And Then There Was One

With the results of the US stress tests now official, the options for additional reform of the financial system now rest with one solution.  That solution is the embrace of the FDR Framework by the banking regulators.

Why is additional financial reform finished?

It is no longer politically feasible.  All the existing outstanding reform proposals are subject to being crushed by the 'level playing field' argument and its related race to the bottom or are no longer viable under the 'something can not be and be at the same time' principle.  These proposals include:

• Higher capital requirements.  In the UK, the Bank of England has been pushing higher capital requirements since the beginning of the credit crisis.  Recently, David Miles and Adair Turner have taken turns advocating for capital ratios (equity to assets) in the range of 20%.

• Separation of retail and investment banking.  In the UK, the Independent Commission on Banking has been looking at separating retail and investment banking in a modern day version of the Glass-Steagall Act.  Sir John Vickers, the chairman of the commission, has asked whether it makes sense to ring-fence and separately capitalize retail and investment banks owned by the same financial institution.  In theory, the retail bank with its access to the government safety net would be insulated from the failure of the investment bank, but, if the retail bank runs into difficulty, could tap the investment bank for capital.

• Enhanced liquidity requirements.  The Basel Committee has been developing liquidity requirements that would make financial institutions less vulnerable to a 'run on the bank'.  Potential rules included a requirement to hold up to 30 days of funding in highly liquid, marketable securities like government bonds.

• Breaking up the Too Big to Fail.  Looking at the hazard posed by financial institutions that are too big to fail, a number of politicians, regulators and academics have proposed proposed breaking up these institutions into smaller firms that can fail.

What is the 'level playing field' argument?

The basic 'level playing field' argument goes as follows:  ABC country has enacted reform that does not exist in XYZ country; this puts ABC country's banks at a competitive disadvantage with banks located in XYZ country; ABC country needs to level the playing field and adopt the same same rules as XYZ country.

By definition, XYZ country is always that country with the least binding regulation.  For example, HSBC is already on record as threatening to move from London to Hong Kong if the UK government adopts higher capital standards - either as a percentage of assets or via a ring-fence requirement.

Potential reforms that are subject to the 'level playing field' argument include: higher capital standards, separation of retail and investment banking and breaking up too big to fail.

What is the 'something cannot be and be at the same time' principle?

This principle says there is no halfway house.  For example, banks cannot be adequately capitalized so that they can pay dividends and also be required to hold more capital.  Either they have enough capital to be adequately capitalized or they do not.  Once the US said that several of its largest banks could resume paying dividends, it set the minimum capital ratio for being adequately capitalized globally.  

Potential reforms that are subject to the 'something cannot be and be at the same time' principle include:  higher capital ratios and enhanced liquidity requirements.

The last remaining option for reform of the financial system is the adoption by bank regulators of the FDR Framework.  It does not require any additional legislation.  Since it is a reform in the way banking regulators operate, it results in a race to the top and it is immune to both the 'level playing field' argument and the 'something cannot be and be at the same time' principle.

How can adoption of the FDR Framework be an internal choice by bank regulators?

There are three observations that support this conclusion:

• A bank examiner is entitled to see any information that a bank has that the examiner would like to see [at least in the US, there are no restrictions].  The examiner does not need to ask "permission" of the bank where the bank has the option of saying no, we will not let you see that data. (I)

• A bank examiner can see the requested information at the bank or alternatively bring it back to the office for further analysis. (II)

• If the examiner needs help analyzing the information, the examiner is permitted to hire an expert without consulting with the bank that provided the information. (III)

Together, these observations suggest that bank regulators do not need to talk with the banks and ask their permission in order to make current asset/liability level data available. The bank regulator is collecting the data for supervisory purposes (I and II) and is making the data available to experts, in this case the market, for their help in analysis and supervision (III).

This also suggests that the politics of deciding to create the database are internal to the bank regulators.  While the banks will not be happy with the creation of the database, creating the database is consistent with the bank regulator fulfilling its financial stability and supervision mandates.