Thursday, January 17, 2013

BoE's Andrew Haldane: have we solved 'TBTF'? No!

In an interesting article on VoxEU, the Bank of England's Andrew Haldane asks the question of have we solved the Too Big to Fail problem and answers with an emphatic 'no'.

Regular readers are not surprised by this answer as the only way to solve the TBTF problem is to require all banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The reason ultra transparency solves the TBTF problem is it subjects the banks to market discipline.  Specifically, with this information, market participants can truly assess the risk of each bank and adjust their exposure accordingly.  The result is to link each bank's cost of funds to its risk.

Linking risk to each bank's cost of funds will put pressure on the banks to reduce their risk.  Pressure that banks will respond to by becoming smaller and more easily understood.  In short, market discipline will cause the TBTF to break themselves up into smaller units with less risk that the market places a higher value on (please note that this happened with corporate conglomerates).

Today, a bank's cost of funds is not related to its risk because the banks are in Mr. Haldane's words 'black boxes'.

Leading up to the financial crisis, market participants understood the banks were black boxes and turned to the financial regulators for insight into the risk of each bank.  The reason market participants turned to the financial regulators is they have a monopoly on all the useful, relevant information on each bank in an appropriate, timely manner.  Recall that the financial regulators have examiners at the banks 24/7/365.

One lesson from the financial crisis is that even if the examiners correctly assess the risk of each bank, the financial regulators will not communicate this risk to the market.  There are a number of reasons this occurs including political pressure and concerns over the safety and soundness of the financial system.

That financial regulators will not communicate the risk of each bank to the market has been shown time and time again with the bank stress tests.  We had banks throughout Europe collapse shortly after the financial regulators said they were well capitalized.  In the US, we had at least two banks who required a subsequent bailout.

It is interesting to note that besides the banks there is another part of the financial system that is Too Big to Fail:  the financial regulators.  Without ultra transparency, market participants are dependent on the financial regulators.  When the financial regulators fail, and they did because we had a bank solvency led financial crisis, the taxpayers bailed them out.

Not only that, but the policy responses since, like the Dodd-Frank Act, have increased the size and role of the financial regulators and made them even more TBTF.

Like the TBTF banks, financial regulators and their role is also cut down to size by requiring ultra transparency.  With ultra transparency, market participants can see if the financial regulators are doing what they are suppose to do.

Mr. Haldane's answer to the question of have we solved the TBTF problem:

That is not my pessimistic verdict; it is the market’s. Prior to the crisis, the 29 largest global banks benefitted from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, those same global leviathans benefit from around three notches of implied support. Expectations of state support have risen threefold since the crisis began. 
This translates into a large implicit subsidy to the world’s biggest banks in the form of lower funding costs and higher profits. Prior to the crisis, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions (Haldane 2012). In other words, if the market’s expectations are to be believed, the regulatory response to the crisis has not plugged the 'too-big-to-fail' sink.... 
What is certainly true is that, in the light of the crisis, regulation to quell the too-big-to-fail problem has come thick and (at least in regulatory terms) fast. This reform effort falls into roughly three categories: 
(a) Systemic surcharges: of additional capital levied on the world’s largest banks according to their size and connectivity. ... Last year, the Financial Stability Board (FSB) agreed a sliding scale of systemic surcharges for the world’s largest banks. The highest surcharge was set at 2.5% of capital. 
Yet therein lies the problem. Based on my estimates (Haldane 2012), a charge levied at this rate would leave the majority of the systemic externalities associated with the world’s biggest banks untouched. The reduction in default probabilities associated with lowering leverage by a percentage point or two would not offset the higher system-wide loss-given-default associated with the world’s largest banks. The systemic tax is being levied at rates which are too low...
If the banks were required to provide ultra transparency, there would be no need for complex rules like systemic surcharges.

Market participants could independently assess the banks' default probabilities, also known as risk.  The result would be the banks would be under pressure to reduce their risk as their cost of funds increases and makes much of their risk taking unprofitable.

As your humble blogger has said repeatedly, the combination of complex rules and regulatory oversight is an inferior substitute to transparency and market discipline.
(b) Resolution regimes: In principle, orderly resolution regimes for banks could lower the collateral costs of a big bank defaulting, thereby tackling at source these systemic externalities. .... A key component of these plans is the ability to impose losses on private creditors – so-called 'bail-in' – rather than have those losses borne by taxpayers. 
As with systemic surcharges, the issue here is not to so much the bail-in principle, but its application in practice. Bail-in, whether of big banks, sovereigns or companies, faces an acute time-consistency problem. Policymakers face a trade-off between placing losses on a narrow set of tax-payers today (bail-in) or spreading that risk across a wider set of tax-payers today and tomorrow (bail-out). 
A risk-averse, tax-smoothing government may tend towards the latter path – and historically has almost always done so, most notably in response to the present financial crisis. Next time may of course be different. But the market is sceptical.... 
As I have repeatedly said, the idea of bail-in completely misses how our financial systems were designed based on the FDR Framework.

Regular readers know that the FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

There is no need to be discussing bail-in or bail-out under the FDR Framework because market participants know under the principle of caveat emptor that they are responsible for losses on their exposures.

By definition under the FDR Framework, all unsecured debt and equity holders are subject to losses if a bank is insolvent and the financial regulators close it.

The reason these debt and equity holders will exert discipline on bank management to limit the risk of the bank is to avoid these losses.

Please note, the FDR Framework only holds true so long as the governments ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Given the financial regulators information monopoly, this is not currently true for banks.  Hence, the discussion of bail-in versus bail-out.  A discussion that is rendered moot by requiring banks to provide ultra transparency.
(c) Structural reform: One way of lessening that dilemma may be to act on the scale and structure of banking directly. Several recent regulatory reform initiatives have sought to do just that, notably the “Volcker rule” in the US, the 'Vickers proposals' in the UK and, most recently, the 'Liikanen plans' in Europe. While different in detail, each of these proposals shares a common objective: a degree of separation or segregation between investment and commercial banking activities. 
In principle, these ringfencing initiatives confer both ex-post (improved resolution) and ex-ante (improved risk management) benefits. Because they act on banking structure, they have a greater chance of proving time-consistent. While this is a clear step forward, those benefits are only as credible as the ringfence itself. The issue raised by some is whether, in practice, the ring-fence could prove permeable. Without care, today’s ring-fence could become tomorrow’s string vest. 
Again, ultra transparency addresses the issue of structural reform.  As I have previously said, regulation has two components:  the rule and the enforcement.

The Volcker Rule says that banks should not take proprietary bets.  By making the banks provide ultra transparency, market participants can assess the bank's positions and see if they are in compliance.

Oh, by the way, ultra transparency will also improves the banks' risk management.  Recall that market discipline has a bias towards banks taking less risk.
If each of these initiatives is necessary but none is individually or collectively sufficient to tackle too-big-to-fail, what is to be done? 
One solution might lie in strengthening these proposals. For example, re-sizing the capital surcharge, perhaps in line with quantitative estimates of the 'optimal' capital ratio (Miles et al (2012), Admati et al (2011)), would be one option for bearing down further on systemic externalities. 
Another more radical option, mooted recently by a number of commentators and policymakers, would be to place size limits on banks, either in relation to the financial system as a whole or, more coherently, relative to GDP (Hoenig (2012), Tarullo (2012)). 
Proposals of this type typically face two sets of criticism. 
The first, practical issue is how to calibrate an appropriate limit. ....
The second, empirical issue is whether size limits would erode the economies of scale and scope which might otherwise be associated with big banks....
What is to be done is to require the banks to provide ultra transparency.

Contrary to what the banking industry lobbyists say, there is no limit on transparency as there are a number of market participants who are capable of assessing the exposure details from the global banks (not the least of which are the competitor global banks).
Too-big-to-fail is far from gone. It is even more important it is not forgotten.
And it won't be gone until the banks are required to provide ultra transparency so that they can be subject to market discipline and forced to reign in their risks.

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