Too Much Capital in the Banking System, Not Enough Safety?

There is a strong consensus that banks had insufficient reserves set aside for a rainy day and that they should be required to hold more capital. This column says we should differentiate institutions less by what they are called and more by how they are funded. Encouraging individual risks to flow to those who can absorb them would make the system safer and introduce new players with risk capacities.

There is a strong consensus that banks had insufficient reserves set aside for a rainy day and that they should be required to hold more capital – more capital for credit risks, more capital for the economic cycle, more capital for liquidity risks, more capital for operational risks, more capital for risks as a result of compensation practices, in short, more capital for anything that moves (see Gersbach 2009; Perotti and Suarez 2009). Banks, so dependent on governments for both liquidity and capital today, are in no position to argue otherwise. However, requiring the banking system to hold more capital on average will not improve the resilience of the financial system if we do not also better match risk-taking to risk-capacity. Indeed, piling up capital requirements may also act as an anti-competitive barrier, reinforcing the spectre of a few banks holding a government hostage because they are too big to fail.

John Nugee and I have argued that at the heart of the failure of the “Basel” system of financial regulation, was a misguided view of risk that said risk was an absolute, constant property of an asset, which can be measured, sliced, diced and transferred (Nugee and Persaud 2006). This is an elegant view of risk and has the merit of being measurable in a way that allows banks to build highly complex models based on it and sell highly complex risk management products to handle and distribute it. It is also an artificial construct that has little bearing on the nature of risk.

In reality, there is not one constant risk. The three broad financial risks are:

» credit risk,
» liquidity risk, and
» market risk.

These risks are very different. Moreover, the potential spillover risks of someone holding an asset depends as much on who is holding it as the nature of the asset. Different holders have different capacities for different risks. The distinction between “safe” and “risky” assets is deceptive; you can do a lot of damage with a simple mortgage.

Capacity for a certain type of risk is best assessed by considering how that risk is hedged. Liquidity risk – the risk that an immediate sale would lead to a large discount in the price – is best hedged using through time and held by institutions that do not need to respond to an immediate fall in price, perhaps because the financing for that asset is fixed, rather like a traditional pension, insurance, or private equity fund. A bank funded with short-term money-market deposits has little capacity for liquidity risk. Credit risk – the risk that someone holding your money defaults – is not hedged by having more time for the default to happen but through offsetting credit risks. Banks with their closeness and access to a wide range of credits have a far greater capacity to hedge credit risks than most.

The way to reduce systemic risks is to encourage individual risks to flow to where there is a capacity for them. Unintentionally, regulation did the opposite. By not requiring firms to put aside capital for maturity mismatches and by encouraging mark-to-market valuation and daily risk-management of assets by everyone, regulators encouraged liquidity risks to flow to banks that boosted earnings by leveraging up liquidity risk even though they had little capacity for it. By requiring banks to hold capital against credit risks, regulators encouraged credit risk to flow to those who yearned for the extra yield, were not required to set aside capital for credit risks, but had limited capacity to hedge that risk. No amount of capital can remedy a system that inadvertently leads risk-bearing assets to be held by those without a capacity to hold them.

Conclusion

What is to be done? We need to differentiate institutions less by what they are called and more by how they are funded. We should require more capital to be set aside for risks where there is no natural hedging capacity. This will draw risks to where they can be best absorbed. We must also work to make value accounting and risk management techniques sensitive to funding and risk capacity – a call echoed in the Goodhart Report. A resilient financial system is one in which at times of stress, assets with good credit quality but poor liquidity are sold by institutions with short-term funding using short-term valuation and risk rules and at a suitable valuation are bought by institutions with long-term funding using long-term valuation and risk rules. Under the current system, the natural risk absorbers behave like risk traders, selling and buying when everyone else is.

Capital requirements that encourage those with a capacity to absorb a type of risk to hold it will not only make the system safer – without destroying the risk-taking vital for economic prosperity – but also introduce new players with risk capacities. This would both strengthen the resilience of the financial system and reduce our dependence in a crisis on a few banks that appeared well capitalised during the preceding boom.

References

Geneva Report (2009). “The Fundamental Principles of Financial Regulation” a VoxEU.org Publication, by Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash Persaud, and Hyun Shin.
Nugée, John and Persaud, Avinash D., Redesigning Regulation of Pensions and Other Financial Products. Oxford Review of Economic Policy, Vol. 22, No. 1, pp. 66-77, 2006.
Gersbach, Hans (2009), Banking on the average: A new way to regulate banks, VoxEU.org, 8 January.
Perotti, Enrico and Javier Suarez (2009) Liquidity insurance for systemic crises, VoxEU.org, 11 February.

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