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Sunday, January 24, 2010

"Making Sense of Obama’s Bank Reform Plans"

Here's the introduction to an analysis of Obama's bank reform proposal by Viral Acharya and Matthew Richardson:

Obama’s sweeping proposal for financial regulation took the world by surprise. Here two of the world’s leading professors of finance explain why it is step in the right direction from the standpoint of addressing systemic risk. They also point out a number of drawbacks that should be fixed.

And here's the analysis. As noted, in general they support the Obama bank plan, but there are caveats to that support. One place they differ a bit from other analysts is on the issue of bank size. They say there are significant economies of scale, and that it is scope rather than scale that matters most. That is, they argue that there is "little rationale for such hard restrictions on size. It is clear that for diversification purposes as well as efficient market-making or liquidity provision, firms need to be large." It is "the complexity of large financial institutions that seems a primary issue in resolving them efficiently, which can be effectively addressed through scope restrictions.":

Making sense of Obama’s bank reform plans, by Viral Acharya and Matthew Richardson, Vox EU: In what has constituted a surprise for most in industry, policy and academic circles, the Obama administration has proposed sweeping changes to the financial sector regulation going forward.

Obama’s two-part plan

  • First, The Obama administration is planning to charge banks a fee related to the costs of the government bailout of the financial industry. The fee is expected to raise $117 billion over about 12 years, and $90 billion over the next 10 years. The tax would hit around 50 banks, insurance companies and large broker-dealers, but around 60% of the revenue will come from the 10 largest financial firms. If approved by lawmakers, the fee would go into effect June 30 and last at least 10 years. It would amount to 0.15% of total assets minus high-quality capital, such as common stock, and disclosed and retained earnings. Federal Deposit Insurance Corp (FDIC)-covered deposits and insurance-policy reserves would be untaxed because such assets are already subject to federal fees, according to the White House.
  • Second, President Obama has adopted the ideas of Paul Volcker, the former Fed chairman, in proposing a prohibition on commercial banks from engaging in proprietary trading, in particular, trading purely for their own account and a ban on owning hedge funds and private equity firms.

This is effectively bringing to banking landscape a modern form of Glass-Steagall restrictions which when implemented earlier in the US since 1934 (and formally repealed in 1999) restricted commercial banks from any investment banking activity.

While there may be political reasons behind these actions, we focus below only on their economic merits.

Main cause of the crisis: Government guarantees and too-big-to-fail

First and foremost, we need to understand the main cause of the financial crisis. The discussion below is largely based on Acharya and Richardson (2009).

A large number of banks and other major intermediaries managed to increase risks by exploiting loopholes in regulatory capital requirements to take a highly leveraged, one-way bet on the economy. Particularly popular were bets tied to residential real estate, but also to commercial real estate, and consumer credit. They bet the farm on the persistence of favorable economic and financial conditions. When things went wrong, banks had no capital cushion to bear the risk. Many were so large that there were no easy bankruptcy procedures nor any way of ensuring they continue to perform their financial plumbing while in bankruptcy. Of course, they were bailed out.

These bet were financed largely by lenders – for example, by insured depositors and the uninsured large creditors of Fannie Mae, Freddie Mac. The too-big-to-fail banks also lent. Due to government guarantees, all these lenders were more or less indifferent to the consequences things going wrong. Guaranteeing the liabilities of large financial firms offers them an unfair advantage, because they can raise capital at a lower cost. Because the guarantee is so valuable and pervasive, these firms face little market discipline and have a perverse incentive to expand their scope, scale, risk exposure, leverage, and interconnectedness.

Importantly, this situation has not gone away. The bailout of virtually all the heavily exposed financial intermediaries means that this moral hazard has only gotten worse.

Role of proprietary trading

Some argue that all this had nothing to do with the proprietary trading at banks and large, complex financial institutions. This argument reflects a lack of understanding of why the housing price shock brought down the entire financial sector.

Consider the AAA-rated tranches of mortgage-backed securities held by banks. These were effectively a way to manufacture the tail risk on the economy but were originally intended for marketing to the now-proverbial Norwegian pension fund. But banks were never fully successful in this intended purpose.

Some of the tranches remained in the “warehouse” of banks. After all, such tranches paid a nice “carry” (i.e., premium) due to the aggregate nature of their risk, their illiquidity, and the low-cost of short-term debt with which they were financed. Banks soon converted the warehouse into a “principal” or prop-trading activity, allocating capital to build-up of more exposure. When the tranches lost money, the tremendous leverage built in them brought down these institutions, but they were too big to fail and were bailed out. Lehman Brothers was the exception that proved the rule – its failure underscored the exact meaning of ‘too big to fail.’

101 on regulating systemic risk: First best solution

The goal of bank regulation should be to contain such systemic risk rather than focus only on the individual risk of institutions (Acharya, 2009).

From an economic point of view, the best solution to contain the excessive systemic risk created by too-big-to-fail institutions is to charge them upfront for the implicit taxpayer guarantees they enjoy. They should pay a fee both for their expected losses in the event of failure and for expected losses when failure occurs in the context of a systemic crisis (which could be broadly defined as the financial system as a whole becoming undercapitalized).

  • The first piece of the fee is similar in principle to the FDIC deposit insurance premium;
  • The second piece is explicitly a fee against systemic crises and recognizes that there are spillovers to the real economy in such crises.

Indeed, such a structure of the fee can be shown to be optimal in a setting where there is a negative externality on the real sector whenever there is a systemic crisis (Acharya, Santos and Yorulmazer, 2009, and Acharya, Pedersen, Philippon and Richardson, 2009a, 2009b).

The key point is that, when faced with these fees, the financial institution will on the margin choose to hold more initial capital (i.e., be less levered), take less risky positions and organically choose to become less systemic.

Separating proprietary trade: Containing moral hazard in a second-best world

In a first-best case, where bank actions can be perfectly observed and fees based on these, not much more may be necessary. Such observability is unlikely.

If bank actions are not perfectly observed, the fees will undercharge some activities – most likely those that have more cyclical risk. For example, Stiroh (2004) shows that trading revenues are far more cyclical than investment banking, which itself is far more cyclical than interest income. What this means is that a pure fee-based approach is likely to result in excessive loading by banks on systemically risky activities.[1]

Separating commercial banking from proprietary trading is a way of containing the moral hazard arising from government guarantees – not just from actions of financial firms that receive the guarantees, but through competitive pressures, also through actions of other firms in the financial sector. The point is that when risks are not perfectly seen – and new ones are created (“innovated”) by banks to get around any restricting regulation – a blunt isolation of the government guarantees provides an additional firewall against systemic risk.

To summarize, a pragmatic design of regulation to contain systemic risk consists of simplifying the regulation problem by ring-fencing the use of government guarantees, and then charging a fee for usage of government guarantees for the ring-fenced activities (and potentially also a fee on the activities outside of the ring if they contribute significantly to systemic risk).

Assessing Obama’s plan: The fee

Given this conceptual framework for regulating systemic risk, it is clear that a fee against systemic risk of institutions makes a lot of economic sense. The trick is in devising a system that is implementable and leads to optimal system-wide behavior on the part of banks. On this front, it is clear that there are some flaws in the fee proposed by Obama administration:

  • First, the view that the fee should be charged only to recover bailout costs incurred in the current crisis is flawed. It is the same mistake that is currently being made by the FDIC in charging its premiums whereby banks pay most of the bailout cost in the worst possible time and little in good times (Acharya, Santos and Yorulmazer, 2009). In contrast, the fee should in fact be higher when times are good and risk-taking incentives stronger.
  • The proposed fee is exclusively based on portion of assets that are funded through leverage. However, systemic risk arises not just from leverage but also from type of assets, financial interconnectedness, and being a critical player in financial plumbing of the economy. Ignoring these sources of systemic risk will create a penchant for taking them on in due course.
  • The clause that FDIC-insured deposits be excluded is partly problematic.

FDIC insurance premium is not charged based on the systemic risk of institutions. And most banks pay no premium once FDIC reserves are high (again, see Acharya, Santos and Yorulmazer, 2009). Thus, the fee seems to unduly favor deposit-taking institutions.

Assessing Obama’s plan: Restrictions on proprietary trading

Separating commercial banking and other forms of financial intermediation from proprietary trading, equity investments and holding of structured investment products (which were meant to be distributed to capital market investors in any case) is a step in the right direction; it limits systemic risk without affecting financial sector’s ability to perform its core functions. This is because there is little evidence of any economies of scope that argue persuasively for principal investing to be located inside a financial conglomerate (Schmid and Walter, 2009). In fact, the primary advantage to these institutions appears to be to become too-big-to-fail, and thereby have access to a low cost of funding.

While the spun-off activities may still reside in firms that are systemically important (e.g., Long-Term Capital Management in 1998), the task of designing efficient resolution mechanisms to wind up these “narrow” firms would be substantially simpler.[2]

Similarly, commercial banks will remain subject to moral hazard induced by the explicit or implicit government guarantees and the inability to charge a perfectly risk-adjusted fee. They will also continue to attempt regulatory arbitrage of capital requirements that will need to be scrutinized and curbed. Thus every effort should be made to ensure that guarantees and forbearance are reduced for commercial banks even after ring-fencing their activities, for example, through an extension of FDIC’s prompt corrective action that can work also for large players. In essence, creating simple banks will reduce the complexity of resolving distressed financial firms and enable the regulators to get a better grip on the vulnerability of the financial sector to welfare-endangering crises.

There are several concerns, however, with the current proposal to restrict commercial banks from proprietary trading as enunciated by the Obama administration:

  • Its restrictive focus on deposit-taking institutions;
  • Its lack of clarity as to whether market making or dealer functionality would be considered as “proprietary trading”, or will the economies of scale necessary to perform this functionality allowed to remain within deposit-taking institutions (potentially subject to audits that market-making is not morphing into speculation), and;
  • Whether proprietary trading and investments will be carefully defined not just to include speculative activities based on external funding from customers but also on internal funding or principal (since a firm’s internal capital is often raised on the back of government guarantees).

We discuss these issues in some detail in Acharya and Richardson (2010).

Other issues

Though much less detail has been spelled out on it, the administration has also mentioned imposing size-based restrictions on institutions. There is little rationale for such hard restrictions on size. It is clear that for diversification purposes as well as efficient market-making or liquidity provision, firms need to be large. The too-big-to-fail problem with being large thus needs to be counterweighed against some natural economies of scale. It is the complexity of large financial institutions that seems a primary issue in resolving them efficiently, which can be effectively addressed through scope restrictions.

Of course, there are many other things that need to be fixed with Obama’s plan. For starters, if proprietary trading is to be separated from government-guaranteed institutions, first and foremost the financial investments arm of Fannie and Freddie, the government-owned surprises, needs to be shut down. Will that ever happen?

There should also be an additional type of penalty in bad times to get (even the narrowly designed) institutions to avoid “regulatory arbitrage” around the fee scheme they face. This could be either (i) the creation of an insolvency regime for firms that would make creditors face potential losses through an orderly failure or restructuring of insolvent firms, or (ii) the requirement that financial institutions hold in their capital structure a claim that has a forced debt-for-equity conversion whenever a pre-specified threshold of distress (individual and systemic) is met. All of these measures show up in some (albeit imperfect) way in the proposed reforms in the US and the UK, so there is hope that the governments may get this right.

Summary

On balance, President Obama’s plans – a fee against systemic risk and scope restrictions - seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions.

Editor’s note: The writers have been following the post-crisis regulation from the start with the NYU Stern School colleagues; see, the NYU Stern School’s books on the financial crisis ‘Restoring Financial Stability: How to Repair a Failed System,’ John Wiley & Sons, 2009 (whitepapers.stern.nyu.edu/home.html), and the eBook ‘Real-time Recommendations for Financial Reform

References

Acharya, Viral V, “A Theory of Systemic Risk and Design of Prudential Bank Regulation”, Journal of Financial Stability, 5(3), 2009, 224-255.

Acharya, Viral V and Matthew Richardson, “Causes of the Financial Crisis”, 2009, Critical Review, 21(2–3): 195–210.

Acharya, Viral V and Matthew Richardson, “Obama’s bank plan is a start”, 22 January 2010, FT.com, http://www.ft.com/cms/s/0/1705ff00-0774-11df-915f-00144feabdc0.html

Acharya, Viral V, Joao Santos and Tanju Yorulmazer, “Systemic Risk and Deposit Insurance Premiums” 2009, forthcoming, Economic Policy Review, Federal Reserve Bank of New York.

Acharya, Viral V., Lasse Pedersen, Thomas Philippon and Matthew Richardson, “Regulating Systemic Risk”, 2009a, in “Restoring Financial Stability: How to Repair a Failed System”, Viral V. Acharya and Matthew Richardson, editors, (c) John Wiley & Sons, March 2009.

Acharya, Viral V., Lasse Pedersen, Thomas Philippon and Matthew Richardson, “Measuring Systemic Risk”, 2009b, Working paper, NYU-Stern.

Schmid, Marcus and Ingo Walter, “Do Financial Conglomerates Create or Destroy Value?” Journal of Financial Intermediation, 2009, 18(2), 193-216.

Stiroh, Kevin, "Diversification in Banking: Is Noninterest Income the Answer?," Journal of Money, Credit and Banking, 2004, 36(5), 853-82.


[1] A classic example of the speculative distortion induced by government guarantees is that of the government-sponsored enterprises, Fannie and Freddie. Their debt is effectively government guaranteed for the purpose of facilitating securitization of prime (high-quality) mortgages. Now, for every dollar of capital they put in, Fannie and Freddie could raise twenty-five dollars of virtually risk-free debt and invest these in sub-prime backed securities created by rest of the financial sector. The case of UBS, which essentially raised debt at cost of insured deposits and betted it all on AAA-tranches of sub-prime mortgages, is no different.

[2] Creating silos of risks for managing them better is not a new practice or concept in the financial sector. For instance, banks isolate risks themselves (within their own bank holding structures) by creating well-capitalized, AAA-rated subsidiaries to trade in swaps; Standardized derivatives are traded on exchange and clearing-houses, whereby collateral and margin that firms post on their derivative positions are “segregated”, that is, made entirely available only for settlement of these positions; and a large number of inter-bank contracts and repurchase agreements are ring-fenced and enjoy exception from the bankruptcy procedures. In all of these cases, the goal is clear: Separating risks enables easy settlement of claims when risks materialize, which makes it easier to contain the distress of individual firms from spreading to others. While bankers have considered this privately beneficial, it is potentially also socially beneficial. 

    Posted by on Sunday, January 24, 2010 at 12:31 PM in Economics, Financial System, Regulation | Permalink  Comments (1)

          


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