VoxEU Column Financial Markets

Everything the IMF wanted to know about financial regulation and wasn’t afraid to ask

Does anybody have a clear vision of the desirable financial system of the future? This column has one. It gives simple answers to 12 simple questions panellists at a recent IMF conference failed to answer.

I was honoured when the IMF asked me to moderate the Financial Regulation panel at this year’s Rethinking Macro II conference. And while naturally, I delivered one of the more enlightening and thought-provoking policy discussions of the conference, I did fail in my duties as moderator to make sure my panellists covered all the excellent questions our sponsors submitted to us. Of course, this was to be expected, as panellists at these types of events almost never address the topics requested of them (I certainly never do), but rather, like Presidential candidates, answer the questions they want to answer. However, being the conscientious person I am, who accepts responsibility for my mismanagement (unlike some bank CEOs we know), I will now step up and answer those questions myself.

1) Does anybody have a clear vision of the desirable financial system of the future?

Yes, me. It should be smaller, simpler, less leveraged and more focused on meeting the credit needs of the real economy. And oh yes, we should ban speculative use of credit default swaps from the face of the planet.

2) Is the ATM the only useful financial innovation of the last thirty years?

No. IF bankers approach the business of banking as a way to provide greater value at less cost to their customers, (I know – for a few bankers, that might be big 'if') technology provides a virtual gold mine for product innovations. For instance, I am currently testing out a pre-paid, stored value card which lets me do virtually all my banking on my I-phone. It tracks expenses, tells me when I’ve blown my budget, and lets me temporarily block usage of the card when my daughter, unbeknownst to me, has pulled it out of my wallet to buy the latest jeans from Aeropostale. The card, aptly called Simple, was engineered by two techies in Portland, Oregon. (Note to mega-banks: ditch the pin stripes for dockers and flip flops. The techies are coming for you next.)

3) Does the idea of a safe, regulated, core set of activities, and a less safe, less regulated, non-core make sense?


The idea of a safe, regulated, core set of activities with access to the safety net (deposit insurance, central bank lending) and a less safe, MORE regulated, noncore set of activities which DO NOT UNDER ANY CIRCUMSTANCES have access to the safety net – that makes sense.

4) How do the different proposals (Volcker rule, Liikanen, Vickers) score in that respect?

Put them all together and you are two-thirds of the way there. The Volcker Rule acknowledges the need for tough restrictions on speculative trading throughout the banking organisation, including securities and derivatives trading in the so-called “casino bank”. Liikanen and Vickers acknowledge the need to firewall insured deposits around traditional commercial banking and force market funding of higher risk “casino” banking activities. Combining them would give us a much safer financial system.

But none of these proposals fully address the problem of excessive risk taking by non-bank financial institutions like AIG. Title I of Dodd-Frank empowers the Financial Stability Oversight Council to bring these kinds of “shadow banks” under prudential supervision by the Fed. Of course, that law was enacted three years ago and for nearly two years now, the regulators have promised that they will be designating shadow banks for supervisory oversight “very soon”. This was repeated most recently by Treasury Secretary Jack Lew on 22 May 2013, before the Senate Banking Committee (but this time he REALLY meant it). For some reason, the Fed and Treasury Department were able to figure out that AIG and GE Capital were systemic in a nano-second in 2008 when bailout money was at stake, but when it comes to subjecting them to more regulation now, well, hey we need to be careful here.

5) How much do higher capital ratios actually affect the efficiency and the profitability of banks?

You don’t have to be very efficient to make money by using a lot of leverage to juice profits then dump the losses on the government when things go bad. In my experience, the banks with the stronger capital ratios are the ones that are better managed, do a better job of lending, and have more sustainable profits over the long term, with the added benefit that they don’t put taxpayers at risk and keep lending during economic downturns.

6) Should we go for very high capital ratios?

Yep. I’ve argued for a minimum leverage ratio of 8%, but I like John Vickers 10% even better (and yes, he put out that news-making number during my panel…)

7) Is there virtue in simplicity, for example, simple leverage rather than capital ratios, or will simplicity only increase regulatory arbitrage?

The late Pat Moynihan once said that there are some things only a PhD can screw up. The Basel Committee’s rules for risk weighting assets are Exhibit A.

These rules are hopelessly overcomplicated. They were subject to rampant gaming and arbitrage prior to the crisis and still are. (If you don’t believe me, read Senator Levin’s report on the London Whale.) A simple leverage ratio should be the binding constraint, supplemented with a standardised system of risk weightings to force higher capital levels at banks taking undue risks. It is laughable to think that the leverage ratio is more susceptible to arbitrage than the current system of risk weightings given the way risk weights were gamed prior to the crisis, e.g. moving assets to the trading book, securitising loans to get lower capital charges, wrapping high risk CDOs in CDS protection to get near-zero risk charges, blindly investing in triple A securities, loading up on high-risk sovereign debt, repo financing … need I go on?

8) Can we realistically solve the “too big to fail” problem?

We have to solve it. If we can’t, then nationalise these behemoths and pay the people who run them the same wages as everyone else who work for the government.

9) Where do we stand on resolution processes, both at the national level and cross border?

Good progress, but not enough. Resolution authority in the US could be operationalised now, if necessary, but it would be messy and unduly expensive for creditors. We need thicker cushions of equity at the mega-banks, minimum standards for both equity and long-term debt issuances at the holding company level to facilitate the FDIC’s “single point of entry” strategy, and most importantly, we need regulators who make clear that they have the guts to put a mega-bank into receivership. The industry says they want to end “too big to fail” but they aren’t doing everything they can to make sure resolution authority works smoothly. For instance, industry groups like ISDA could greatly facilitate international resolutions by revising global standards for swap documentation to recognise the government’s authority to require continued performance on derivatives contracts in a Dodd-Frank resolution.

10) Can we hope to ever measure 'systemic risk'?

Yes. It’s all about inter-connectedness which mega-banks and regulators should be able to measure. Ironically, inter-connectedness is encouraged by those %$#@& Basel capital rules for risk weighting assets. Lending to IBM is viewed 5 times riskier as lending to Morgan Stanley. Repos among financial institutions are treated as extremely low risk, even though excessive reliance on repo funding almost brought our system down. How dumb is that?

We need to fix the capital rules. Regulators also need to focus more attention on the credit exposure reports that are required under Dodd-Frank. These reports require mega-banks to identify and quantify for regulators how exposed they are to each other. Mega-bank failure scenarios should be factored into stress testing as well.

[Since these questions relate to financial regulation, I will not opine on measuring systemic risks building as a result of loose monetary policy.]

10) Are banks in effect driving the reform process?

Sure seems that way.

11) Can regulators ever be as nimble as the regulatees?

Yes. Read Roger Martin’s Fixing the Game. Financial regulators should look to the NFL for inspiration.

12) Given the cat and mouse game between regulators and regulatees, do we have to live with regulatory uncertainty?

Simple regulations which focus on market discipline and skin-in-the-game requirements are harder to game and more adaptable to changing conditions than rules which try to dictate behaviour. For instance, thick capital cushions will help ensure that whatever dumb mistakes banks may make in the future (and they will), there will be significant capacity to absorb the resulting losses. Unfortunately, the trend has been toward complex, prescriptive rules which smart banking lawyers love to exploit. Industry generally likes the prescriptive rules because they always find a way around them, and the regulators don’t keep up.

You can see that dynamic playing out now, where the securitisation industry is seeking to undermine a Dodd-Frank requirement that securitisers take 5 cents of every dollar of loss on mortgages they securitise. They say risk retention is no longer required because the Consumer Bureau has promulgated mortgage lending standards. But these rules are pretty permissive (no down payment requirement, and a whopping 43% debt-to-income ratio) and I’m sure that the Mortgage Bankers Association is already trying to figure out ways to skirt them.

Rules dictating behaviour can sometime be helpful, but forcing market participants to take the losses from their risk-taking can be much more effective. One approach tells them what kinds of loans they can make. The other says that whatever kind of loans they make, they will take losses if those loans default.

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