Something very peculiar is afoot. Well after the bank regulatory reform debate was supposedly settled, central bankers seem to be reopening that discussion. It’s puzzling because the very reason the banks won so decisively was that central bankers were not prepared to get all that tough with their charges.
I’m not clear what has led central bankers to get a bit of religion. Is it the spectacle of the Bank of England talking about breaking up the banks (they won’t get their way thanks to bank lobbyist working over the Independent Banking Commission, but no one doubted their sincerity)? Or the Swiss National Bank imposing 19% capital requirements, which as we discussed, is likely to lead to the investment banking are of UBS being domiciled elsewhere (assuming a country capable of bailing it out will have it)? Or perhaps it is central bankers being forced to recognize that their Plan A of extend and pretend and super low interest rates simply won’t lead banks getting to meaningfully higher capital levels when the staff continues to take egregious amounts out in compensation? Or have they realized how bad bank balance sheets are in the Eurozone and how tight the linkages still are among the major capital markets players, and they belatedly realize they need them to be much more shock resistant?
The bottom line is that various central bankers have taken the surprising step of insisting their banks meet more stringent requirements for the biggest banks than those originally planned to be to be included in Basel III. Per Bloomberg:
The Basel Committee on Banking Supervision is considering extra capital requirements of as much as 3.5 percentage points that the largest banks may face if they grow bigger, according to two people familiar with the talks.
The so-called surcharge would take the form of a boost to capital the banks must hold and would apply to financial institutions whose collapse would harm the global economy. A list of such banks hasn’t been disclosed.
Draft plans circulated before a meeting next week would subject banks to a sliding scale depending on their size and links to other lenders, said the people, who declined to be identified because the proposals aren’t public. Banks wouldn’t initially face the highest surcharge, which is intended as a deterrent to expansion, one person said. The largest banks may face a 3 percentage point levy at their current sizes
Predictably, banks who have been conditioned to throw temper tantrums to get their way are now howling at the prospect of being asked to hold more capital. But to me, the most important element here is that being exposed to other banks, or “tightly coupled” is being discouraged. As we have discussed in other posts, following the work of the Bank of England’s Andrew Haldane, there are two approaches to companies that produce externalities, like pollution and financial crises: taxation or prohibition. Which is appropriate depends on the level of private costs versus social costs. When social costs are high relative to private costs, prohibition makes more sense. Haldane did a back of the envelope calculation that showed that taxation was grossly inadequate as a remedy (we’ve cited this quote repeatedly precisely because we think it’s critically important):
….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. That means that taxation (and capital charges are effectively a form of taxation, in that they are meant to change the economics of the business so as to discourage certain behaviors) is an inadequate remedy and far more aggressive measures are warranted.
That view is confirmed by another way of thinking about the problem. The TBTF banks are tightly coupled, which means when Something Bad happens, problems propagate through the system so rapidly that it is well nigh impossible to interrupt the process. It’s like a badly designed electrical grid where a bolt of lightening hitting one transformer would take the entire eastern half of the US down.
In tightly coupled systems, you need to undo the tight coupling first. That’s why remedies like exchanges and clearing houses are in theory improvements, since they create contained points of failure (but in practice, the derivatives clearinghouses mandated in Dodd Frank may wind up being inadequately margined due to the unwillingness to require sufficient margin on credit default swaps since they would render the product uneconomical, and not sufficiently independent of the big banks to achieve the desired risk reduction). But the most important measure, that of breaking up the big banks and requiring firms to be more specialized (say investment banks, retail banks, and asset managers) and subject to sector-specific rules, is off the table.
If the excessive integration is not alleviated, measures intended to reduce risk typically make matters worse. This was a discussion from reader Lune on March 17, 2008. Notice how many elements of the forecast, the stresses on Fannie and Freddie becoming untenable and the mortgage market continuing to be a mess, have come to pass:
We’ve already seen the law of unintended consequences so far:
1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.
2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.
Lune also provided a forecast that in many respects was prescient. And that was because, just as you’d expect in a tightly coupled system, the more you try to do, the worse things get.
And not only has Basel III not addressed why our financial system is so disaster prone, but it also falls short on other fronts. Our Richard Smith provided very informative write-ups (see here, here and here)
The bizarre bit here is the sudden gear shift by central bankers. Basel III was correctly criticized on a number of fronts: ridiculously attenuated phase in (the new capital rules aren’t fully in effect until 2019), preserving the concept of risk weighted assets (when as London Banker scathingly pointed out, hasn’t fared too well), and a failure to address liability side issues (particularly as relating to derivatives; they were a major culprit in why Lehman’s leak turned out to instead be a black hole). This is Richard Smith’s drive-by shooting:
Here are my main gripes:
Valuation: the capital ratios mean nothing if the assets are overvalued. Waldman is always going on about this. It ends up as quite a radical critique: capital ratios without valuation reform = cart before horse.
Accounting: there is still no harmonization of accounting practices on all the shadow banking apparatus: for instance, special purpose vehicles, derivative netting and repos. Actually, of course, when you come across things like Repo 105, or BoA’s quarter end balance sheet manipulations, there don’t seem to be any relevant reputable accounting practices at all; even if you think Lehman’s liquidity pool probably is an outlier, some of this stuff really, really needs fixing. And do we think that under Basel III there will be more accounting dodges that will cross the line from ‘asset sweating’ to ‘accounting manipulation’? Not Basel III’s fault, but I rather think we do expect exactly that.
Regulatory risk weightings are still a mess, with the ratings agencies still ensconced as the arbiters of credit quality.
Then of course there is shadow banking, which Basel III largely dances around. One particularly glaring example is the whole custody/client money/asset segregation/rehypothecation/title mess in London. There’s not a peep, burble or whisper here in the UK about the sort of legal reforms (somewhat in the manner of the US’s 1934 Securities Act, perhaps, plus a UK version of SIPC) that would sort this out. Recent Lehman-related rulings on Client Money actually mess the situation up even more. Of course, our obligingly vague 17th century line on “who owns what” works very capital-efficiently for Prime Brokerages. Which is a big part of why Mayfair now houses a $4 Trillion shadow banking system. Push from Basel III would have helped get more of a grip.
I have nothing to say about enforcement; it’s been such a long time since I’ve seen any that I’ve forgotten what it is.
So it should not be at all surprising that former Kansas City Fed chief Thomas Hoenig gives a very strongly worded diss to what passes for financial reform in the US. His point of departure was the idea that UBS might decide to move its investment banking operations to the US. Hoenig dismissed that idea because our regulations are too weak and we should not be allowing new big players to be in a position to fail on our taxpayer nickel. As Hoenig wrote in the Financial Times:
Some argue that both the US Dodd-Frank Act and Basel III capital requirements have now ended US bail-outs. But these efforts do not solve the fundamental flaw in the system: there are highly complex and opaque banking organisations engaged in a variety of non-core, high-risk activities while backed by a public safety net. The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.
These new regulatory changes actually extend, or make more complicated, what we have tried to do before. For example, Dodd-Frank requires enhanced prudential supervision and regulation that increases incrementally with the systemic risk of the largest financial companies. Yet that design simply cannot be effective if the risk cannot be monitored or assessed.
Similarly, the new Financial Stability Oversight Council is to look for evolving systemic risk and take appropriate actions – an impossible task because problems are only obvious after the fact. There are many examples over the past 20 years, but one need look no further than the recent housing bubble. I applaud the Swiss for requiring significantly higher capital ratios, but if that were enough, Swiss authorities would be more interested in having UBS retain its investment banking activities.
Hoenig outlined his own proposal, which is presented in longer form at the Kansas City Fed website. It goes considerably in the direction of prohibition, such as limiting the activities of banks to socially useful activities and restricting the access of shadow banks to wholesale funding markets. One can quibble with the particulars of Hoenig’s proposals, but that is the direction we need to go in if we are to have any hope of preventing another large scale financial crisis.