How to end panics and impose market discipline

William Isaac and Richard Kovacevich wrote an interesting column in the Financial Times offering their solution on how to end panics and impose market discipline.  They propose that banks issue debt at least once per year and carry a combination of long term, subordinated debt and equity equal to 20% of assets that can be used to cover any 'reasonably conceivable loss'.

Market discipline will come from the credit markets that will link higher returns to higher risk.

Their solution naturally reflects their background as former regulator and former bank CEO respectively.  It is inconceivable to either of them given their long history of promoting and protecting opacity in the financial system that the simple solution is to require the banks to provide ultra transparency.

Without ultra transparency, how exactly do they expect market participants in the credit markets to be able to determine how risky a 'black box' bank is?

Their solution also assumes that regulators will close banks as soon as the banks are unable to access the long term and subordinated debt markets.  By this definition, given that both the interbank lending and unsecured bank debt markets are frozen in the Eurozone, all of the banks in the Eurozone should be closed.

The US has suffered three severe financial crises in the past 40 years, each driven by excessive risk taking, particularly in real estate. Regulators had plenty of authority to rein in the abuses but failed to do so....

A simple statement of the facts.

But even if we had the ideal regulatory structure, we could not rely on regulation alone to control excesses in the financial industry that too often lead to crises. 

Even with an ideal regulatory structure, your humble blogger has argued that we should not rely on regulation alone to control excesses in the financial industry because it leaves financial stability dependent on a single point of failure.

There is no reason to gamble on financial stability by making it dependent on the regulators always performing their role perfectly.

To end the boom-bust cycles and accompanying panics, we do need smarter, more effective and less politicised regulation – but it is also critically important to impose stronger marketplace discipline on financial institutions, particularly the largest that were previously regarded as too big to fail....

The only way to bring market discipline is if the big financial institutions are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off balance sheet exposure details.

This is the data that market participants need if they are going to be able to assess the risk of a financial institution.

[Currently, regulators have access to this data through their examination function. Presumably they use this data to assess risk at each bank.  Since regulators have access to this data and market participants do not, market participants rely on regulators to properly assess and communicate the risk of each bank.  Effectively, the regulators monopoly on this data makes independent market discipline impossible.]

When regulators finally gather the information needed to understand the biggest institutions, they must develop a plan to ensure these are structured and operated in a way that will allow them to be re-organised or to fail without creating panics that cripple the economy. The plan must be simple, practical and credible to convince markets it will be employed when needed.

Actually, ultra transparency addresses the issue of allowing the biggest institutions to be re-organized or fail without creating panics or crippling the economy.  Ultra transparency eliminates panics because market participants can see the build up of risk and adjust their exposure well before the biggest institution needs to be re-organized or fails.

Even better, ultra transparency is simple, practical and credible because it allows the market participants to see that the regulators are doing their job to re-organize or resolve the biggest institutions when they fail.  Since market participants can see the regulators doing their job, it eliminates the regulators' default position of bailing out the banks under a Japanese model for handling a bank solvency led financial crisis.

Requiring big institutions to increase their common equity capital to breathtaking levels – say above 9 per cent of assets – is not the answer. It lowers returns on equity to a point where banks will not be able to raise enough capital and will shrink their balance sheets, impeding growth – as is happening in Europe. 

Moreover, equity holders, even when they perceive the risks to be excessive, cannot impose the same discipline on management as creditors. Finally, equity holders may gain from taking risks and so are more tolerant of risk than creditors. 

Without ultra transparency, neither creditors nor equity holders can enforce market discipline as they cannot assess the risk of each bank.  Instead, they do what they are currently doing and that is go on a buyers' strike as seen in the freezing of the Eurozone interbank lending and unsecured bank debt markets.

A more effective form of market discipline would be to require large financial institutions to issue, at least annually, both long-term senior and subordinated debt. The total long-term debt should be more than enough, when coupled with a bank’s equity and reserves, to cover any reasonably conceivable losses the institution might incur. 

If the institution faced insolvency, the FDIC would put the institution into a “bridge bank” that would operate under FDIC control with new management and directors. The bridge bank would continue to serve depositors and borrowers, leaving the equity and long-term debt behind in a receivership with no guarantee of recovery. The bridge bank would be privatised as soon as possible. 

If total equity and long-term debt were set at 20 per cent of assets, it is hard to imagine the FDIC, much less taxpayers, ever incurring losses on the failure. If a bigger cushion were desired, a 5 or 10 per cent hold-back on uninsured depositors could also be imposed.

Who knows how much in the way of losses is being hidden on and off bank balance sheets today.

Let's look at potential sources of losses:  opaque, toxic subprime mortgage backed securities; second mortgages; commercial real estate mortgages; and sovereign debt.  This is before we consider off balance sheet derivative exposures to banks that may be insolvent.

This plan would not only protect the FDIC and taxpayers against losses in the event of failure, it would also impose discipline making failure much less likely. A bank would be required to issue senior and subordinated long term debt on a regular basis. A risky bank would have to pay higher interest and ultimately might not be able to issue debt, which would curtail growth and force it to adopt a new strategy. 

For this plan to work, creditors need to be provided with ultra transparency so they can independently assess how risky each bank is and adjust the price and amount of their exposure according to this assessment.