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Friday, September 17, 2010

Financial Regulation: The Empire Strikes Back

If banks are too big for politicians to ignore, is it possible to break them up?:

The Empire strikes back, by Avinash Persaud, Vox EU: There are two remarkable aspects of the consensus around international financial regulation emerging in the run up to the November G20 meeting in Seoul. The first is that there is a consensus. International regulators are agreed that banks must set aside much more capital for risky assets; be less dependent on the whims of money markets; constrain the maturity mismatches between their assets and liabilities and set aside capital for holding complex derivatives where there may be settlement and clearing risks. They also agree that capital adequacy should move counter to the economic cycle and that banks should not be “too big to fail”. Getting an international consensus around action that is sensible – save for the emphasis on “too big to fail”- is no mean achievement.
The second is that despite appearing to be down and out, the banking lobby has struck back, successfully making the case that all of these initiatives should be postponed or phased-in between 2015 and 2019. By then the pressure for regulatory reform could be a distant memory. Financial regulation veterans will be experiencing déjà vu. In each of the last seven international financial crises, plans for a radical shake up of international regulatory or monetary arrangements made surprising progress, only to be tidied away and stuffed in the bottom drawer once the economy recovered. Many of the new initiatives being proposed today have been pulled out of that same drawer, dusted down and updated.
The argument that the banking system is too broken and the world economy too fragile, to support more onerous regulations, is seductive for politicians desperately trying to boost consumer demand. But it is suspect. It highlights that attempts to make banking regulation more counter-cyclical have not gone far enough. The point of counter-cyclicality is to loosen the constraints to lending in times of recession like today and to tighten them when growth and optimism have returned and the worse credit mistakes are being made. Counter-cyclicality needs to be at the heart of the new regulatory regime and not an optional extra. As Professor Charles Goodhart of the LSE and I have said before, crashes will not be avoided if we continue to feed the booms. The methodology of counter-cyclicality is complex and given that economic cycles are more national or regional than global, it makes for greater host country regulation and national ring-fencing of bankers’ operations. International banks do not like that. To counter they appeal to the “right”-sounding notion of level playing fields.
The other problem of kicking regulatory initiatives into the long grass is that as long as the prospect of new profit-squeezing regulation is out there, uncertainty will limit the one thing everyone is agreed the banking system needs more of – capital from investors. It is one of those delicious fallacies of composition that what banks want individually is often not in their collective interests. I recall writing in October 2002, what the FT headline writers presciently captured as “Banks put themselves at risk in Basel”.
Competitive finance is critical to the development of a robust and dynamic economy – locally and globally. But the lesson currently being repeated is that regulatory capture – subtle, sophisticated, and seductive – has the power to stops us from developing a financial industry that serves the economy rather than the other way around.
Tackling regulatory capture head on is the better argument for limiting bank size. The notion that smaller institutions will make the financial system safer ignores history. The UK Secondary Banking Crisis of 1973-75, for example, had a bigger impact on property prices and the stock market than the current one. The principal avenue of financial contagion is the panic-stricken search for institutions that look similar to the one that has just failed. Moreover, a large number of small institutions doing the same dangerous thing is just as toxic, if not more so, than a small number of large institutions engaged in the same activity. But smaller institutions invest less in political lobbying. A politically less powerful financial system has a better chance of being reassuringly boring.
The way to make the financial system safer is to break up institutions not by the porous boundaries of “narrow” and “wholesale” banking, but by the more fundamental boundaries of risk capacity. To create systemic resilience we need a systemic approach to capital adequacy requirements across the entire financial system, one that pushes different financial risks to wherever across the entire financial there is greater capacity for those different risks.
This is simpler than it sounds. There are three major types of risk: credit risk, market risk, and liquidity risk. Their differences can be found by the different ways in which these risks can be hedged or absorbed. The capacity to absorb liquidity risk comes from having time to sell an asset because liabilities, like promises to pay a pension in twenty years, are long-term. The capacity to absorb credit risk comes from having access to a wide range of uncorrelated credit risks to pool together, like a loan to an international oil company and another to a local wind farm. A financial system in which liquidity risks were held by young pension funds because of the capital required to set aside maturity mismatches, and credit risks by large consumer banks, because of the capital required to set aside for concentrated credit risks, would be far safer than one with twice the amount of capital but where the banks fund illiquid private equity investments and pension funds hold credit derivatives because regulators and accountants treated risk as if all that mattered was price volatility not risk capacity. Limiting risk taking to risk capacity would limit the size of banking institutions. It would create opportunities for new players with different risk capacities.
But the odds of a systemic approach to systemic risk appear slim. It’s politics, stupid!

The last point is something I've talked about as well, but in more general terms. Essentially, if we break up the big banks into a bunch of "mini-me's," then a shock that would bring down a big bank would likely also cause widespread failure among its smaller clones. But if the small banks pursue heterogeneous strategies, e.g. as described above, then the impact of the shock may not be as wide.

From an earlier post on this, I'm skeptical about how well this would work, partly because the institutions may still be highly interconnected and hence subject to cascading failure:

... One argument against breaking up large banks, one I've given myself, is that it won't necessarily eliminate systemic risk. A shock that pushes a large bank into bankruptcy could just as easily cause a large number of smaller firms engaged in the same business to fail. This could create just as much trouble for the financial system as the failure of a single bank encompassing the smaller entities. In fact, it could be even harder for regulators to figure out how to address the failure of, say, one hundred small firms rather than just one large firm. Thus, breaking up large banks may do little to reduce systemic risk, but, as the argument goes, there is a chance that efficiency will fall. If so, then this is not a good policy.
But I think there are several counterarguments to this. First, there may be some shocks that would take a single, large bank down, but might not do the same to the smaller banks derived from it. The key here is that the smaller banks pursue diversified strategies so that only some of them are vulnerable to a particular type of shock. If they all do the same thing as the large bank did before it was broken up, then they will still face common risks. However, even with diversified strategies, I'd still worry that there is not that much safety from breaking banks up, i.e. that most shocks that would take down large banks will also take down enough small banks to create similar problems. ...

Breaking up the big banks and then imposing heterogeneity is certainly worth a try. If nothing else it may reduce their political influence. But it's unlikely to be enough by itself, and we should also be sure to reduce system vulnerabilities through other means such as leverage limits, orderly resolution for troubled banks, improved monitoring of system/network risks, the elimination of incentives to take on excess risk, and so on.

Update: I just posted something related at MoneyWatch: Will Basel III's Capital Requirements Make the Financial System Safer?.

    Posted by on Friday, September 17, 2010 at 12:42 AM in Economics, Financial System, Regulation | Permalink  Comments (15)


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