Blog Post

FinReg

What’s at stake: There is a broad international process underway, via the G20, the BIS and the IMF, to come up with new capital and liquidity rules to be applied around the world to replace Basle 2. And now that healthcare reform is off the agenda in the US, there is a pretty serious discussion […]

By: Date: April 5, 2010 Topic: Banking and capital markets

What’s at stake: There is a broad international process underway, via the G20, the BIS and the IMF, to come up with new capital and liquidity rules to be applied around the world to replace Basle 2. And now that healthcare reform is off the agenda in the US, there is a pretty serious discussion about financial reform and how good the legislation – the bill put together by Senator Chris Dodd of Connecticut – currently on the table is. One side — exemplified by Paul Volcker — sees limiting the size and scope of the biggest banks as the core issue in reform. The other side disagrees, and argues that the important thing is to regulate what banks do, not how big they get.

Paul Krugman writes that breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy. The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. So what’s the alternative to breaking up big financial institutions? The answer instead is to update and extend old-fashioned bank regulation to shadow banks, institutions that carry out banking functions and are therefore perfectly capable of creating a banking crisis, but, because they issue debt rather than taking deposits, face minimal oversight. Regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and there have to be prudential limits on shadow banks, above all limits on their leverage.

Michael Konczal argues that what the legislation needs are explicit rules, rules that would force action even by regulators who don’t especially want to. The Dodd bill tries to fill the hole in the system by letting federal regulators impose “strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.” It also gives regulators the power to seize troubled financial firms — and it requires that large, complex firms submit “funeral plans” that make it relatively easy to shut them down giving in effect shadow banking something like the regulatory regime we already have for conventional banking. But what will actually be in those “strict rules” is left at the discretion of the Financial Stability Oversight Council, a sort of interagency task force including the chairman of the Federal Reserve, the Treasury secretary, the comptroller of the currency and the heads of five other federal agencies.

Dave Altig argues that in evaluating the benefits of busting up the big guys, we shouldn’t lose sight of the possibility that this is also a strategy that could carry very real costs. One popular suggestion for dealing with the too big to fail (TBTF) problem is to just make sure that no bank is "too big." Two scholars leading that charge are Simon Johnson and James Kwak. They, for example, propose strict asset caps (as a percentage of gross domestic product, i.e., relative to the size the overall economy) on financial institutions that are adjusted for the types of assets and obligations held by those institutions. But Altig argues that we have big banks because there are efficiencies associated with getting bigger – economies of scale. David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking. If economies of scale are in some way intrinsic to at least some aspects of banking – and not just political economy artefacts – the costs of placing restrictions on bank size could introduce risks that go beyond reducing the efficiency of the targeted financial institutions. 

Greg Mankiw writes that his favourite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalisation in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance. Bankers may balk at this proposal, because it would raise the cost of doing business as the buyers of these bonds would need to be compensated for providing this insurance. But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.

Giancarlo Corsetti, Michael P. Devereux, Luigi Guiso, John Hassler, Gilles Saint-Paul, Hans-Werner Sinn, Jan-Egbert Sturm and Xavier Vives argue that regulation by itself, without the involvement of the intermediaries, may fail to restore trust in bankers and financial markets. Instead, it would be advisable to reinforce the regulatory approach by making the financial industry itself work towards regaining the trust of its customers. The authors examine three possible mechanisms: A rating system that even the most financially illiterate investors can understand; a trust-based compensation scheme where the compensation of an intermediary is tied to the level of trust an investor has in it, therefore creating an incentive for the intermediary to behave in a trustworthy manner; and promoting investors’ financial education.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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