Social Value Of The Financial Sector, The: Too Big To Fail Or Just Too Big?

Too Big to Fail or Just Too Big?

Viral V Acharya, Thorsten Beck, Douglas D Evanoff, George G Kaufman, Richard Portes

• Publisher: WSPC
• Year: 2013
• eBook ISBN: 9789814520300
• Topic: Business
• Subtopic: Finance
• Index: Business

As a result of the recent financial crisis, there has been significant public debate on the role of the financial sector in bringing about the “Great Depression.” More generally, there has been debate about whether the current industry structure has enhanced social welfare or served a detrimental role.

This book is a collection of papers presented at the conference held at the Federal Reserve Bank of Chicago, in November 2012 that examined the social value of the financial sector as currently structured. Issues evaluated include what are the perceived benefits and costs of the current financial system? How valuable have industry innovations been for society? Should regulation be used to “move” the industry in a direction thought to be more valuable for society? Should “big” banks be broken up? What are the welfare implications of the current industry structure? In the book, leading industry scholars debate these issues with a goal of influencing public policy toward the industry.

Contents:

• Keynote Addresses:
  • A Ferment of Regulatory Proposals (Charles A E Goodhart)
  • Progress and Priorities for Financial Reform (Mary John Miller)
• Description and Measurement of the Financial System:
  • What Is Meaningful Banking Reform, Why Is It So Necessary … and So Unlikely? (Charles W Calomiris)
  • The Great Leveraging (Alan M Taylor)
  • Finance and Economic Development in a Model with Credit Rationing (Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza)
  • Too Much Finance, Too Much Credit? Comments on Papers by Calomiris, Arcand–Berkes–Panizza, and Taylor (Eugene N White)
• Social Benefits and Costs of the Current Financial System:
  • Bank Regulatory Reforms and Racial Wage Discrimination (Ross Levine, Alexey Levkov, and Yona Rubinstein)
  • Finance: Economic Lifeblood or Toxin? (Marco Pagano)
  • Finance: Is Bigger Badder? (Gerard Caprio, Jr)
• Financial Industry Innovation:
  • A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market (Viral V Acharya and T Sabri Öncü)
  • Reexamining Financial Innovation after the Global Financial Crisis (W Scott Frame and Lawrence J White)
  • Financial Innovation and Shadow Banking (Luc Laeven)
• Effects of Regulation, the Safety Net and Other Government Guarantees:
  • Evolving Intermediation (Nicola Cetorelli)
  • The Socially Optimal Level of Capital Requirements: A View from Two Papers (Javier Suarez)
  • Effects of Regulation, the Safety Net, and Other Government Guarantees (Mathias Dewatripont)
• Finance and Economic Activity: Variations across Emerging and Developed Markets:
  • Legal and Alternative Institutions in Finance and Commerce (Franklin Allen and Jun “QJ” Qian)
  • Finance in the Tropics: Understanding Structural Gaps and Policy Challenges (Thorsten Beck)
  • Foreign Banks: Access to Finance and Financial Stability (Neeltje van Horen)
  • Institutions, Finance, and Economic Activity: Views and Agenda (Elias Papaioannou)
• Break Up the Big Banks?:
  • Breaking (Banks) Up Is Hard to Do: New Perspective on Too Big to Fail (James R Barth and Apanard (Penny) Prabha)
  • Restructuring the Banking System to Improve Safety and Soundness (Thomas M Hoenig and Charles S Morris)
  • Ending Too Big to Fail: A Proposal for Reform (Richard W Fisher and Harvey Rosenblum)
• Where to From Here? The Implications for Financial Regulatory Policy:
  • Where to From Here? Implementation, Implementation, Implementation (Claudio Borio)
  • Complexity in Financial Regulation (Andrew G Haldane and Vasileios Madouros)
  • Financial Reform: On the Right Road, at the Right Pace? (Thomas F Huertas)
  • Banking Regulation and Supervision in the Next 10 Years and Their Unintended Consequences (Danièle Nouy)
  • The Social Value of the Financial Sector: Where to From Here? (Barbara A Rehm)
  • Public Policy Options (Jürgen Stark)

Readership: Undergraduate/graduate students, researchers, and academics in international finance and banking; financial regulators, financiers, and bankers.

PART I

KEYNOTE ADDRESSES

A Ferment of Regulatory Proposals

Charles A. E. Goodhart*

London School of Economics

A Simpler Approach?

The financial crisis has spawned a ferment of ideas for improving regulation. As with most fermentation, some rather odd notions have bubbled up to the surface. One such is that there was a golden era in the past, between World War II and the 1970s, when banking was simple, straightforward, and trustworthy; banking crises were nonexistent; and, as an ordinary depositor, one could actually talk personally to one’s bank manager, either face to face or over the phone.

Actually in my country, the UK, those conditions were primarily achieved by direct controls over both the amount of bank lending to the private sector, and often its direction between sectors, and by a rigorous suppression of competition in the financial sector. All parts of finance were cartelized, and rates were set via such central cartels, all with the vocal encouragement of the authorities. You could, indeed, talk to your bank manager, but he (there were no “shes”) was programmed to say “no.”

From the late 1960s onward, a small group of us in the Bank of England, led by John Fforde but including Eddie George and Andrew Crockett, campaigned to end this tightly controlled system, and in 1971 we succeeded with the publication of “Competition and Credit Control.” The competition-easing aspect worked fine, but during the subsequent 1972–1973 boom the credit control left much to be desired, not least because of political constraints over the flexible use of the interest rate weapon.

More recently, interest rates have been predicated to the primary need to achieve an inflation target, and that, once again, has meant that, during a contemporaneous housing boom, interest rates could not be, or at any rate were not, used to stabilize credit and asset price expansion. This has led to proposals for other instruments of control, in particular via macroprudential regulatory control. There is, however, a problem here. If regulation is to be effective, it must have the effect of preventing the regulated from doing what they want to do. So they will attempt to avoid it. Usually they succeed, though perhaps only after a time. As Ed Kane has argued, there is a dialectic in the regulatory process: Crisis leads to regulation, which begets avoidance and erosion, which begets crisis, and so on ad infinitum. Let me coin an aphorism, “If regulation is simple, it will be simple to avoid it.” The Basel I risk buckets were simple, and they were simply avoided, for example, via securitization.

Indeed this suggests a second dialectic. We start with a simple regulatory proposal. The regulated then find some fairly easy ways around it. This leads to a more complicated and lengthy second round of regulations to prevent or mitigate such avoidance measures. These more complicated measures in themselves then open up further ways of trying to avoid such regulations, which, in turn, leads to a vastly more complex third stage of countervailing measures. At this point the regulations run into hundreds of pages, and no one is quite sure quite how they operate, if they operate effectively at all. At this juncture the cry goes up that we must revert to a simpler system. This proposal has obvious advantages, and so we start on yet another cycle.

Incidentally I have never owned, and have rarely seen, a dog that could catch frisbee, which, as you may recall, was the title of Andy Haldane’s much-quoted paper at the latest Jackson Hole Conference, arguing for more simplicity in regulation. Perhaps that was because my dogs took after their owner in being resolutely nonmathematical. Indeed, my cairn terriers would have regarded chasing plastic Frisbees rather than flesh-and-blood squirrels as below their dignity.

Almost all regulatory structures, on their own, can be avoided and manipulated. The direction and channeling of the recent crisis was considerably influenced by regulatory arbitrage between US banks, which were subject to an overall leverage limit but not to Basel II, and US broker–dealers and European banks, which were subject to Basel II but not to a simple leverage ratio. What happened, unsurprisingly, was that the Basel II banks gorged on supposedly low-risk leverage expansion, while the US banks took on the riskier tranches of MBS, and indeed suffered higher losses per unit of assets than their European counterparts.

In my view, the Europeans came off worst in this exchange, partly because risk weighting is inherently defective. The riskiness of an asset is not constant over time, but context dependent, even more so in the face of innovation. Moreover, the risk weights adopted are inevitably somewhat subject to political interference involving the exercise of national interest, as witnessed by the long saga of what risk weight to attach to the government bonds of other states. Governments, as well as private sector agents, can be subject to conflicts of interest. Thus, I personally am sorry that Basel III still places much more emphasis on risk-weighted ratios than on a simpler leverage ratio, with the latter being so permissive, at 33 to 1, that it is hardly more than a back-up minimal protection; though I would just note, en passant, that the central banks themselves are not now practicing what they preach in this respect. I hesitate to calculate their own leverage ratios in case I might scare someone.

I would prefer to shift the regulatory balance more toward the simpler overall leverage ratio, but to believe that by itself would suffice is to forget my prior aphorism. Simple leverage ratios can be overcome by taking on riskier assets, by accounting tricks, and by disintermediating over the boundary between what is included and what excluded in both the numerator and denominator. I would certainly not go so far as to promote a theory about the conservation of risk, but nevertheless much regulation has more influence on the locus where risk becomes concentrated rather than its overall extent. Nevertheless, the greater reliance in the US on simpler leverage ratios did help to limit the size, and hence the potential damage from the financial sector here, in contrast to Europe.

It has now become fashionable in economics to switch our similes from physics to epidemiology and ecology. In that vein, let me note that when a dangerous condition is resistant to a single antidote, it can often be treated by a cocktail of drugs. In the field of regulation that means that we should not aim to rely on a single approach, but use both risk-weighted and overall simple leverage ratios, belt and braces.

How to Get from Here to There

There are many who might claim that this issue of how to design the regulatory approach, i.e., risk-weighted, or simple leverage, or both, or something else again, is a second-order problem. The first-order problem was, instead, that the required amount of loss-absorbing equity capital, and available liquid assets, was just too low. Waving our Modigliani–Miller theorem in the air, we triumphantly demonstrate that the equilibrium interest rate spreads would not be much higher, whereas safety would be greatly enhanced, if normal equity ratios were raised by some sizable multiple over its pre-2008 starting point. Moreover, unless the standard, normally maintained, equilibrium ratio is much higher, how could the authorities possibly lower required ratios during periods of economic and financial stress, which is exactly what countercyclical macroprudential policy would imply that you should do.

Well okay, but such very much higher ratios have two consequential implications. First, they should not be treated, as they have been in the past, as reputational lower limits. They must be part of a usable buffer. That implies devising a ladder of sanctions as banks start to eat into such a large buffer, and on the need to make a conscious decision on where the bottom, acceptable limit, beyond which intervention and resolution should occur, is taken to be. Basel III has made a start in this direction, with the conservation range between 7% and 4.5% of core tier 1 equity, with banks in this range being restricted in their payouts to shareholders and management. But much more needs to be done to change ideas, presentation, and semantics to shift from treating all regulatory ratios as minimums to having many of them seen as norms.

But what is more immediately important is that the Modigliani–Miller analysis represents a comparison of static equilibrium states and has relatively little bearing on the dynamic process of shifting from state 1 to state 2. Indeed, several of our best economists who have been most prominent in defending Modigliani–Miller from the assault of bankers, for example, Anat Admati and Martin Hellwig, have been equally vocal in warning that the dynamic process of trying to move toward a much higher equilibrium capital ratio is fraught with difficulty and danger.

A combination of debt overhang, miserable price to book equity value ratios, and bank executives whose wealth is largely tied up with their own bank’s equity valuation means that banks will prefer deleveraging to making new equity issues. The more that regulators force up required ratios now, the worse will be deleveraging. Some answer that it is the market, not regulators, who demand higher bank equity ratios. Up to a point, but remember that so long as such ratios are treated as reputational minimums, what the market will demand is satisfactory buffers, or margins, above such regulatory ratios, whereas the latter are set by the regulatory authorities. To some extent the strong incentive at present not to issue more equity capital can be partially met by setting regulatory requirements, for the time being at least, in absolute rather than in ratio format, and using limitations on payouts to shareholders and bank executives as a sanction, or incentive, to get from here to there. In all such respects the actions on this front taken in the US have been much, much better than those in Europe.

Let me next draw your attention to an important recent British development related to the current Funding for Lending Scheme, or FLS. In economics, especially microeconomics, we are well aware of the important distinction between marginal and average. We can, and perhaps should, make that same distinction in regulation. Thus, under the FLS, additional lending to the UK private sector enjoys a waiver of risk-weighted CARs, while for other assets CARs have been greatly increased. Thus, by divorcing marginal from average regulatory requirements we can, to some extent, influence portfolio distribution separately from average safety requirements. I have advocated doing the same trick with commercial bank reserves at the central bank by lowering marginal returns, relative to the average returns on such reserves. One concern that I do have is that such schemes could be used to reinforce national financial protectionism by privileging lending at home rather than abroad. Another concern could be that regulatory instruments, which should be primarily about systemic safety, could then be increasingly employed for other macroeconomic purposes. But, that said, it is generally better to have more instruments rather than fewer.

A More Structural Approach

So there are undoubtedly difficulties in moving at all rapidly to a world in which the norm would be for banks to maintain substantially higher capital (and liquidity) ratios than in the recent past. Moreover, the ease of avoiding simple regulations suggests that we will have to maintain complex belt-and-braces combinations of risk-weighted and simpler leverage ratios. Even then, many would back clever bank employees to circumvent whatever the regulators think up. In this context there is a growing bandwagon toward a much more dirigiste approach to financial intermediation, constraining what banks can do, and what they are not permitted to do, a more structural approach. Let me repeat: I saw this latter kind of systemic structural approach personally when I started back in the 1960s and 1970s, and I did not much like it then. No doubt my views are colored by my personal experience.

Perhaps the leading example of this approach is to be found in the recommendation to separate retail and wholesale banking, as advanced by the British Independent Commission on Banking, the Vickers Report, and taken on in a marginally different guise by the recent Liikanen Report. It is far from clear to me why this separate subsidiarization under a single holding company should make for greater safety. Moreover, the bets that sank our banks were primarily about lending on property, commercial as well as residential. Such property-related loans are the bread and butter of retail banking. One of my legal colleagues in the UK has quipped that the effect of the separation will be to protect the safer wholesale bank from the risky retail outlet.

Moreover, with reinforced deposit insurance in place, and the availability of bridge banks, and good bank/bad bank mechanisms, the adverse externalities of allowing a retail bank to be closed and liquidated are, I would guess, considerably less than those arising from the closure of a similar-sized wholesale bank. The latter are likely to be far more interconnected, and their liquidation would, I expect, have a far more widespread and devastating effect on asset prices and the financial system more generally. The limitation of the public sector’s bailout safety net to the retail subsidiaries of banks strikes me as owing more to real-politik than to economic analysis.

Apart from the 1981–1982 LDC loan crisis, all the recent periods of severe financial stress in the UK, 1973–1975, 1991–1992, and 2008–2009, have all been connected with property price bubbles and busts. The adoption of the Vickers Report will not prevent the next banking crisis in the UK, which I forecast will probably occur around 2026–2027, (note the 16-year gaps between each of the last three cases). Several of the more radical structuralists, such as Larry Kotlikoff in the US or John Kay in the UK tend to concur, and to advocate that retail banks get forcibly transformed into “narrow” banks, holding only short-dated or cash claims on the public sector.

But narrow bank deposits would have a low return. If one were to allow broad, wholesale banks to compete by offering transactions related, short-dated deposits, there would be a hugely procyclical stampede of such deposits out of broad banks into narrow banks during busts, and in the opposite direction during good times. Our radical structuralists have, however, thought of this, and would respond by preventing broad banks from offering any transactions-related, or short-dated deposits. Such broad banks could only be financed by equity or by long-dated deposits with significant penalties for early withdrawal. They would be made run-proof by diktat.

Such a system with narrow banks holding only cash-type assets, and all other finance done through the equivalent of investment trusts would, indeed, be safe. But it would also be inflexible and inefficient. Banks currently make promises to potential borrowers that they will be prepared to lend to them in future, in the form of facilities and overdrafts, at a time of the borrower’s choosing without the bank having first already obtained the funding necessary to pay out to the borrower. It can do so because the bank in turn has, often short-term, lines of credit in wholesale markets, holds liquid assets, and at a pinch can also borrow from the central bank. Under the radical structural reforms, the investment banks would be left entirely reliant on their buffer reservoir of liquid assets for flexibility, or alternatively on the public sector providing the marginal funding. Either this buffer would have to expand a lot, which would both reduce the volume and raise the cost of the residual loans to the private sector, or potential private sector borrowers would have to queue until the broad banks had the funds in hand to lend on.

Overall the need for narrow banks to hold public sector debt and for broad banks to rely on a liquid assets buffer, presumably largely also of public sector debt, would privilege sales of public sector debt, relative to private sector debt, the hallmark of a repressed financial system. Indeed one aspect of Michael Kumhof’s “Chicago Plan Revisited” is that it helps to resolve the problem of financing an over-large public sector debt.

That was more or less exactly how the banking system worked in the UK and Europe before liberalization. Admittedly the constraint was direct controls over bank lending rather than the narrow bank/investment bank set up, but the effects would be much the same. Certainly it was safer; but I did not like it then and I would not like it now. Let us try the belt-and-braces approach to capital adequacy first, moving much more carefully toward a much higher norm for equity ratios, before turning...

Table of contents

• Cover
• Halftitle Page
• Title Page
• Copyright Page
• Contents
• Preface
• Acknowledgments
• Part I. Keynote Addresses
• Part II. Description and Measurement of the Financial System
• Part III. Social Bene?ts and Costs of the Current Financial System
• Part IV. Financial Industry Innovation
• Part V. Effects of Regulation, the Safety Net and Other Government Guarantees
• Part VI. Finance and Economic Activity: Variations across Emerging and Developed Markets
• Part VII. Break Up the Big Banks?
• Part VIII. Where to From Here? The Implications for Financial Regulatory Policy
• Agenda
• Index