By Edward Kane, Professor of Finance at Boston College and founding member of the hadow Financial Regulatory Committee
“We are a moving company not a storage company”
…Apocryphal Bear Stearns executive
Regulators define a financial institution’s capital as the difference between the value of its asset and liability positions. The idea that capital requirements can serve as a stabilization tool is based on the presumption that, other things equal, the strength of an institution’s hold on economic solvency can be proxied by the size of its capital position.
This way of crunching the numbers shown on a firm’s balance sheet seems simple and reliable, but it is neither. It is not simple because accounting principles offer numerous variations in how to decide which positions and cash flows are and are not recorded (so-called itemization principles), when items may or may not be booked (realization principles), and how items that are actually booked may or may not be valued (valuation principles). Accounting capital is not a reliable proxy for a firm’s survivability because, as a financial institution slides toward and then into insolvency, its managers are incentivized to manipulate the ways they apply these principles to hide the extent of their weakness and to shift losses and loss exposures surreptitiously onto the government’s safety net.
These incentives are reinforced by the reluctance of government lawyers to pursue managers of key financial firms in open court and by the ethically questionable notion that managers owe fiduciary duties of loyalty, competence, and care to their stockholders, but only covenanted duties to taxpayers and government supervisors. By covenanted duties, I mean those established by explicit legislative and regulatory requirements.
In policymaking, framing is crucial. Bear Stearns failed because the volume of dicey deals it was processing expanded its pipeline and put it into the storage business in a big way. Framing a nation’s safety net as an insurance scheme rather than a source of implicit equity provides similarly misleading cover for managers of difficult-to-fail financial firms to pick the pockets of other citizens.
Casting taxpayers as insurers makes it seem both wise and lawful to put the onus on professional regulators to understand the risks and to develop and enforce covenants intended to stop protected parties from gaming the safety net. Cousy (2012) notes that, while traditional insurance law imposed a duty on the insured party to disclose relevant information on its circumstances, modern insurance law increasingly focuses on protecting the policyholder rather than the insurer. The sanction of termination and forfeiture is now often limited to “serious cases where some high degree of intention and culpability is involved” (p. 131).
Conceiving of taxpayers as disadvantaged equity investors in protected firms suggests that they should have a legal standing similar to that of explicit shareholders. One way to do this is to reimagine taxpayers’ stake in protected firms as a kind of trust fund. Such a perspective implies that managers owe taxpayers fiduciary duties, including those of disclosure and nonexpropriation of their funds. If these duties were expressly written into corporate and even criminal law and taxpayers’ stake measured and managed by a dedicated board of nonregulator trustees with long-lived appointments, it would be easier for regulators and the courts to punish managers for dishonest accounting schemes and nontransparent forms of risk-taking that pilfer value from the safety net. As long as the fear of timely and effective individual punishments remains low, the temptation to circumvent or evade regulatory restraints will be extremely strong.
The root problem is twofold: (1) the existence of government safety nets gives protected firms an incentive to conceal leverage and aggressively manage their risk-weighted assets as a way of shifting tail risk to taxpayers and (2) regulators have insufficient vision and incentives to stop them. Asking firms to hold more capital than they want lowers the return on equity their current portfolio can achieve. This means that installing tougher capital requirements has the predictable side effect of simultaneously increasing a firm’s appetite for risk, so as to increase the rate or return on its assets enough to establish a more satisfying equilibrium. As Basel III becomes operational, aggressive institutions can and will game the system. Aided by the best financial, legal, and political minds that money can buy, they will ramp up their risk-management skills and expand their risk-taking over time in clever and low-cost ways that, in the current ethical and informational environments, overweening regulators will find hard to observe, let alone to discipline. When it comes to controlling regulation-induced risk-taking, regulators are outcoached, outgunned, and always playing from behind.
Cousy, Herman, 2012. “About Sanctions and the Hybrid Nature of Modern Insurance Contract Law,” Erasmus Law Review, 5 (no. 2), 123-131.