How to make the latest banking regulations work

The recent financial crisis has exposed the failures of regulation. We have witnessed how the three pillars of the Basel II approach – namely capital requirements, supervision, and disclosure and market discipline – have been insufficient to prevent or contain the crisis. Banking has proved much more fragile than expected. Among the problems that have surfaced is the danger of an overexposure to wholesale financing, as demonstrated by the demises of Northern Rock and Bear Stearns. Another startling development has been the large impact of public news, such as the decline of the ABX index of credit derivatives on subprime mortgages in 2007, credited with inducing the run on structured investment vehicles (SIVs) in the summer of that year (see, e.g., Gorton 2008). The effects of disclosure requirements have also been dramatic, such as the implementation in 2007 of FAS rule 157 – a piece of mark-to-market accounting legislation – which was credited with aggravating the consequences of the bursting of the real-estate bubble by forcing banks to disclose large losses on their portfolios of mortgage-backed securities.¹

The regulatory response has been, in the so-called Basel III process, to increase capital requirements, introduce liquidity requirements and strengthen transparency requirements.² Apart from this, structural reform has been proposed in the US, the UK, and the EU in order to separate traditional banking from market-oriented activities to a certain degree. Some of these measures have already been implemented. Furthermore, in the immediate response to the crisis, antitrust concerns were set aside and large banks were allowed to merge in the US, the UK, and Spain among other countries – not to mention the amount of state aid granted to the banking sector with the effect of distorting competition.

Problems with the Basel III approach

The approach in the Basel III process has been to calibrate capital and liquidity requirements independently, with the latter still not quite settled, and to think about disclosure requirements separately. With regard to competition policy, the standard idea has been to enforce it independently of the level of prudential regulation. I argue in Vives (2014) that this approach may prove problematic:

1. Capital and liquidity requirements are both necessary but partially substitutable in the regulatory aims of keeping the probabilities of insolvency and illiquidity in check. This means that an increase in one requirement should be accompanied by a reduction in another requirement to accomplish regulatory objectives in an efficient way.
2. The optimal levels of capital and liquidity requirements are not independent of the level of disclosure in the market. For example, more disclosure may need to be accompanied by a higher liquidity requirement in order to keep the probability of illiquidity in check.
3. Optimal prudential policy is not independent of the level of competitive pressure that banks face.

I obtain these results in a model of crises that distinguishes solvency from liquidity problems, and which is based on a simple game of strategic complementarities with incomplete information (e.g. Morris and Shin 2004, Rochet and Vives 2004). The financial intermediary obtains unsecured wholesale financing that may not be renewed depending on the information received by fund managers. If this happens, the intermediary typically will need to liquidate some assets at fire sale prices in order to meet its debt obligations. Those sales can be moderated by holding more liquidity.

The result is that there is a range of fundamentals of the investment portfolio of the bank for which the entity is solvent but illiquid. The intermediary faces a coordination failure that leads to fragility in the sense that a small change in the environment may move the equilibrium of the investors’ game from safe to unsafe. This fragility is linked positively to the co-movement of investors’ actions or, in more technical terms, to the degree of strategic complementarity of their actions. I find then that strategic complementarity and fragility are increasing in the weakness of the balance sheet of the intermediary (high level of wholesale short-term financing and low level of liquid reserves), market stress parameters (such as the extent of fire sales penalties of early asset sales or of the cost of funding), and the precision of public signals about the fundamentals.

Partial substitutability of capital and liquidity requirements

The probabilities of insolvency and illiquidity can be controlled with capital and liquidity requirements. If the regulator aims to cap the probabilities of insolvency (to mitigate moral hazard) and illiquidity (to mitigate contagion risk), it can accomplish this by setting minimum capital and liquidity requirements. Those requirements are partially substitutable, and typically a change in the environment that calls for an increase in one will imply a decrease (at least weakly) in the other. For example, higher fire sales penalties to liquidate assets will call for an increased liquidity requirement and a relaxed solvency one, whereas increased competition raising funding costs will call for an increased solvency ratio and a stationary liquidity ratio. The latter prescription is important when the regulator faces a liberalisation episode such as that of Savings and Loans in the US in the 1980s. In this case the failure to tighten solvency requirements led to disaster.

Regulatory implications of public signals

A more subtle change in the environment is in disclosure requirements or the introduction of strong public signals. In an environment with weak balance sheets and market stress, bad news provided by a strong public signal may coordinate expectations on a run equilibrium.

This is what seems to have happened with the SIVs crisis in 2007. The SIVs were mostly funded short term in the wholesale market, and investors had poor information when deciding whether to roll over their loans given the opaque nature of residential-based subprime securities. The introduction of the ABX index in 2006 provided a potent public signal about the state of subprime mortgages, and when this index started to decline in early 2007 it eventually triggered a run on the SIVs. All the conditions that make investors’ actions co-move strongly were present: a high level of unsecured short-term financing in particular, coupled when the crisis started with high fire sales penalties, and a strong public signal in relation to the accuracy of private signals.

With hindsight, and according to my analysis, the regulator should have tightened liquidity requirements when the ABX index was established. If properly calibrated, the liquidity requirement would have decreased the profitability of SIVs but avoided the run. Similarly, the regulator should have established a liquidity ratio when introducing the mark-to-market accounting FAS rule 157 in 2007 in order to avoid increasing the risk of illiquidity.

Concluding remarks

In conclusion, independently of the debate on the right amount of capital (see e.g. Admati et al.2013 and Corsetti et al. 2011), regulators should look at the interaction between capital, liquidity, and disclosure requirements. Regulators should take into account also the level of competitive pressure when setting prudential requirements. This implies that competition policy and prudential policy are not independent either. Taking these interactions into account in a holistic approach will lower the likelihood of regulatory blunders and improve the chances that the Basel III process delivers the expected results.

References

Admati, A, P de Marzo, M Hellwig, and P Pfleiderer (2013), “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”, Stanford University GSB Research Paper 13-7.

BIS (2014), “Review of the Pillar 3 Disclosure Requirements”, Basel Committee on Banking Supervision, Consultative Document.

Corsetti, G, M Devereux, J Hassler, G Saint-Paul, H-W Sinn, J-E Sturm, and X Vives (2011), “A New Crisis Mechanism for the Euro Area”, in The EEAG Report on the European Economy 2011, CesIFO: 71–96.

Morris, S and H S Shin (2004), “Coordination Risk and the Price of Debt”, European Economic Review 48: 133–153.

Gorton, G (2008), “The Panic of 2007”, in Maintaining stability in a changing financial system, Proceedings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City.

Rochet, J C and X Vives (2004), “Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?”, Journal of the European Economic Association 2(6): 1116–1147.

Vives, X (2014), “Strategic Complementarity, Fragility, and Regulation”, Review of Financial Studies27(12): 3547–3592.