He compares contagion to a disease and looks to the study of infectious disease for a solution. The solution he finds to stop the spread of a disease is to target the most likely spreaders of the disease. In this case, large, interconnected banks.
The preventative solution that he recommends is to inoculate these large banks against spreading contagion by requiring them to hold more capital.
Unfortunately, more capital has never been shown to prevent contagion!
Moving the capital ratio from 5 to 10% would not have stopped the credit markets from freezing in 2008. Every financial institution was concerned with the solvency of every other financial institution and, as discussed in the Financial Crisis Inquiry Commission report, lacked the information to know who was and who was not solvent.
Capital is at best a one-off solution. Even worse, it is a one-off solution that can lead to the preverse outcome of actually increasing the risk of the large, interconnected banks. As discussed in a previous post, management has an incentive to maximize its compensation even if this means increasing the risk of the large, interconnected bank to overcome the drag of higher capital ratios.
There is a better way to inoculate large, interconnected banks and protect the rest of the financial system from contagion!
The direct solution is to make the large, interconnected banks disclose their current asset-level data. With this data, credit and equity market analysts and competitors can analyze the risk and solvency of each large, interconnected bank.
Based on the risk of the large, interconnected bank, market participants can adjust their exposure to the institution. If the large, interconnected bank adopts a riskier strategy, then its cost of funds will increase and its access to funds and interconnectedness will decrease. This will naturally cause the large, interconnected bank to cut back on its risk. Exactly the outcome needed to reduce the probability of contagion.
Unlike disease, where it might be impossible to identify if the carrier is infected, risk held by the large, interconnected banks can be identify if these banks are required to disclose their current asset-level data.
Why gamble on higher capital ratios, which might not halt transmission of a bank's solvency problems through contagion, when there is the alternative of requiring current asset-level disclosure that will halt transmission of a bank's solvency problems before they get started? [emphasis added]
Regulators want big, complex banks to hold larger buffers of capital to protect the financial system. Big banks argue this is unnecessary because risk is diversified across their larger balance sheets.
Who is right?
Natural sciences – especially epidemiology, ecology and genetics – provide clues.
... There is no evidence that failure probabilities are lower among big, complex banks than smaller ones.
But even if there were, the case for big banks holding higher levels of loss-absorbing capital would not be weakened. That case rests not on the probability of large banks failing, but on their system-wide impact. What matters is not a bank’s closeness to the edge of the cliff; it is the extent of the fall. And this will depend on a bank’s size, complexity and numbers of market counterparties.
These basic principles have long been known in the study of infectious diseases. Optimal strategies for preventing disease spread focus on “super spreaders”: not those most likely to die, but those with the greatest capacity to infect counterparties. The same calculus applies to big, complex banks.
These super-spreaders of the financial world have huge balance sheets and often comprise
thousands of distinct legal entities. Their numbers of counterparties are often mind-boggling. When Lehman Brothers failed, it had more than 1m such relationships. These spread financial infection on a global scale.
Fortunately, epidemiologists provide us with a simple preventative solution: target the
super-spreader. For banks, this means the largest, most complex and most interconnected banks should hold higher amounts of loss-absorbing capital. This lowers the chances of them contracting disease, thus heading off its contagious consequences. Rather than seeking to equalise the probability of failure across institutions (irrespective of size), regulation would seek to equalise each bank’s contribution to systemic risk.