In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking…
Andrew Haldane, executive director of the Bank of England’s Financial Stability unit, seems to have latched onto an effective, if not exactly modern, potential solution to the problem of excessive risk-taking at banks. And while he doesn’t think executing bankers was “conspicuously” successful in the past, he does have some less antiquated suggestions for reforming the banking sector in a joint presentation with the BoE’s Piergiorgio Alessandri. They include:
Limits on leverage:
- Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the run-up to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives.
This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule (Pillar I), rather than being left to supervisory discretion (Pillar II).
Changes to capital risk-weightings:
- Recalibrating risk weights: With hindsight, the capital assigned to certain categories of high-risk and off balance sheet transactions by Basel rules was far too low. Those mis-calibrations were then arbitraged by the banks in ways which included inflated trading books and an over-expansion into high-risk loans and securitised assets.
The Basel Committee has already set about trying to correct some of the more obvious of these defects. For example, materially higher risk weights are set to be introduced for trading book assets from the end of 2010. This will include, importantly, securitised and re-securitised products, whose payoffs profiles too closely resembled deep out-of-the-money options (Figure 3). New risk weights should better reflect the tail risk these products embody.
These reforms will close a regulatory loophole and thereby lower the beta of, and hence systematic risk in, the banking system. They leave open some rather more fundamental questions, which the Basel Committee are also considering. These include whether the distinction between banking and trading books, and the re-securitisation of assets, are necessary in the first place. If a robust financial and regulatory system is one which is parsimonious and transparent, the answer might be that they are not. It may be time to take Occam’s razor to regulatory rulebooks.
Altering the capital structure of banks:
- Rethinking capital structure: Asymmetry of payoffs risks excessive risk taking. The source of this asymmetry is limited liability. It is revealing that limited liability was first introduced into banking in the UK in the mid-19th century. That was roughly the time state support for banks took shape. This is unlikely to have been serendipity. So could the distortions from limited liability be tackled at source?
. . .
Given the likely need to rebuild bank equity in the future, now may not be the time to return to unlimited liability. Fortunately, there are two alternative approaches to adapting capital structure which alter the balance of risk-taking incentives, without jeopardising the flow of risk capital. Both involve operating not on equity, but on debt. And both involve making debt, like equity, a more loss absorbing instrument in stress events.
First, contingent capital is a means of automatically converting debt instruments into equity in the event of a capital top-up being needed. The capital structure of banks thereby becomes more malleable. There has been recent interest in contingent capital instruments as a means of providing banks with an extra degree of freedom in stress situations.18 The benefits in principle seem clear. The difficulties in practice include whether there is likely to be sufficient investor demand for such hybrid instruments.
Second, wholesale debt instruments at present rank equally with retail deposits in the UK in the event of a wind-up. In the US, depositor preference has operated nationally since 1993, with retail deposits ranking ahead of wholesale debt. There are benefits to depositor preference both ex-ante (by heightening debtor incentives to monitor risk) and ex-post (by facilitating resolution). There are also some potential downsides, including causing unsecured creditors to run sooner. It may be a good time to reweigh these arguments in the UK.
More reform suggestions, plus some great charts of the evolution of the banking system (from 1880 onwards), in the
full paper.These two in particular are worth reproducing:
Related links:
Contingent capital comes to pass, with a little help from the EC - FT Alphaville
Bernanke does bank regulation and supervision - FT Alphaville
