Scott Sumner  

Could Gramm, Leach, Bliley (1999) have prevented the 2008 banking crisis

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(The following post is based on a series of very helpful comments 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how "deregulation" caused the 2008 banking crisis, many point to Gramm, Leach, Bliley (1999), which supposedly repealed the Glass-Steagall Act of 1933, which had separated commercial and investment banking.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.

This is from a 2014 Wall Street Journal article by Calomiris, which summarizes the basic idea:

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.


Comments and Sharing


CATEGORIES: Finance




COMMENTS (20 to date)
ThomasH writes:

Whether Dodd-Frank or something else, clearly people are still concerned about financial system leveraged risk taking, so much so that some people have even suggested that interest rate have to be raised now before the price level has been restored to its pre-crisis trend to prevent market participants from engaging in risky behavior!

James Alexander writes:

A problem with having bail-in bonds as a way to make banks better behaved is that there is an assumption that the fixed income investors who buy them will enforce less risky behaviour at the banks. From what I have observed this class of investor aren't any better (or worse) than bank management or equity investors. The moral hazard of big banks will always be with us.

Scott Sumner writes:

Thomas, Bad banking policies create bad monetary policies, and bad monetary policies create banking turmoil.

James, There's a difference between bankers making mistakes and moral hazard. In my view if the bondholders were equally bad as equity holders, that would be a HUGE win. It would dramatically reduce moral hazard. The problem now is that bankers are not acting in the interest of their shareholders unless they take socially irresponsible risks. Under the new proposed plan they sill might misbehave, but they would no longer have an incentive to misbehave.

And the taxpayers would no longer be on the hook for their mistakes, the bondholders would suffer instead.

John Becker writes:

Why should banks have to hold a certain amount of debt to equity (market or book value) in the first place? What if a bank took on a lot of leverage and made winning investments? This is something for the market profit and loss test to figure out. There is no bureaucratic solution. The only reason I suspect that these proposals even sound better than what we have in the first place is because of the massive moral hazards created by the FDIC and TBTF (too big to fail) policies.

Emerson writes:

The CoCo bond seems to be a near perfect solution to the issue of bank failure. It was mentioned in Dodd Frank as a consideration. There was a report to Congress on CoCo 's in July 2012. This report seems to have been ignored, or maybe it was stifled by the bank lobby.

CoCos are near perfect, but here are a few problems.

1): When the CoCo is converted to equity of sufficient quantity to improve the bank's capital position, there will be share dilution. Given that the bank is already under pressure, this could potentially result in a stock price " death spiral" that would further reduce the bank's viability.

This becomes a non issue if, as presented by Prof. Sumner, the trigger for conversion is bank resolution.

This " death spiral " issue is the main point of debate concerning the best trigger point for conversion.

2): There are tax issues involved. If a bank sells a normal bond, the interest paid on that bond is considered an expense (tax deductible). However, with a CoCo, the interest payment is likely to be considered a dividend. This issue has not been resolved in the U.S. It will need to be sorted out before CoCo bonds can be implemented.

Overall, it seems as though the potential problems of CoCo bonds are minor and can be easily resolved. Hopefully they will become a standard part of all bank balance sheets in the near future

John Hall writes:

I liked this post.

Emerson writes:

For those interested the report by the Financial Stability Oversight Council, July 2012 can be found by simply searching:

"Report to Congress on Study of a Contingent Capital Requirement"

Njnnja writes:

CoCo's do have a lot of benefits, but they are not a silver bullet. The negative convexity that Emerson mentions is a big problem, because investors will get paid for that. So you have a security that has great tail risk, is totally wrong way risk, and has a serious problem with "winner's curse" type of problems (i.e. the owners, namely the highest bidders for them, will be those who least understand the tail risk, and think that the extra yield is "for free"). When the bank that issues the coco's runs into difficulty, the contagion is merely pushed to coco holders, who may not have properly accounted for the risk. This is very common with complex securities that pay off a little better than plain vanilla securities by bundling with a bunch of out of the money puts. Like picking up nickels in front of a steamroller.

Second, the reality is you will never get rid of moral hazard. Even if today's Congress creates a perfect system that has no potential for taxpayer money going into a bailout, you can't bind tomorrow's Congress (or Fed) from organizing a bailout when East Moneystan has a debt crisis.

Most unfortunately, this is all missing the biggest problem with moral hazard, namely that the decisions to make risks are made by individuals, not companies, and there is a huge agency problem here. Regardless of the consequences to the company, it is very hard to align incentives well enough to avoid the moral hazard that executives face, even if their firms don't.

It's not so much, "heads I win, tails I get bailed out," it's "heads I win, tails I just have to find a new job/career." Jimmy Cayne's compensation was very closely tied to Bear Stearns stock, and he lost almost a billion dollars when Bear Stearns went under. Maybe his entire net worth dropped by 90%, but he still has more than enough to live comfortably. What compensation system could possibly have aligned his incentives to avoid moral hazard? Making him lose more than 100% of his net worth, and eliminate the possibility of bankruptcy? Anything short of that appears not to have worked.

It is true that this is an example of the fallacy of the one sided bet but it is definitely how people in the real world make decisions.

First, congratulations to Scott for a well-written and comprehensive explication of CoCos and the Fed research team's belated acknowledgement (without their mentioning it took them 16 years) of their benefits. This press release from the Fed was ignored by almost everyone. Yet, it is a potentially momentous change in the way banks are regulated.

Next, Emerson is correct that Dodd-Frank also has a mention of CoCos. That probably is the nudge the Fed needed.

James Alexander said; 'From what I have observed this class of investor [bondholders] aren't any better (or worse) than bank management or equity investors. The moral hazard of big banks will always be with us.'

Yes, moral hazard will always be with us, and not just for big banks. But that doesn't mean we shouldn't do what we can to MINIMIZE it. That's what CoCos will do.

Presumably the people who invested in bonds when they could have chosen equity in the same institution, won't want to be forced to give them up in an equity swap. And the market price of the bonds will decline as the market value of the bank trends downward toward the trigger. My experience with people losing money on their investments is that that gets their attention.

This is the real genius behind the CoCos; they'll probably never have to be used. To paraphrase a saying, The prospect of having your interest income taken away from you in the morning concentrates the mind wonderfully.

Njnnja wrote;

So you have a security that has great tail risk, is totally wrong way risk, and has a serious problem with "winner's curse" type of problems (i.e. the owners, namely the highest bidders for them, will be those who least understand the tail risk, and think that the extra yield is "for free"). When the bank that issues the coco's runs into difficulty, the contagion is merely pushed to coco holders, who may not have properly accounted for the risk.

To which I ask the question every economist should always ask; Compared to what?

Don't you think that the bondholders who see the value of their investment decline in the market, as the bank's stock price moves down toward the trigger, will be BETTER positioned to do something than, say, the general public?

Similarly, won't the current equity holders have an incentive to pressure management of THEIR money to 'straighten up and fly right'?

Most unfortunately, this is all missing the biggest problem with moral hazard, namely that the decisions to make risks are made by individuals, not companies, and there is a huge agency problem here. Regardless of the consequences to the company, it is very hard to align incentives well enough to avoid the moral hazard that executives face, even if their firms don't.
No, Njnnja, that's not being missed at all. It's the entire point of Scott's post; minimization of the moral hazard that will exist by the nature of banking. By giving both the bondholders and equity holders in the bank a strong incentive to monitor their agents (i.e., the managers).

Managers who lose their investors money can be fired, or threatened with same if they don't reverse course and move the bank's stock price upward.

From the report to congress that Emerson references above;

Insurance companies in the United States have issued instruments with characteristics similar to contingent capital. Insurance companies have used these types of instruments to facilitate raising new equity following a catastrophic event that requires them to pay large amounts in claims. One arrangement involves an option to issue surplus notes upon the occurrence of extreme event losses that exceed a predetermined threshold.4 Another involves an equity put option that enables insurers with catastrophic loss exposure to issue new preferred or convertible preferred stock following a natural catastrophe. These transactions can help insurers during periods of financial stress, in addition to absorbing losses.
Njnnja writes:

@Patrick R. Sullivan:
To which I ask the question every economist should always ask; Compared to what?
Compared to straight equity. The risk of equity is levered to the health of the bank, so even a little bit of a problem hits equity holders quickly. CoCo's are exactly the opposite; they look like a perfectly sound (A+ rated!) bond, until they don't. It's like the difference between sending a canary down a coal mine versus sending an olfactory-challenged man down the mineshaft with a match to light the way.

Don't you think that the bondholders who see the value of their investment decline in the market, as the bank's stock price moves down toward the trigger, will be BETTER positioned to do something than, say, the general public?
No, I don't think that. It sounds good in theory, but in practice, selling out of the money puts bundled into an otherwise safe looking FI investment is much more likely to burn the ignorant and greedy than it is to add a new and sophisticated layer of concerned bank supervision. The fact is that regular bondholders didn't seem to care enough, so why would someone who has less to lose care more?

There is a place for coco's in the capital structure of banks, and they are better than some awful forms of funding (say overnight repos), and they will certainly help make for a more organized restructuring if it comes to that, but it will not lead to a sudden outburst of market-forced discipline.

Managers who lose their investors money can be fired, or threatened with same if they don't reverse course and move the bank's stock price upward.
As I already wrote, it's "heads I win, tails I just have to find a new job/career." They know that, but the expected value is great enough that it is worth it to take the risk. Unless you want to make it possible to pierce the corporate structure and actually reach into managers' pockets it will tend to be more beneficial to take more risk and deal with a bankruptcy if it comes.

Anyways, let's take a look at the bigger picture. I'll put the "economist question" back to you: Moral hazard is bad, but compared to what? I have been thoroughly convinced by Prof. Sumner's posts that the Great Recession was caused by poor Fed monetary policy, *not* by financial system instability. If you say that you are worried about unemployment, then focus directly on not having the Fed make bad decisions rather than worry that moral hazard will cause financial instability which will cause the Fed to make poor decisions. (Yes, NGDP targeting would do this well). If you are worried about taxpayer money, note that the financial institutions bailed out by TARP basically paid everything back.

The fact is that regular bondholders didn't seem to care enough, so why would someone who has less to lose care more?
That's because bondholders stand in line ahead of equity holders AND they had expectations of being protected by the government. Which expectations turned out to be well founded.

CoCos change those incentives.

More from the report to congress;

Some advocates of contingent capital would design the trigger mechanism so that it would be activated during severe macroeconomic conditions, or when financial system stress is very high. The goals of such trigger mechanisms may be to mitigate and shorten a systemic crisis, to stabilize financial markets, or to reduce the contraction of credit. The focus is on the condition of the financial system or the economy as a whole, rather than on the condition of the issuer of the instrument.

Loss absorption. Because historically severe macroeconomic conditions and material stress in financial conditions have occurred infrequently, this triggering mechanism would be expected to cause conversions infrequently. For this reason, an instrument with a macroeconomic or systemic trigger would likely be priced more like debt than equity. A lower cost of contingent capital instruments would incentivize the issuer to fund itself more with such instruments and less with debt.

If the macroeconomic or systemic trigger is calibrated correctly, loss absorption capacity for the financial system would be increased during crisis conditions. With more capital funding for large banks and other issuers of contingent capital instruments, the probability and severity of asset fire sales and the potential for damaging runs by debt holders and counterparties could be reduced. For example, a distressed institution may face a relatively reduced need to sell assets due to the earlier conversion of a contingent capital instrument.

However, contingent capital instruments requiring conversion and creating loss-absorption capacity only based on macroeconomic or systemic triggers would not necessarily increase loss absorption when the issuer incurs a large, idiosyncratic loss. This problem could be addressed by using a dual trigger that would trigger conversion upon the earlier to occur of a macroeconomic/systemic trigger and a firm-specific trigger event.

charlies writes:

I'll have to agree with the poster arguing that CoCo bonds are not some ingenious invention that could have saved us all.

In practice, simply requiring banks to have lower leverage would have the same result. The CoCo bonds have some clever features that may make them work slightly better or worse than regular capital requirements and that can be debated. But there is always someone holding the most junior debt and they will have an incentive to monitor, contingent debt doesn't add much there.

You might want to read the Calomiris-Herring paper, charlies. Here's a bit from near the beginning;

...many months passed between the initial financial shocks of the crisis—the first revelations of the spring of 2007, the August 2007 run on asset-backed commercial paper, the Bear Stearns bailout of March 2008—and the systemic collapse of mid-September 2008. During the year and a half leading up to the systemic collapse, roughly $450 billion in capital was raised by global financial institutions. Clearly, global capital markets were open, and there were many willing investors, especially hedge funds and private equity funds, as well as wealthy individuals. But many of the financial institutions most deeply affected by the crisis prior to September 2008, despite persistent and significant declines in the market value of their equity relative to assets, chose not to raise sufficient capital.

A top executive at one of those banks confessed to one of us over breakfast during the summer of 2008 that despite the need to replace lost equity, the price of his bank’s stock was too low. Issuing significant equity in the summer
of 2008 would have implied substantial dilution of stockholders—including existing management. Institutions that had suffered large losses preferred to wait, hoping for an end to the crisis in the summer of 2008 and the elevation of risky asset prices that would accompany that market improvement. After the bailout of Bear Stearns, they also believed that if their situation deteriorated severely, the government would be likely to step in. That further undermined any incentive to replace equity capital promptly much less preemptively. On balance, the best strategy was to wait and hope for the best.

Cocos would have changed that incentive, because of a Sword of Damocles hanging over the CEO's head. Lehman and Bear Stearns would have played out very differently had they been forced to issue CoCos as part of their capital structures.

On page 33 of the Calomiris-Herring paper they actually demonstrate how AIG and Lehman would have turned out differently had CoCos been part of both firms' capital structure;

...a 4 percent trigger based on the ratio of the market cap to the quasi–market value of assets might have been an effective device for preventing the collapse of all of these troubled SIFIs during the 2008–09 crisis. Moreover, each of these institutions would have faced strong incentives to strengthen preemptively the corporate governance of risk and, if necessary, issue equity or sell assets to avoid triggering their CoCos months earlier. And the supervisors could not have claimed to be taken by surprise at the sudden collapse of the firms. Although we illustrate our counterfactual with a 4 percent trigger, we propose an 8 percent trigger in our suggested CoCo requirement, which would have worked even better to prevent the post–September 2008 collapse because it would have created strong incentives for voluntary equity issues by banks long before September 2008. In particular, our proposed CoCo requirement would have reduced the damage from the two largest failures—those of AIG and Lehman Brothers.
Then, eliding a bit of fluff;
... both firms crossed the CoCo trigger six to eight months before their demise. Since Lehman was heavily owned by its managers and employees, the prospect of dilution would have surely concentrated their minds on raising new equity, while they still had access to equity markets, or on selling lines of business or assets. Even if they had hit the conversion trigger, however, the automatic recapitalization would have given them more time to find a private solution to their problems, which might have involved a merger, a restructuring, an additional recapitalization, or a change in management. At a minimum, it would have warned the supervisors and resolution authorities of impending trouble so that there would have been no necessity to engage in desperate measures over a sleepless weekend. Breaching the PCA trigger would have conserved liquidity by restricting dividends, share buybacks, and bonuses.
Also, they note that bank regulators would have been forewarned about impending problems with AIG and Lehman.

Before leaving this discussion, I want to point out that one of the world's premier economists (and former colleague of David Henderson at the Council of Economic Advisers under Martin Feldstein) Paul Krugman, is unaware of all of what Scott has posted here. Just last month in the NY Times he wrote;

Mr. Sanders has been focused on restoring Glass-Steagall, the rule that separated deposit-taking banks from riskier wheeling and dealing. And repealing Glass-Steagall was indeed a mistake. But it’s not what caused the financial crisis, which arose instead from “shadow banks” like Lehman Brothers, which don’t take deposits but can nonetheless wreak havoc when they fail. ….

But is Mrs. Clinton’s promise to take a tough line on the financial industry credible? Or would she, once in the White House, return to the finance-friendly, deregulatory policies of the 1990s?

…. Robert Rubin of Goldman Sachs became Bill Clinton’s most influential economic official; big banks had plenty of political access; and the industry by and large got what it wanted, including repeal of Glass-Steagall.

Which indicates that Krugman not only does not know that Glass-Steagall was never repealed (only two of its 'affiliations' provisions, which did nothing to GS's separation of commercial and investment banking under provisions #16 and #21), nor, and much more importantly, of the irony that Gramm, Leach, Bliley DID have a provision that, had it been implemented, probably would have spared the country the worst of the financial crisis of 2008-09.

Scott Sumner writes:

John, I agree that government created moral hazard is the root problem. Without that, regulation would not be needed.

Everyone, I read all the comments, and appreciate the information. I didn't respond because I feel Patrick is more knowledgeable on this than I am. I'll keep an open mind on the issue.

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