Following the demise of Lehman Brothers, the debate on regulatory reform has led to the conclusion that large banking institutions must be broken up and their risk-taking activities limited by law along the lines of the ‘Volcker rule’ (Gros 2010). Not only are such actions unnecessary, they may be hard to implement and could reduce the availability of credit to the economy (if for example they reduce the ability of banks to hedge their credit positions). The main consequence of such a plan would be the disintegration of global financial markets as they break down into segregated national markets.
In recent research, my colleagues and I set out an alternative solution that can achieve a more stable and resilient financial system without renouncing the benefits of global and multi-purpose financial institutions and innovative finance (Carmassi et al 2010).These are predicated on effectively curtailing moral hazard and strengthening market discipline on banks’ shareholders and managers by raising the cost of the banking charter to fully reflect its benefits for the banks, and restoring the possibility that all – or at least most – large banks can fail without unmanageable systemic repercussions.
Back to basics
The crisis was generated by cross-border banks levering their deposit base and acting, through the wholesale interbank market, as the residual suppliers of liquidity for all the other players in financial markets. This multiplied funds for speculation and helped to sustain a gigantic inverted pyramid of securities made up of other securities and yet again other securities. Without the money-multiplying capacity of the banks, the asset price bubble and the explosion of financial intermediation and aggregate leverage would not have been possible. Extreme investment strategies by bankers obviously reflect moral hazard created by the expectation that governments would step in to bail them out in case of large losses.
The first thing that needs to be done in order to restore corrective incentives for bank managers and shareholders is to eliminate the most obvious pitfall in banking regulation, that is, reliance on capital requirements based on risk-weighted assets. This approach is flawed since asset risk cannot be assessed and measured independently of market conditions and market sentiment. As a result, the need for capital will always be underestimated under favourable market conditions, leading to balance-sheet fragility and precipitous asset sales when market sentiment turns sour. Banks need a capital buffer to overcome the massive asymmetries of information between bank managers on one side, and investors and regulators on the other. This asymmetry currently makes it easy for bankers to accumulate excessive risks in the quest for higher returns, before markets become aware. The way to do this is to set capital requirements in straight proportion to total assets or liabilities of banking groups.
Fixing flaws in prudential capital rules does not remove moral hazard from the banking system, whose specific sources must be tackled separately. These are:
- the deposit-institution franchise,
- the implicit or explicit promise of bailout in case of threatened failure, and
- regulatory forbearance.
The problem associated with the deposit franchise is well known. If depositors have doubts on the bank’s solvency, they will run for the exit, forcing rapid liquidation of banks’ assets, possibly with large losses and contagion spreading instability to other banking institutions.
First pillar for tackling moral hazard
Deposit insurance can reassure depositors, and thus is the first pillar for tackling moral hazard, but it also mutes their incentive to monitor the management of their bank, since they no longer risk losing their money.
More importantly, deposit insurance has evolved in most countries into a system effectively protecting the bank, or the entire banking group, rather than depositors. When a bank risks becoming insolvent, supervisors step in to cover its losses and replenish its capital so as to avoid any adverse repercussions on market confidence. Moreover, most deposit insurance systems are inadequately funded by insured institutions, entailing an implicit promise that taxpayers’ money will make up the difference in case of failure of large banks.
Thus, in order to re-establish a proper price for the banking charter, banks should carry, ex ante, the full cost of deposit protection, making sure that in most circumstances the guarantee fund would be adequate to reimburse depositors when individual banks fail. Of course, no fund could ever be sufficient to meet a general banking crisis, but a fund of an appropriate size would offer adequate protection in normal circumstances, with only a predictable share of banks going bankrupt.
Deposit insurance fees are the right instrument to make banks pay for risk generated by banks. They should be determined on the basis of a careful probabilistic assessment of the likelihood of failure within the overall pool of deposits and risks of the banking system (within appropriately defined market jurisdictions). This is where the risk profile of banks’ asset and loan portfolios can be taken fully into consideration, together with, more broadly, the quality of bank management and risk control, thus creating effective penalties for riskier behaviour. Size itself could be appropriately penalised by higher fees that would incorporate a probabilistic price for the potential threat for systemic stability.
Second pillar: Not “too big to fail”
The second pillar required in order to greatly limit moral hazard in the financial system is credibly removing the promise that large banks cannot fail. To this end, all main jurisdictions should establish special resolution procedures – as already exist in the US and the UK – managed by an administrative authority, with powers to require early recapitalisation, manage required reorganisations and, once all this has failed, liquidating the bank with only limited systemic repercussions. Crisis prevention, reorganisation and liquidation would all be part of a unified consolidated resolution procedure managed for each bank, by one administrative authority.
In order to make resolution feasible, all banks and banking groups would be required to prepare and provide to their supervisors a document detailing the full consolidated structure of legal entities that depend on the parent company for their survival, the claims on the bank and their order of priority, and a clear description of operational – as distinct from legal – responsibilities and decision-making, notably regarding functions centralised with the parent company. This “living wills” document may also comprise “segregation” arrangements to preserve certain functions of systemic relevance even during resolution: for clearing and settlement of certain transactions, netting out of certain counterparties, suspension of covenants on certain operations.
Third pillar: No regulatory forbearance
Finally, the third pillar of an effectively reformed financial system is a set of procedural arrangements that will prevent supervisory forbearance. Supervisory discretion to postpone corrective action would be strictly constrained, so that bankers, stakeholders and the public would know that mistakes would always meet early retribution. To this end it is necessary to establish a system of early mandated action by bank supervisors ensuring that, as capital falls below certain thresholds, the bank or banking group will be promptly and adequately recapitalised. Should capital continue to fall, then supervisors should be required to step in and impose all necessary reorganisation, including disposing of assets, selling or closing lines of business, changing management, ceding the entire bank to a stronger entity.
Should this not work, then liquidation would commence. A bridge bank would take over deposits and other “sound” banking activities, thus ensuring their continuity. All other assets and liabilities, together with the price received for the transfer of assets to the bridge bank, would remain in the “residual” bank, which would be stripped of its banking licence. An administrator for the liquidation of the residual bank would be appointed to determine its value and satisfy creditors according to the legal order of priorities (based on the law of the parent company and other jurisdictions involved).
The attractive feature of mandated corrective action is that asset disposals and change of management will normally take place well before capital falls to zero, so that losses for the insurance fund and ultimately taxpayers are more likely to be much smaller.
Carmassi, Elisabetta Luchetti and Stefano Micoss (2010), “Overcoming too big to fail - A Regulatory Framework to Limit Moral Hazard and Free Riding in the Financial Sector”, CEPS-Assonime Report.
Gros, Daniel (2010), “Too interconnected to fail = too big to fail: What is in a leverage ratio?”, VoxEU.org, 26 January.