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.


  • Mike C says:

    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.

    Eventually they would realize?

    I find myself rarely disagreeing with you, but as mistaken as *some* elites might be at times, I’ve got to think it would be much worse under some sort of popular vote by the masses. Simply observe the utter disaster that is Congress/the legislative process and the influence of special interest groups, and that legislation is almost always focused on the short-term rather then the long-term. And these are the same people who bought hook, line, and sinker into the tech and housing bubbles thinking trees could grow to the sky, economic reality could be suspended, and that you can always get “something for nothing”. I don’t know. I shudder to think what monetary policy would be like if those responsible for it were subject to popular vote from the “people”. There are very good reasons that Supreme Court justices are appointed, not elected, and that generally speaking the judicial branch is immune from political pandering.

  • PaulinKansasCity says:

    This is real insight David; well said

  • Consider my thoughts to be comparative, Mike — my view is that no institution in a democracy should be a place where one can have a self-perpetuating oligarchy that acts against the interests of the people. This is true of the Fed, it is true of the professions that shield their members from the courts, it is true of the judiciary itself. It is true of the economics profession, and many other academic disciplines that exclude rival ideas. It is true of our gerrymandered House of representatives, and many State assemblies.

    Term limits are one way of dealing with these. So are elections. Electing judges is not a bad thing.

    So, should we elect Fed Governors? No. But there has to be some way to remove control of the Fed from the cadre of bureaucrats and academic economists with their failed paradigms.

    Politicians would be better off saying, “We’ve proven that we are no good at managing the economy. Let it manage itself. We will deal with domestic tranquility and defense. Let the courts deal with the rest.”

    I would rather the Fed did not exist, but if it does exist, let the terms be short.

    All that said, one benefit of the Dodd proposal is that there would be no reason to employ all of the economists at the Fed.

  • Michael - NYC says:

    This is really ill thought-out:

    1 – Insurance regulatory regime is awful. Worse than banks. The results are worse based on AIG alone.

    2 – The reason your loose thinking allows you to believe this… is because this crisis was a mortgage/housing crisis. That is where the spec bubble was. It burst. This obviously affects those closest to the mortgage credit chain most — BSC, LEH, FNM, FRE, WAMU, Wachovia, etc…

    Drawing other conclusions is silly.

    • Michael —

      Sorry, aside from not regulating AIG’s Securities Lending, there were no major errors in the regulation of AIG for solvency by the insurance regulators.

      The insurance regulators had no control over AIGFP, which was the main problem.

      Insurers have actuaries. Banks don’t. The actuarial risk models are more robust than the bank models. Insurers had the right to invest in risky mortgages, but given that they are longer term investors, chose not to. I’ve been on both bank risk committees and insurer risk committees — what the insurers do is far more rigorous.

      Also, insurers run at lower levels of leverage relative to the riskiness of their business and their funding base. The regulations require it.

      The insurers have not captured the NAIC the way the banking industry captured its regulators.

      I’m willing to hear criticism here, but your perfunctory comments leave me with little to chew on. If you have something big to say, why don’t you start your own blog and take my post apart as your first post? I mean that in a friendly way. The blogosphere has need of good thinkers, and if I am wrong, show the world. We will all be better off.