Arnold Kling  

Combining Stupid and Clever Bank Regulation

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Tyler Cowen and Eric Falkenstein raised doubts about the efficacy of leverage regulation of banks. Here is how I think about it.

1. We assume that banks have a government backstop that is either explicit or implicit. the object of the game for the government is to minimize the moral hazard this creates, and in some sense the object of the game for the banks is to to take maximum advantage of the moral hazard.

2. Leverage regulation is "stupid" regulation. You require, say, a ratio of capital to assets of 15 percent. The way that banks respond is to raise the riskiness of assets. So even though the bank holds a lot of capital, it takes a huge amount of risk, and wins the game.

3. Risk-based capital regulation is "clever" regulation. In my view, the best form of clever regulation is stress testing. You apply tests, such as "what happens if interest rates jump 200 basis points?" or "what happens if house prices fall 20 percent?" The problem with stress testing is that the results are model-dependent. As the financial crisis hit, the Basel rules were in the process of pivoting toward stress testing, with banks doing their own modeling (as Tyler would say, Yikes!). The problem with clever regulation is that whatever stress test you use, the bank can structure its balance sheet to just pass the stress test even though it holds practically no capital. In a sense, that is what the whole mortgage securitization structure was all about, except that the regulatory regime relied on AAA ratings to serve the function of stress tests.

4. I think that a combination of both forms of regulation would be much better than either one alone. Clever regulation can spot the worst abuses of stupid regulation. Stupid regulation can serve as a backstop as banks learn to how to game clever regulation. So the question of which type of regulation should be employed should not be answered "either-or," it should be answered "both."


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COMMENTS (7 to date)
eccdogg writes:

I agree that if we are going to have a govt back stop (something I am against but see no hope of changing), then we have to have some regulation.

However you know as well as I do that ANY regulation even a combination of smart and stupid can be pretty easily gamed.

In fact they taught us to do it in graduate school using optimization routines. Put in the regulatory constraints and the yields for assets and it spits our the assets you should hold to maximize your return given the test. Since TRUE risk is priced into the securities what you end up with is a portfolio that contains risk that the market recognizes but the regulations do not.

fundamentalist writes:

Seems to me that the problem was regulation. Basel commanded banks to hold securities he considered safe, AAA and AA rated. That left government debt and MBS's for them to invest in. So every bank concentrated their funds on those assets and were not diversified. European banks are facing a similar crisis, but with state debt instead of MBS's. The problem is that if everyone in the world holds the same asset because the state decrees it, say stock in Microsoft, and then a news story motivated most of them to sell, the crash will be disastrous. But Microsoft stock was not the problem. The problem was with the state decree that everyone has to own that stock.

Yancey Ward writes:

I am becoming more and more fatalistic. The backstops offered seem politically unstoppable, thus the system is ultimately doomed to collapse upon itself no matter what feasible methods are adopted. I am no longer even convinced that we buy much time between systemic conflagrations and rebirths by any combination of clever or dumb regulation.

Brock writes:

How about we get rid of limited liability, and require that all managing directors be equity stakeholders in their banks? That worked for Goldman Sachs for a long time.

Patrick R. Sullivan writes:

A prescient piece from 2006

The international bank capital accord proposal known as Basel II is a statistical and probabilistic effort to replicate what the market would do if government regulation had not interfered with market discipline. The proposal has many flaws, and a recent test suggested that it would reduce bank capital requirements substantially below current U.S. levels. In other areas, formulas and mathematical models have failed to represent the real world accurately; there is little reason to believe that a model of how the market might assess bank risk would be any more successful. A leverage ratio seems essential, at least as a stopgap measure, but a better idea would be to use a special kind of subordinated debt to discover the market’s perception of a bank’s risk position.

As Charles Calomiris has pointed out, that proposal for bank capital in the form of subordinated debentures to act as the canary in the coal mine was authorized by Gramm, Leach, Blilely back in 1999. And ignored by the Fed at the time.

Anon. writes:

A more significant issue with "clever" regulation is that nobody knows how to model these assets correctly. Or at least regulators can't (because if they could, they wouldn't be regulators).

fundamentalist writes:

Yancy, Hayek made a similar statement in "Monetary Theory and Trade Cycles". The issue is fractional reserve banking. It easily and automatically and rapidly increases credit when the circumstances are right. We currently have no way of knowing when to stop that credit expansion. Current monetary theory doesn't even know that frb is a problem. Regulators are clueless, too.

If you look at economic history, we have had depressions of some kind every decade for the past 300 years at least. And there isn't much difference between them. Check out Washington Irving's account of the Mississippi Bubble (1720) in his Crayon series of essays. Swap cars for carriages and it sounds like it was written today. There was a stock market bubble, real estate bubble, and a bubble in the production of carriages. Richard Cantillon got richer from short selling stock. When the crash came, everyone blamed greedy businessmen and speculators. Not much has changed since then.

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