Sunday, July 17, 2011

More Capital, No Bailouts?

Too bad banks didn't have more capital back in 2007, the thinking goes, or they wouldn't have needed bailouts. Right? True, if one makes an unwarranted assumption that the riskiness of bank assets would have been unaffected, or even improved, under higher capital requirements.

Leverage is what allows banks to make money by holding safe assets. At one extreme, think of the hedge fund Long Term Capital Management. It used massive leverage to hold extremely safe assets (and blew itself up).

At the other, think of your neighborhood loan shark. He uses no leverage. He makes loans entirely out of his own capital and, if he's to have any hope of profit, must seek out the riskiest customers (i.e. those who can't get a credit card or payday loan), charge them usurious interest rates and send two really large thugs to break their legs when they don't pay.

Moral hazard does not play a role in the loan shark's business model since he's betting his own money.

So the equation more capital = safer is not as straightforward as it seems. Happily, the complexities are not lost on the gnomes of Basel, the Swiss gang of global regulators who've been trying to solve the problem of too big to fail since the 1970s, after the failure of the now-forgotten Bank Herstatt.

Their latest solution, Basel III, would seriously hike the amount of capital banks must hold, but otherwise persists with the basic strategy of setting different levels of capital against different assets precisely to preserve the incentive of banks to invest in assets perceived as safe.

The fatal conceit, of course, is "perceived." Triple-A mortgage securities once were seen as safe. Greek bonds were safe. Under TBTF, when banks receive no discipline from their own creditors who expect to be bailed out, it falls on regulators not only to guess which assets are safe but to lean against the incentive of banks to categorize risky assets as safe in order to hold less capital against them.

How well regulators have performed this function can be guessed from a succession of global financial crises—as well as the rough-and-ready regulatory wisdom that has actually prevailed in those crises: "Big banks don't need capital. They just need liquidity."

And so it proved in the recent crisis, when the Federal Reserve and FDIC did the heavy lifting to keep the banks afloat. So it has proved in every banking crisis for the past 40 years. Nor is it pound-foolish to avoid banking panics at the cost of increasing moral hazard. But the fact remains: Everything we do ends up increasing moral hazard.

Here's the problem: Banks may be able to blow up the world economy, but they are just another company in the portfolio of stock investors, who use the same incentives to motivate bank CEOs as they do all other CEOs. Under TBTF, gaming whatever capital standards are imposed becomes virtually a competitive necessity if banks want to keep up with rivals and CEOs want to keep their jobs.

With each hike in capital for the biggest banks—we've gone from 3% to 9.5%, with some now calling for 15%—the effects are magnified. Bankers may be proscribed by self-interest from acknowledging any impact of TBTF on their own behavior, but even they will acknowledge one perverse outcome: a heightened incentive to play global regulators off each other. In this regard, see the recent speech of Fed Governor Dan Tarullo for a catalog of unintended hubris, given all the factors bank examiners would use (size, complexity, global "interconnectedness") to set capital levels for each specific bank.

Lacking, meanwhile, has been any willingness to grasp the nettle of moral hazard directly. We want a messiah, but apparently not one who asks anything radical of us or challenges us to relinquish any sacred cows.

All but dismissed, for instance, has been the idea of contingent capital—requiring banks to sell a bond that would convert to equity if the bank gets in trouble.

Forget the trifling argument over whether such convertibles should count as "capital." What matters is the creation of a class of tradable debt exempt from bailout, giving speculators an incentive to scour for early signs of trouble.

Or how about requiring government-insured deposits to be 100% backed by Treasury bills?

Don't underestimate the importance of FDIC deposit insurance to the edifice of TBTF. If government were seen acting in advance to protect its own claims in a bank failure, and devil take the hindmost, it would have a powerful effect on the thinking of the hindmost.

Bank creditors might begin to doubt their own rescue and demand more transparency and less complexity from bank CEOs. Government will always have a role in a liquidity panic, but we might have fewer such panics in the first place if different incentives operated on the banks and their creditors.