VoxEU Column Financial Markets International Finance

The Dodd-Frank Act, systemic risk and capital requirements

Macroprudential regulation aims to reduce systemic risk by correcting the negative externalities caused by breakdowns in financial intermediation. This column describes the shortcomings of the Dodd-Frank legislation as a piece of macroprudential regulation. It says the Act’s ex post charges for systemic risk don’t internalise the negative externality and its capital requirements may be arbitrary and easily gamed.

The economic theory of regulation is clear. Governments should regulate where there is a market failure. It is a positive outcome from the Dodd-Frank legislation that the Act’s primary focus is on the market failure – namely systemic risk – of the recent financial crisis. The negative externality associated with such risk implies that private markets cannot efficiently solve the problem, thus requiring government intervention.

More concretely, current and past financial crises show that systemic risk emerges when aggregate capitalization of the financial sector is low. The intuition is straightforward. When a financial firm’s capital is low, it is difficult for that firm to perform financial services; and when capital is low in the aggregate, it is not possible for other financial firms to step into the breach. This breakdown in financial intermediation is the reason severe consequences occur in the broader economy. When a financial firm therefore runs aground during a crisis period, it contributes to this aggregate shortfall, leading to consequences beyond the firm itself. The firm has no incentive to manage the systemic risk.

For the first time, the Act highlights the need for macroprudential regulation, that is, (i) to measure and provide tools for measuring systemic risk (an example being the Office of Financial Research), (ii) to then designate firms, or even sectors (eg money market funds), that pose systemic risk, and (iii) to provide enhanced regulation of such firms and sectors.

While arguably this type of regulation was always in the purview of central banks and regulators, the current crisis has shown the importance of writing it into law. With sufficient progress in both analytics and regulation, we will several years from now have much better data, much more developed processes for dealing systemic risk, and overall a much better understanding of systemic risk.

We believe the benefits of macroprudential regulation outweigh its costs. However, there are two especially worrying outcomes of the Dodd-Frank Act and its implementation. One concerns the ex ante rather than ex post charges for systemic risk. The second concerns the calculation of capital charges for systemically important financial institutions.

But first, it needs to be pointed out that the Dodd-Frank Act puts a heavy reliance on the creation of an Orderly Liquidation Authority. Resolution is by its nature a balancing act between two forces that (potentially) work against each other. On the one hand, the regulator would like to mitigate moral hazard and bring back market discipline. On the other hand, the regulator would like to manage systemic risk. So how well does Dodd-Frank do in terms of balancing these two forces? From our viewpoint, it does not perform very well.

It seems to us that the Act is for the most part focused on the orderly liquidation of an individual institution and not the system as a whole. Of course, what is unique about a financial firm’s failure during a crisis is that it has an impact on the rest of the financial sector and the broader economy.

To put this into perspective, consider Federal Reserve Chairman Ben Bernanke’s oft-cited analogy for why bailouts, however distasteful, are sometimes necessary. Bernanke has described a hypothetical neighbour who smokes in bed and, through his carelessness, starts a fire and begins to burn down his house. You could teach him a lesson, Bernanke says, by refusing to call the fire department and letting the house burn to the ground. However, you would risk the fire spreading to other homes. So first you have to put out the fire. Only later should you deal with reform and retribution. This is what we would call legislation prior to Dodd-Frank.

We would argue that you should call the fire department, but instead of saving the neighbour’s house, the firefighters stand in protection of your house and those of your other neighbours. If the fire spreads, they are ready to put it out. And by the way, because a fire company is expensive to keep, we will charge all the smokers in the neighborhood the cost. And over time, the neighborhood will have fewer smokers. This is what we mean by balancing moral hazard mitigation and systemic risk management.

Dodd-Frank does not do this. Here is one example. The Act creates wrong incentives by charging ex post rather than ex ante for systemic risk. In particular, if firms fail during a crisis and monies cannot be fully recovered from creditors, the surviving systemically important financial institutions must make up the difference ex post. This actually increases moral hazard because there is a free-rider problem – prudent firms are asked to pay for the sins of others. It also increases systemic risk in two important ways. First, firms will tend to herd together and a race to the bottom could ensue. Second, this clause is highly procyclical because it requires the surviving firms to provide capital at the worst possible time.

Our second concern relates to recent developments on the macroprudential dimension. The basic thrust of Basel III is higher capital requirements overall – and then, for systemically risky institutions, even higher capital requirements. The criteria for systemic risk are five factors based on size, interconnectedness, lack of substitutability, complexity, and level of global activity. To the extent that the capital requirements for systemically risky firms could increase by 2.5%, one has a terrible feeling that implementation might be very Basel-like and just assign 0.5% to each of these factors. Whether it is risk weights, level of new capital required, how firms are chosen to be systemic, and surcharges on these systemic firms, it all seems somewhat arbitrary and not based on objective criteria. And, for sure, the implementation will be quite coarse and therefore easily gamed.

What we care about is the risk that a firm will falter when other firms are struggling, in other words, the codependence between financial firms. Key factors that go into this measurement are therefore how much leverage a firm has, how correlated its assets in the bad state of nature are, and whether its failure increases the likelihood of other firms failing.

In the following, we provide one such way to think about setting capital requirements in a systemically risky world. 

1. Why are capital requirements so important and why are capital levels cyclical?

When a large part of the financial sector is funded primarily with leverage and is hit by a common shock such as a steep drop in house prices, individual financial firms cannot meet immediate repayments demanded by their creditors. There simply are not enough well-capitalized, or low-leverage, firms in the system to buy other firms’ assets, re-intermediate with their borrowers, or lend at reasonable rates and maturities in interbank markets. Capital is thus the lifeblood of the financial system when it is under stress. But that is precisely when capital becomes scarce. Invariably, an aggregate credit crunch and loss of intermediation ensue. 

2. How should capital requirements be designed in good times to prevent and manage this systemic risk that collective under-capitalization of the financial sector can create spillovers to real and household sectors?

A reasonable criterion is to set the capital requirement such that a financial firm should in expectation have enough capital to withstand a full-blown crisis. In other words, E[Ei|crisis>/ KiE[Ai|crisis], where Ei is financial firm i’s equity, Ai is the firm’s total assets (ie, its equity capital plus debt obligations), and 1/Ki is the firm’s maximum leverage ratio at which it still provides full financial intermediation. For example, in Basel III, the minimum ratio of common equity capital to assets Ki = 3%. 

3. What does this criterion imply for capital requirements?

It is possible to derive that the minimum required capital today is

where MES is the firm’s marginal expected shortfall, defined as its expected percentage loss in equity capital conditional on a financial crisis.

4. How would this work?

Consider the recent financial crisis. The average return of the worst quartile of performing bank holding companies was -87% versus -17% for the top performing quartile during the crisis. For the 3% minimum, this would translate to a 19.2% capital requirement before the crisis for the more systemic firms (as measured by ex post MES of 87%) and just 3.6% for the less systemic ones (MES of 17%). Alternatively, using ex ante measures, the NYU Stern risk rankings of the 100 largest financial firms suggest a range of MES from 40% to 75%, implying capital requirements ranging from 5% to 11%. 

5. What are the key implications of this methodology?

a. The first is that this capital requirement is fairly simple to interpret and can be calculated in a straightforward manner. What is required is an expectation of a firm’s equity capital loss during a financial crisis. One could employ statistical-based measures of capital losses of financial firms extrapolated to crisis periods. With a number of our colleagues here at NYU Stern, we have done just that with state-of-the-art time-series techniques. The aforementioned systemic risk rankings of financial firms are provided at http://vlab.stern.nyu.edu/welcome/risk. Of some interest, these measures estimated in 2006 and early 2007 load quite closely on the firms that performed poorly during the financial crisis. Or, regulators could estimate a firm’s capital losses during adverse times via stress tests of financial institutions. Stress tests are conducted routinely by regulators and the estimated percentage losses from these tests could simply be substituted into the above formula for capital requirements. Of course, the regulator would need to impose scenarios that necessarily coincide with financial crises, in other words, much more severe than those employed in stress tests this year both in the US and Europe.

b.      The second point is that our risk factor

is a scaling-up factor on firm’s assets, a kind of ‘systemic risk weight’ that is rather different from the asset-level risk weights set forth in Basel II, and now expanded in III. A strong case can be made that the current crisis was all about large complex financial firms exploiting loopholes in Basel risk weights to make a one-way concentrated bet on residential and commercial mortgages. By attempting to estimate a firm’s losses in a bottom-up, granular manner, the Basel risk weights create room for tremendous gaming by the financial sector, and provide incentives to enter into specific spread trades and concentrate risk. In other words, there is a reason why firms loaded up on AAA-rated higher-yielding securities and purchased protection on these securities from AA- or AAA-rated insurance companies like AIG. In contrast, our approach, based on a top-down, market-based systemic measure, incorporates the risk of the underlying assets when we care most, namely during a financial crisis, and is much harder to game.

6. What are the capital requirements changes under Basel III?

With respect to capital requirements, Basel III effectively increases (with the conservation of capital buffer) capital requirements from 4% to 7%. On top of these requirements, based on a series of firm characteristics related to Basel’s systemic risk criteria, these capital requirements can be increased by an amount ranging from 0%-3%. Along with a number of other adjustments, Basel III introduces a new ‘simple’ leverage ratio as a supplementary measure to risk-based capital which is to be set at 3%. For practical purposes, Basel III continues the risk weights that are tied to credit ratings both within and across asset classes

7. Are the changes under Basel III sensible?

a.      First and foremost, the systemic risk weights seem arbitrary and are not based on objective criteria. Thus, across-the-board higher capital requirements, as are being proposed for systemically important financial institutions, may actually exacerbate the problem. Regulation should not be about more capital per se but about more capital for systemically riskier financial firms.

b.      Second, our methodology makes clear that higher capital requirements resulting from systemic risk do not have to coincide with larger financial institutions. For a variety of reasons, it may well be the case that large financial institutions deserve heightened prudential regulation. But if the criterion is that they need sufficient capital to withstand a crisis, it does not follow that size necessarily is the key factor unless it adversely affects a firm’s marginal expected shortfall, ie its performance in a crisis.

c.      Third, it is certainly the case that a bank’s return on equity does not map one-to-one with a bank’s valuation. A higher return on equity might simply reflect higher leverage on the bank’s part, and the benefit of leverage may be arising from the government safety net. Therefore, calling for a higher equity capital requirement may be sensible. That said, there seems to be little economic analysis of what the right level of capital should be.

d.      Finally, whatever is being proposed for the banking sector in terms of capital requirements should have comparable regulation for the shadow banking sector, lest the activities simply be shifted from one part of financial markets to another. The result of such a shift could actually lead to an increase in systemic risk.