By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
Edward Kane argues, in a recent VOXEU communique (Jan. 30th) that in the current information and ethical environments, regulating accounting leverage cannot adequately protect taxpayers from regulation-induced innovation. A financial institution’s capital is defined as the difference between the value of its asset and liability positions. The idea that capital requirements can serve as a stabilization tool is based on the presumption that the strength of an institution’s hold on economic solvency can be proxied by the size of its capital position.
This way of crunching the numbers seems simple and reliable, but it is neither. Accounting principles offer variations on how to decide which positions/cash flows are recorded, booked, and valued. It provides the wrong incentives for survivability, management and government guarantees.
Capital adequacy is a flawed center piece for regulation as taught from the crisis. Capital-requirements medicine not only failed to prevent the last crisis, it helped to inflate the shadow-banking and securitization bubbles. The increasing the dosage and complexity of the capital-requirements medicine will not increase system stability. Capital requirements have turned out to be toothless whenever tested.
The real problem is that the existence of government safety nets gives protected firms an incentive to shift risk to taxpayers. Asking firms to hold more capital than they want lowers the return on equity than their current portfolio can achieve. This means that installing tougher capital requirements has the predictable side effect of simultaneously increasing a firm’s appetite for risk, so as to increase the rate of return.
Meaningful reform must begin by changing the informational and ethical environment to make it harder for aggressive firms to extract uncompensated benefits from taxpayer-funded safety nets. The value of taxpayers’ credit support deserves to be recorded as a contra-liability because it supplies implicit ‘safety-net capital’ that substitutes one-for-one for on-balance-sheet capital by transferring responsibility for financing. Unlike a voluntary guarantee or put contract, taxpayers’ contingent equity position in difficult-to-fail firms is coerced, poorly disclosed and contractually unlimited, and cannot be traded away. The value of safety-net capital can be extracted synthetically from the behavior of a firm’s stock price and return volatility since it contributes to a firm’s stock-market capitalization.
Conceiving of systemic risk as a portfolio of ‘taxpayer puts’ likens it to a disease that has two symptoms. Official definitions have focused almost exclusively on the primary symptom. The extent to which authorities and industry sense a potential for, first, substantial ‘spillovers’ of defaults across a national or global network of leveraged financial counterparties and, second, from this hypothetical cascade of defaults to the real economy. This first symptom combines exposure to common risk factors (e.g. poorly underwritten loans) with a jumble of debts that institutions owe to one another. However, it neglects an important second symptom: Inserting taxpayer interests into the financial-regulation game – the ability of ‘difficult-to-fail’ institutions to command bailout support from their own or other governments.
The value of any firm’s taxpayer put comes from a combination of its risk-taking and authorities’ selective exercise as an ‘option to rescue’ it in stressful circumstances. Large banking organizations endeavor to convert authorities' side of their firm's rescue option into something approaching a ‘conditioned reflex’. They do this by undertaking structural and portfolio adjustments designed to make their firm harder and scarier for authorities to fail and unwind. Observationally, this corresponds to flows of accounting profits from building political clout and increasing their firm's size, complexity, leverage, connectedness, and/or maturity mismatch. It is a contingent claim whose short side deserves to be serviced at market rates. Drawing on the deposit-insurance literature, firms and officials can estimate the annual ‘Insurance Premium Percentage’ that a protected firm ought to pay on each dollar or euro of its debts.
The inevitability of industry leads and regulatory and legislative lags make it foolish to subject all very large banks to a fixed structure of premiums and risk weights over time. For market and regulatory pressure to discipline and to potentially neutralize incentives for difficult-to-fail firms to ramp up the value of their taxpayer put, two conditions must be met: stockholder-contributed capital must increase with increases in the ex-ante volatility of their rate of return on assets; and the value of a firm’s taxpayer put must not rise with increases in the volatility of this return. Logically, each requirement is in itself only a necessary condition. The first is the minimal goal of the Basel system, and it usually holds. But the second condition – which is needed to bring about sufficiency – is seldom met.
Cross-country differences in the costs of loophole mining help to explain why the current crisis proved more severe in financial centers and other high-income countries. Basel's risk-weighted capital ratios failed to predict bank health or to signal the extent of zombie-bank gambling for resurrection. During the crisis, the sudden surge in nonperforming loans simultaneously increased market discipline and panicked regulators. This experience should have driven home the conceptual poverty of Basel’s attempts to risk-weight broad categories of assets.
Authorities need to put aside their unreliable, capital proxy. They should measure, control, and price the ebb and flow of safety net benefits directly. This requires: changes in corporate law aimed at establishing an equitable interest for taxpayers; and tasking regulators with seeing that taxpayers’ position in these firms is adequately serviced. To carry out their side of this task, regulatory officials must redesign their information systems to focus specifically on tracking the changing value of their portfolio of taxpayer puts.
Large financial firms should be obliged to build information systems that bring to the surface the value of the taxpayer puts they enjoy. Auditors and government monitors should be charged with double-checking the values reported. Regulatory lags could be reduced if data on earnings and net worth were reported more frequently and responsible personnel were exposed to meaningful civil and criminal penalties for deliberately misleading regulators.
www.voxeu.org/article/inadequacy-capital-adequacy-regulations-and-public-equity-alternative
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