(The following post is based on a series of veryhelpfulcomments left by Patrick Sullivan. Any mistakes are my own.
When I ask progressives how "deregulation" caused the 2008 banking crisis, many point to Gramm, Leach, Bliley (1999), which supposedly repealed the Glass-Steagall Act of 1933, which had separated commercial and investment banking. (I'm told that's not quite accurate, but that's the perception.)
In his recent memoir, Bernanke tends to agree with progressives that bank regulation wasn't tough enough, but interestingly on page 439 he suggests that Gramm, Leach, and Bliley was not the problem, indeed the law helped to prevent the crisis from being even worse, by allowing JP Morgan to merge with struggling investment bank Bear Stearns and allowing a weak Merrill Lynch to be rescued by Bank of America.
But that's not all. A 2011 paper by Richard Herring and Charles Calomiris argued that risk of banking crises could be greatly reduced by requiring banks to supplement their capital with bonds that could be automatically converted to equity when capital levels fell too low.
Start with a requirement that a megabank maintain a 10% book equity-to-asset requirement--but add to it the requirement that 10% of its assets be issued in CoCos that convert from debt into equity if the market value of equity relative to assets falls below a critical ratio, say 10%, on average for a period of 120 days. If conversion does occur, the CoCos exchange at a premium of, say, 5%. CoCo holders end up with more shares than the face value of their debt holdings.
By using the market value of a bank's equity as a conversion trigger, bank managers have an incentive to maintain sufficient true economic capital. Conversion means a significant amount of stock is issued, diluting the value of the equity held by the rest of the owners. To avoid this outcome, bank managers would choose to issue new stock (fewer shares than would be issued than under conversion) to offset declines in their market valuation. Managers would make that choice because dilutive conversion is more costly to existing stockholders; both the holders of newly converted shares and pre-existing shareholders would likely agree to sack management incompetent enough to allow such a conversion to happen.
The 120-day moving average ensures that banks have plenty of time to arrange an offering in response to market perceptions of losses. Setting the CoCo trigger at 10%--far above the insolvency point of the bank--ensures that the bank still will have access to the market to issue new equity.
Relying on the market's perception of bank losses to encourage new equity offerings sidesteps the problem of bank managers and regulators understating or manipulating the riskiness of their assets. Market expectations about cash flows will determine the market value of a megabank's equity, avoiding unwarranted emphasis on balance sheets to gauge bank health. And the higher the riskiness of a bank's cash flows, the more willing the bank will be to maintain a large buffer of equity over and above the trigger threshold. The bank's voluntarily chosen market-to-equity ratio will vary appropriately with its cash flow risk.
In the longer scholarly article from 2011, Herring and Calomiris report this stunning piece of information:
In response to the mandate within the Gramm-Leach-Bliley Act of 1999 that required the Federal Reserve and the Treasury to study the efficacy of a sub debt requirement, a Federal Reserve Board study reviewing and extending the empirical literature broadly concluded that sub debt could play a useful role as a signal of risk. Despite that conclusion, no action was taken to require a sub debt component in capital requirements; instead the Fed concluded that more research was needed.
So the law that provided the flexibility Bernanke needed to deal with the 2008 banking crisis, also suggested a policy reform that might have prevented the crisis entirely. Maybe Phil Gramm deserves a Nobel Prize in economics.
Apparently that "more research" that was needed has now been concluded, as the Fed is finally adopting the idea:
For immediate release
The Federal Reserve Board on Friday proposed a new rule that would strengthen the ability of the largest domestic and foreign banks operating in the United States to be resolved without extraordinary government support or taxpayer assistance.
The proposed rule would apply to domestic firms identified by the Board as global systemically important banks (GSIBs) and to the U.S. operations of foreign GSIBs. These institutions would be required to meet a new long-term debt requirement and a new "total loss-absorbing capacity," or TLAC, requirement. The requirements will bolster financial stability by improving the ability of banks covered by the rule to withstand financial stress and failure without imposing losses on taxpayers.
To reduce the systemic impact of the failure of a GSIB, an orderly resolution process should allow a GSIB to fail, and its investors to suffer losses, while the critical operations of the firm continue to function. Requiring GSIBs to hold sufficient amounts of long-term debt, which can be converted to equity during resolution, would facilitate this by providing a source of private capital to support the firms' critical operations during resolution.
Yes, this is a bit like closing the barn door after the horses have left, but it's still gratifying to see that after all the time wasted on 1000 page monstrosities like Dodd-Frank, we are finally getting somewhere. From the beginning I've argued that moral hazard is the key flaw in our banking system. This is just one solution. We still need to get rid of the GSEs and FHA and reform deposit insurance. I recently discussed some ideas for protecting taxpayers from FDIC bailouts. But this seems like an important step. We don't need lots more complex regulation of banking, we simply need to eliminate the moral hazard problem, which is caused by poorly designed regulations. However I fear that small banks have too much political power to eliminate the regulations that push them to take excessive risks. I hope I'm wrong.