Part 9 (2/2)

In economics, this pheno of this unwieldy ter that's procyclical ae-for example, a boom-and-bust cycle When it co, you want the guidelines not to amplify economic fluctuations but to shi+eld banks from them To avoid procyclicality, one could adopt a different way of calculating capital called ”dyna banks to hold a static amount of capital at all times-like the 8 percent imposed by the Basel accords-a dynamic system would allow it to vary over tio up When things go sour, the capital require has already been used by Spanish banks, and while not a cure-all, its widespread adoption under a new Basel regi

Another possible solution to the probleent capital” This idea, which is gaining adherents, deserves a close look, though it's not without probleood tient convertible bonds” It differs from ordinary debt in that if a bank's balance sheet declines past a particular ”trigger point,” the debt will ”convert” into shares or equity in the bank

Contingent capital potentially provides several benefits First, the bank getsit to stay afloat The ailing bank survives, but at a price: its fornificant ownershi+p stake in it This sudden influx of outside shareholders di shareholders

That's not in the interest of the original bondholders or shareholders So both groups have an incentive to keep a closer eye on what the bank is doing so that it never finds itself at this unfortunate juncture In theory, if the bondholders think the bank is headed in the wrong direction, they will i costs Likewise, the shareholders will rein in risky activity that ht land the bank in trouble

This idea may work better on paper than in practice For it to work, after all, banks would have to issue enough contingent convertible bonds Otherwise, the sort of self-discipline it's e-never mind the capital it's supposed to provide-will be insufficient Still, it's one of the better proposals on the table at the moment, and it may address one of the reeers couldn't restrain risky behavior, its creditors ed to do so in their stead; purchasers of the bank's debt would i costs on banks that took too many risks

Unfortunately, when the recent crisis hit, there wasn't enough bank debt out there to iful overnments around the world threw uarantee all that debt and ent capital ets converted into equity rather than guaranteed, backstopped, and bailed out It ht-perhaps-hold the line on es of Basel to consider is the peril associated with a lack of liquidity As the recent crisis amply demonstrated, financial institutions-both traditional banks and hly susceptible to a liquidity crunch In the past, the Basel Committee paid little attention to this problee As we've noted in previous chapters, the recent disaster was a banking crisis writ large, with financial fir -term, illiquid assets When panic struck, banks and shadow banks couldn't renew their short-term loans They became illiquid

Therefore an essential eleulation of all financial institutions-banks and nonbanks-should be a greater ee it would be to require firnificantly lengthen the maturity and duration of their liabilities A bank that has to renew its borrowing once a year is less likely to suffer a liquidity crunch than one that renews loans every day Again, this technique for : as the recent crisis demonstrated, even institutions that traffic almost exclusively in liquid investet the just a tiny bit of their money into less liquid assets

Another flaith the existing Basel regiives too much discretion to financial institutions to use their own internalrisk The Value at Risk model (VaR) is one, a mathematical formula that purports to calculate the likelihood that a firm will suffer a loss on its assets; another is the Gaussian copula, a statistical tool that was used to price esoteric assets like CDOs Both arded the likelihood of crises and other disruptive events, leaving banks vulnerable when the crisis hit Sadly, the solution is not siood as the people using thenoring risk, they will be able to fiddle with any foret the answer they want

So we must think about other ways tohow financial institutions thee risk At present, the ”silo” approach is dominant: each division or business line considers risk in isolation, never conteht interact with those of other divisions The classic example is AIG: a small branch of the coed to insure enough toxic CDOs to bring down countless other divisions that employed , inalized; after all, they stand in the way of bigger profits That makes it all thethe traders hoement in the future should dispense with the silo hout the organization Thata more powerful chief risk officer who reports directly to the CEO and the board of directors, along with a staff capable ofon indown on risky behavior

The Co radical reforms seem reasonable Much of e've described in this chapter would have seemed extreme and unnecessary in advance of the crisis that hit in 2008 That's no longer the case

The refor accountability and transparency in the financial systeing derivatives under public scrutiny, and putting the putative guardians of the systeencies-on a very short leash These reforms would also ensure that banks and other financial firh liquidity to weather a major financial crisis

These reforms would also put an end to the potential abuses associated with having a s so much of the financial system If derivatives and other financial instruments were more transparent, it would be e their clients outsized fees and bid-ask spreads These firms are understandably reluctant to see these instrues: doing so would deprive them of the ability to extract the kind of profits that co access to information their clients lack Under the current systeh bid-ask spreads because there is no price transparency; they can effectively ”front run” their clients,that they can use information about their clients' investments to makeor even in the actualactivities Greater transparency will frustrate those sorts of behaviors

Skeptics ht reasonably point out that if investors want to pay through the nose for the privilege of alpha-or schmalpha-returns, that's their business But the rise of a small coterie of incredibly powerful, opaque financial fir proble assortination and underwriting, e funds, and assetThe interconnections a those various functions, neverfirms, have created a system that is extraordinarily vulnerable to syste froes would reduce these rent-extracting distortions but, more important, would radically reduce the counterparty risk that makes the financial institutions too interconnected to fail Indeed, the es, the less the systenificantly reduced Not only do we need to reduce the TBTF proble each institution smaller, we also need to unbundle financial services within financial institutions to reduce the too-interconnected-to-fail problees, broker dealers would be involved only in the efficient execution of trades for clients, not in , which is rife with conflicts of interest, lack of price transparency, and large and systeall, and even beyond it, to a financial system in which both institutions and their activities are unbundled toto fail and less too interconnected to fail

In short, the concentration of financial power has created a system that is too interconnected to fail The proposals outlined in this chapter represent the first steps toward curing these problems But far more radical reforms must be implemented if the financial syste years

Chapter 9

Radical Remedies

In early January 2010, Ben Bernanke defended the Fed's handling of the recent financial crisis The lesson he dreas straightforward and siulation could have prevented it As he put it, ”The lesson I take froulation and supervision are ineffective for controlling e risks, but that their execution must be better and sulators do a ”better and s their responsibilities? In this chapter we consider sonificant obstacles that stand in the way of this ambition These obstacles include the intentional evasion of regulatory oversight, or what's known as regulatory arbitrage; the too-many-cooks-in-the-kitchen probleulators and a lack of coordination frustrate effective supervision of the financial systeulations are only as good as the regulators who enforce theulation shows that these probleorous and well-conceived rules and regulations Any successful reforulation and supervision of the financial system will have to confront them

That's a start So too are the commonsense, middle-of-the-road recommendations laid out in the previous chapter But soulations on the status quo; soulatory ”creative destruction” is in order In this chapter, we take up soes that can and should be i banks and i a number of new firewalls in the financial systeh an entirely different but equally radical idea: the use of h it is relatively sihtforward, most econoerous In fact, Bernanke explicitly ruled it out when he delivered his postulation and supervision offered athe proble to differ When used appropriately, monetary policy is one of the most effective and powerful ways to deal with asset bubbles and the crises they cause Its effects are not surgical, but that's precisely the point: monetary policy can have a broader, systemic influence on the speculative climate that creates a bubble in the first place It's therefore worth adding to the toolkit available to policy limpse of the possible future of finance-if and only if policycrises requires so less would be tanta the deck chairs on the titanic

Avoiding Arbitrage

When people think of new financial regulation, they generally think of actual rules, guidelines, and laws that proe stability, and otherwise prevent crises That's all well and good, but bankers and traders have a funny way of dodging even the ulatory arbitrage is one of the issues that policyto have any effect

In the years before the crisis, ordinary banks were reasonably well regulated, and in exchange, they had access to a government safety net: deposit insurance and explicit lender-of-last-resort support This bargain was stifling for bankers anted ly shi+fted banking activities to the shadow banks: institutions that looked and acted like banks but weren't regulated like thee: the purposeful ulated venues

In the wake of the crisis, the consensus holds that these nonbank financial institutions-the shadow banks-have to be regulated like ordinary banks Most of theovernment support; now it's tiulation In addition, the recent crisis demonstrated that many of these firms are systeh the entire financial systeulated

This all sounds good, right? Unfortunately,lessons from history They look at the monster shadow banks-institutions like AIG-and conclude that only the big fish deserve to be regulated That's the philosophy embodied in some of the proposals now on the table For exaulatory refornificant financial firulations would be a profound ulatory arbitrage Next tier, newly regulated institutions to their less significant brethren However sulated institutions would becoate, and their collective failure could be equally probles and loan crisis about fourteen hundred such thrifts went bust; no single one of them was syste and losses had systeulations must be applied across the board to all institutions, not just to those dee everything from capital to liquidity ratios to compliance and disclosure standards should be imposed without exception, even if systeulated than siven their potential systeineers should have no place to run and hide; regulation should not be applied only here and there Otherwise there will be ulatory arbitrage was too easy a game to play in recent years, thanks to as eupheulation” This was the idea that regulators could establish general ”principles” for financial institutions to follow, then request that the firms find some way to conform to them Alulation) bredrisk on their own terms, firms selected models that almost always underestimated the a with the probleulators should be cautious about ioverning each and every kind of structured financial product This would be a fool's errand: such granular regulation will only generate another burst of regulatory arbitrage, as financial engineers figure out how to tweak products so as to evade the law

Superspecific regulations would also be pointless on another level: the degree of financial innovation that has already taken place is staggering One measure can be seen in the relentless expansion of a standard industry guide to derivatives Originally ain 1989 (when it was called Swap Financing), the latest edition, published in 2006 (retitled The Das Swaps & Financial Derivatives Library), fills ally difficult to keep pace with financial innovation

But this doesn't ulators should throw up their hands, return to the old systeood traders and bankers at financial firms will abide by them Rather, they should establish a robust set of si key features of the financial systee-not on ”risk-adjusted leverage” but on absolute leverage The same specificity should apply to capital requirements and liquidity buffers These can and should be absolute and should be applied across the board, to fire and s them should lie not with the bankers, as has been the practice, but with the regulators

That raises a so problem that transcends any particular set of reforulations be administered? What official institutions should take the lead in ad them? And how should those institutions coordinate their efforts?

Enforcement and Coordination

In the United States, a bewildering array of regulatory bodies, at both the state and the federal levels, share responsibility for the financial system These bodies have evolved haphazardly over the course of in on the state level Over the course of the nineteenth and twentieth centuries, each of the fifty states created its own separate banking and insurance commissions These bodies operate in different ways and have varying levels of experiencethe firms in their jurisdictions, which include both state-chartered banks and national banks with federal charters Soulators, akin to the SEC, as well as credit union regulators All of these regulatory authorities vary greatly in their funding, their sophistication, and the rules they are responsible for enforcing

Atop this decentralized structure sits the federal regulatory edifice, sharing enforce it in others The nu from the Office of the Comptroller of the Currency to the Federal Reserve to the Co with encies patrol the same territory, or overlap in substantial ways Finally, as if that weren't confusing enough, there are several governovernment, set rules for financial firms, and even police theirStandards Board (FASB)