How to Regulate the Banks, and other Financials

At the Treasury meeting, I commented that the insurers were better regulated for solvency than the banks.  One of the reasons for that is that they do harder stress tests, and they look longer-term.

So, if one is trying to regulate banks for solvency, there are two things to do:

  • Set risk-based capital formulas so that few institutions fail.
  • Make it even less likely that larger institutions fail.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”  The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.  But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.  It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.  No assets should be bought that the liability structure of the bank cannot hold until maturity.  There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.  After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.

Having managed assets in a framework like this, I can tell you that it creates diversification.  But the next part is even more important, because short-term funding structures are a recipe for default.

It is almost always initially profitable to borrow short and lend long.  That said, it is a noisy trade.  Who can be sure that short rates will remain below the rates at which one invested long?  The second component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.  (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.  Unregulated financials can do what they want.  And no investing in unregulated financials by regulated financials.)

But after all that, there must be a capital penalty on larger institutions.  Let financial institutions get as large as they like, but once they get to a certain level of assets, say $100 billion, start raising capital requirements so that it is uneconomic to manage more than $500 billion in assets.  If we had regulations like that, the too big to fail issue would not occur.  As they got close to the barrier banks would break themselves up, without any external intervention.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Dodd’s Proposals

There are good things in Senator Dodd’s proposals, but I want to focus on a few things.

Either eliminate the Fed, or let it manage systemic risk.  Why?  The Fed creates most systemic risk through its monetary policy.  What tools would a new regulator have to constrain the Fed?  None?  I thought so.  In a fiat currency economy, the central bank must constrain credit in order to constrain monetary policy and systemic risk.

I don’t think there has to be a single regulator, as much as the regulators should choose whom they regulate, rather than vice-versa.  Options are always bad for financial institutions.  One should want them to apply to the Treasury for a regulator, and the Treasury assigns the regulator that will minimize risks to the nation.

As for changing governance of the Fed, Dodd’s bill misses the point.  We don’t care who governs it. We do care what their goals are.  We want them to minimize goods and asset inflation, while not letting the economy go fallow through capital or labor unemployment.

I’m not crazy about Dodd’s plans to select members of the FOMC by a vote from the Fed Board.  That just centralizes power in the hands of incompetent Fed Board members.

Personally, if I can’t eliminate the Fed, I would rather its members be democratically elected each congressional cycle.  Yes, initially the electorate would make errors, electing those that promise greater prosperity, but eventually they would realize that they need to elect those that will restrain inflation, regardless of the consequences.  I trust the people of America more than the elites that have mismanaged it.