Market Oriented Regulation

Oliver Hart and Luigi Zingales wrote:

Just days after announcing his plan to clean up banks' balance sheets of toxic assets, U.S. Treasury Secretary Timothy Geithner hit the airwaves, priming audiences for his next big project: a regulatory system to ensure that this financial crisis is a one-time event. "[The] core thing is to make sure that the institutions at the center of our financial system are subject to much more conservative, much tougher requirements on capital and leverage," he told NBC's David Gregory on Sunday's Meet the Press. Geithner will be taking his show on the road this week as the G20 convenes in London, where regulation will be high on the agenda.Should we welcome Geithner's regulatory rethink? In principle, yes. If there is one lesson to be learned from the 2008 financial crisis, it is that large financial institutions (LFIs) such as Citigroup or AIG are too big to fail. Whether this doctrine is based on economics -- the cost of LFI failure is too high -- or politics -- the pressure to save LFIs is too strong -- the conclusion is the same: We need to reimagine how we regulate these institutions.We'll explain why a market-based system is the best way to achieve this, and how credit default swaps -- yes, the same financial tools that helped get us into this mess -- can play a role. But first, some basic principles.So what's wrong with bankruptcy for financial giants? In a free-market economy, bankruptcy accomplishes two crucial goals: it resolves conflicting claims and it shifts control away from incumbent management. By penalizing owners and managers, bankruptcy gives firms an incentive to repay their debts, thus permitting them to raise capital in the first place. But for LFIs, bankruptcy is a dangerous option. Given their size and the dense web of derivative and short-term financing contracts that these institutions have, bankruptcy spreads uncertainty throughout the economy, as we saw in the case of Lehman Brothers. So, we want a system that achieves the goals of bankruptcy, but at the same time ensures that these other contracts are safe.How do we thread this needle? Here, we can learn from a common market practice: margin accounts. In a margin account, an investor buys stock and puts down only part of the cost. When the stock price drops, the broker who extended a loan for the rest of the stock price asks the investor to post new collateral. The investor then has a choice: He can post the collateral, thereby re-establishing the safety of his position, or he can liquidate his holding, allowing the broker to be paid in full. This analogy can help us figure out how much capital large financial institutions should be required to keep on hand. The answer: an LFI will have to post enough collateral (equity) to insure that its liabilities are always paid in full. When the fluctuation in the value of the underlying assets puts creditors at risk, the LFI's equity holders will be faced with a margin call: They will either have to inject new capital or lose their equity. In both cases the creditors will be protected.The main difference between margin calls and our new capital requirement system is the trigger mechanism. In a margin account, the broker looks at the value of the investments (which is easily determined since all assets are traded) and compares the value of the collateral posted with the possible losses the position might have in the following days. Creditors of LFIs, however, are often dispersed and so unable to coordinate to make a margin call. And since most LFI assets, such as commercial loans and home equity lines, are non-standardized and not frequently traded, their value is hard to assess. Another mechanism will be needed to determine when the margin is too thin.One possibility is to leave the decision of when to make a margin call in the hands of a regulator. However, the risk here is twofold. Either the regulator is powerful, leaving financial institutions exposed to the risk of abuse, or the regulator is weak and will be unduly influenced by failing institutions and intervene too late.Regulators should therefore rely on a market-based trigger: a credit default swap (CDS). Despite being viewed by many as a "financial weapon of mass destruction," CDSs are like any tool that can be used wisely or foolishly. In this context, they are potentially some of the best regulatory instruments available. A credit default swap on an LFI is an insurance claim that pays off if that institution fails and creditors are not paid in full. Since the CDS is a "bet" on the institution's strength (or weakness), its price reflects the probability that the LFI debt will not be repaid. Such CDSs, in essence, indicate the risk that a large financial institution will fail.In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.This regulatory takeover would not be dissimilar to a milder form of bankruptcy, and it achieves all the other goals of bankruptcy -- discipline on management and shareholders -- without imposing any of the systemic costs.Credit-default swaps have been demonized as one of the main causes of the current crisis. It would be only fitting if they were part of the solution.

Oliver Hart is professor of economics at Harvard University. Luigi Zingales is professor of finance at University of Chicago,
Booth School of Business.


update:

Two new papers explore how to regulate the financial system as a whole

BANKS mimic other banks. They expose themselves to similar risks by making the same sorts of loans. Each bank’s appetite for lending rises and falls in sync. What is safe for one institution becomes dangerous if they all do the same, which is often how financial trouble starts. The scope for nasty spillovers is increased by direct linkages. Banks lend to each other as well as to customers, so one firm’s failure can quickly cause others to fall over, too.

Because of these connections, rules to ensure the soundness of each bank are not enough to keep the banking system safe. Hence the calls for “macroprudential” regulation to prevent failures of the financial system as a whole. Although there is wide agreement that macroprudential policy is needed to limit systemic risk, there has been very little detail about how it might work. Two new reports help fill this gap. One is a discussion paper from the Bank of England, which sketches out the elements of a macroprudential regime and identifies what needs to be decided before it is put into practice*. The other paper, by the Warwick Commission, a group of academics and experts on finance from around the world, advocates specific reforms**.

The first step is to decide an objective for macroprudential policy. A broad aim is to keep the financial system working well at all times. The bank’s report suggests a more precise goal: to limit the chance of bank failure to its “social optimum”. Tempering the boom-bust credit cycle and taking some air out of asset-price bubbles may be necessary to meet these aims, but both reports agree that should not be the main purpose of regulation. Making finance safer is ambitious enough.

Policymakers then have to decide on how they might achieve their goal. The financial system is too willing to provide credit in good times and too shy to do so in bad times. In upswings banks are keen to extend loans because write-offs seem unlikely. The willingness of other banks to do the same only reinforces the trend. Borrowers seem less likely to default because with lots of credit around, the value of their assets is rising. As the boom gathers pace, even banks that are wary of making fresh loans carry on for fear of ceding ground to rivals. When recession hits, each bank becomes fearful of making loans partly because other banks are also reluctant. Scarce credit hurts asset prices and leaves borrowers prey to the cash-flow troubles of customers and suppliers.

Since the cycle is such an influence on banks, macroprudential regulation should make it harder for all banks to lend so freely in booms and easier for them to lend in recessions. It can do this by tailoring capital requirements to the credit cycle. Whenever overall credit growth looks too frothy, the macroprudential body could increase the minimum capital buffer that supervisors make each bank hold. Equity capital is relatively dear for banks, which benefit from an implicit state guarantee on their debt finance as well as the tax breaks on interest payments enjoyed by all firms. Forcing banks to hold more capital when exuberance reigns would make it costlier for them to supply credit. It would also provide society with an extra cushion against bank failures.

Each report adds its own twist to this prescription. The Bank of England thinks extra capital may be needed for certain sorts of credit. If capital penalties are not targeted, it argues, banks may simply cut back on routine loans to free up capital for more exotic lending. The Warwick report says each bank’s capital should also vary with how long-lived its assets are relative to its funding. Firms with big maturity mismatches are more likely to cause systemic problems and should be penalised. The ease of raising cash against assets and of rolling over debt varies over the cycle, and capital rules need to reflect this. Regulators should also find ways to match different risks with the firms which can best bear them. Banks are the natural bearers of credit risk since they know about evaluating borrowers. Pension funds are less prone to sudden withdrawals of cash and are the best homes for illiquid assets.

The Warwick group is keen that macroprudential policy should be guided by rules. If credit, asset prices and GDP were all growing above their long-run average rates, say, the regulator would be forced to step in or explain why it is not doing so. Finance is a powerful lobby. Without such a trigger for intervention, regulators may be swayed by arguments that the next credit boom is somehow different and poses few dangers. The bank frets about regulatory capture, too, but doubts that any rule would be right for all circumstances. It favours other approaches, such as frequent public scrutiny, to keep regulators honest.

When banks attack

No regulatory system is likely to be fail-safe. That is why Bank of England officials stress that efforts to make bank failures less costly for society must be part of regulatory reform. That includes making banks’ capital structures more flexible, so that some kinds of debt turn into loss-bearing equity in a crisis. Both reports favour making systemically important banks hold extra capital, as they pose bigger risks when they fail.

The Warwick group also thinks cross-border banks should abide by the rules of their host countries, so that macroprudential regulation fits local credit conditions. That would require that foreign subsidiaries be independently capitalised, which may also be necessary for a cross-border bank to have a credible “living will”, a guide to its orderly resolution. This advice will chafe most in the European Union, where standard rules are the basis of the single market. But varying rules on capital could also be used as a macroeconomic tool in the euro area, where monetary policy cannot be tailored to each country’s needs. Regulation to address negative spillovers that hurt financial stability might then have a positive spillover for economic stability.

* “The role of macroprudential policy”, Bank of England, November 2009

** The Warwick Commission on International Financial Reform, November 2009