weakness and to shift losses and loss exposures surreptitiously towards the government's safety net.
These incentives are reinforced by the ethically questionable notion that managers owe enforceable duties of loyalty, competence, and care to their stockholders and explicit creditors, but not to taxpayers or government supervisors.
Capital adequacy as a flawed centrepiece for regulation
The lessons the crisis teaches about the extent to which managers of failing firms can lawfully overstate their accounting capital make it irrational to allow capital to remain the centrepiece of the world’s strategy of financial regulation. Only by turning a blind eye to their clientele’s finely tuned taste for lawful deceit can regulators portray capital requirements as a powerful medicine that will be taken in the spirit it is prescribed.
- Capital-requirements medicine not only failed to prevent the last crisis, it helped to inflate the shadow-banking and securitisation bubbles which, when they burst, triggered the Great Recession (Caprio, Demirgüç-Kunt and Kane 2010; Admati and Hellwig 2013);
- Increasing the dosage and complexity of the capital-requirements medicine and prescribing it for a larger range of firms cannot make the system stable again.
Capital requirements have turned out to be toothless whenever and wherever their enforceability has been severely tested.
The real problem and how to ameliorate the situation
The root problem is that the existence of government safety nets gives protected firms an incentive to shift risk to taxpayers. Asking firms to hold more capital than they want lowers the return on equity their current portfolio can achieve. This means that installing tougher capital requirements has the predictable side effect of simultaneously increasing a firm’s appetite for risk, so as to increase the rate or return on its assets enough to establish a more satisfying equilibrium. As Basel III becomes operational, aggressive institutions can and will expand their risk-taking over time in clever and low-cost ways that, in the current ethical and informational environments, regulators will find hard to observe, let alone to discipline. When it comes to controlling regulation-induced risk-taking, regulators are outcoached, outgunned, and always playing from behind.
To my mind, excessive financial-institution risk-taking traces to a misconception of the rights and duties conferred on managers of firms protected by a safety net.
- Meaningful reform must begin by changing the informational and ethical environment to make it harder for aggressive firms to extract uncompensated benefits from taxpayer-funded safety nets.
- Authorities must insist that, in the future, accounting principles recognise that national safety nets give taxpayers an ‘equitable interest’ in any firm that threatens to be politically, administratively, or macroeconomically difficult to fail.
The purpose of this is to establish enforceable duties of loyalty and care to taxpayers for managers of financial firms.
- Taxpayers’ stake in such firms deserves to be estimated honestly and recorded explicitly on corporate balance sheets statements as a contra-liability.
The value of taxpayers’ credit support deserves to be recorded as a contra-liability because it supplies implicit ‘safety-net capital’ that substitutes one-for-one for on-balance-sheet capital by transferring responsibility for financing the deep negative tail of profit outcomes from stockholders and creditors who contractually volunteered for these risks to taxpayers who did not even know they were in the game. This shadowy transfer occurs through the political and bureaucratic underpinnings of government-administered safety nets.
Unlike a voluntary guarantee or put contract, taxpayers’ contingent equity position in difficult-to-fail firms is coerced, poorly disclosed and contractually unlimited, and cannot be traded away.
- Taxpayers deserve to be paid a fair dividend for letting politicians put them into so severely disadvantaged a contract.
To provide fairness in a world where other stakeholders have more knowledge, more decision-making power, and more political clout, taxpayers should be accorded rights of disclosure and redress much like those that US and UK common law grants to minority shareholders. Taxpayers – and the regulators who play their hand for them – resemble overmatched players in a long-running poker game. Ethical justification for rewriting the rules of this exploitive game can be found in Immanuel Kant’s second categorical imperative, which forbids using other parties (here, taxpayers) merely as means to personal end (here, the private enrichment of stockholders, creditors, and managers of protected firms).
- The value of safety-net capital can be extracted synthetically from the behaviour of a firm’s stock price and return volatility since it contributes to a firm’s stock-market capitalisation (see Hovakimian, Kane, and Laeven 2012).
If such estimations were a high research priority, it would not stop institutions from gaming taxpayers but it would make the game fairer. This is because thinking of systemic risk as taxpayer loss exposure that is generated by loosely managing a portfolio of disadvantaged taxpayer puts would help safety net officials to rethink and reorient their duties and allow them to distinguish quantitatively between the stand-alone risk of a firm and its particular contribution to systemic risk.
Advantages of conceiving of systemic risk as a portfolio of ‘taxpayer puts’
Conceiving of systemic risk as a portfolio of ‘taxpayer puts’ likens it to a disease that has two symptoms. Official definitions and blame-shifting crisis narratives have focused almost exclusively on the primary symptom:
- The extent to which authorities and industry sense a potential for, first, substantial ‘spillovers’ of defaults across a national or global network of leveraged financial counterparties and, second, from this hypothetical cascade of defaults to the real economy;
This first symptom combines exposure to common risk factors (e.g. poorly underwritten loans) with a jumble of debts that institutions owe to one another.
But these definitions and narratives neglect an important second symptom:
- Inserting taxpayer interests into the financial-regulation game – the ability of ‘difficult-to-fail’ institutions to command bailout support from their own or other governments.
Using consultation, public criticism, campaign contributions, and implicit promises of high-paid post-government employment (i.e. the ‘revolving door’) to align their self-interest with that of their regulators conveys to politically and economically well-connected firms and sectors a subsidised ‘taxpayer put’.
The value of any firm’s taxpayer put comes from a combination of its risk-taking and authorities’ selective exercise of what we may think of as an ‘option to rescue’ it in stressful circumstances. Large banking organisations endeavour to convert authorities' side of their firm's rescue option into something approaching a ‘conditioned reflex’. They do this by undertaking structural and portfolio adjustments designed to make their firm harder and scarier for authorities to fail and unwind. Observationally, this corresponds to flows of accounting profits from building political clout and increasing their firm's size, complexity, leverage, connectedness, and/or maturity mismatch.
In the US, the Federal Deposit Insurance Corporation, the Federal Reserve and the Office of the Comptroller of the Currency are accountable for supervising stand-alone or microprudential risk. But safety nets subsidise the expansion of ‘systemic risk’ in good times partly because the accounting frameworks used by banks and government officials do not actually make anyone directly accountable for measuring, reporting or controlling the flow of safety-net subsidies until and unless markets sour.
Safety net managers should monitor, contain, and finance safety net risk, but – with no accounting requirements for difficult-to-fail firms to recognise the value of their access to safety net capital and with no one tasked to develop ways to report it – growth in a protected firm’s taxpayer put lacks visibility during good times. Then, in crisis circumstances, the sudden surfacing of this value leads safety net managers to panic, and encourages protected firms to reinforce rather than calm their fears (see Sorkin 2010, Bair 2012).
From a multiparty contracting point of view, an important institution’s taxpayer put is not an external diseconomy. It is a contingent claim whose short side deserves to be serviced at market rates. Drawing on the deposit-insurance literature, firms and officials can estimate the annual ‘Insurance Premium Percentage’ that a protected firm ought to pay on each dollar or euro of its debts.
Looking at data covering 1974-2010, Hovakimian, Kane and Laeven find that the mean Insurance Premium Percentage for large banks is sometimes very high, but seldom falls below 10 basis points. Multiplying the Insurance Premium Percentage appropriate to each time interval and an institution's average outstanding debt over the same periods would define a ‘fair dividend’ for taxpayers to receive (e.g. (.0010)($50 Bill.) = $50 million per year from a bank with $50 billion in liabilities).
Rules are for the unruly
The inevitability of industry leads and regulatory and legislative lags make it foolish to subject all very large banks to a fixed structure of premiums and risk weights over time. For market and regulatory pressure to discipline and to potentially neutralise incentives for difficult-to-fail firms to ramp up the value of their taxpayer put, two conditions must be met:
- Stockholder-contributed capital must increase with increases in the ex ante volatility of their rate of return on assets;
- The value of a firm’s taxpayer put must not rise with increases in the volatility of this return.
Logically, each requirement is in itself only a necessary