Banks: Flawed Regulation

by Guest Author Amar Bhidé (see bio & credits below)

Imagine that the arguments triggered by the Hindenberg disaster were about the fire extinguishers and parachutes that airships should carry, rather than about the design flaws that might cause them to ignite. Unfortunately, today’s debates about banking reform have just this character.

Reversing the robotic gigantism of banking ought to be the top priority for reform. Bankers were once supposed to know every borrower, and to make case-by-case lending decisions. Now, however, banks use models conjured up by faraway financial wizards to mass-produce credit and a range of derivative products. Mass-production favors the growth of mega-banks, so, unlike the misjudgments of lending officers, these behemoths’ defective models have had disastrous consequences.

Radical proposals that would help restore a more resilient system, offered by the likes of Governor of the Bank of England Mervyn King, have been smothered by noisy discussion of measures that do nothing to address modern banking’s fundamental defects.

Consider the seemingly heated debate over how much capital banks should hold. Regulators have proposed steep hikes: a Bank of England study, for example, suggested a more than three-fold increase.

Bankers, who may really be worried about their own bonuses, warn that higher capital requirements will force them to curtail lending, thus impeding economic growth. In fact, this is all a pointless charade.

Yes, the principle of regulating bank capital seems sensible. Borrowing increases risk in any business: you can’t go bankrupt if you have no debt. Heavy borrowing also encourages owners and managers to go for broke, because it’s the creditors who bear most of the downside risk. Prudent lenders therefore try to limit both how much a business can borrow and the other risks it can take.

But creditors don’t have an incentive to place tough limits on banks. Because runs on banks can trigger widespread distress, governments explicitly guarantee insured deposits and implicitly guarantee all the other debts of mega-banks. Governments that guarantee bank liabilities, however, must then also demand that bankers exercise more prudence than they might on their own.

Yet focusing mainly on how much banks borrow while ignoring other, more serious recklessness is a bad regulatory bet.

Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.

Regulators then shifted to edicts requiring banks to maintain a specified capital cushion, thick enough to cover potential losses. This approach presupposes that bank assets and exposures can be accurately measured. In fact, the financial statements of mega-banks are impenetrable works of fiction or wishful thinking.

The problem goes beyond deliberate obfuscation. J.P. Morgan and Deutsche Bank have paid substantial sums to settle charges ranging from bribery to illegal foreclosures to abetting tax evasion. Ruling out the connivance of top executives raises an alarming question: Does Jamie Dimon, J.P. Morgan’s highly regarded CEO, have as little grasp of the exposures embedded in his bank’s nearly $80 billion derivatives book as Tony Hayward, the hapless ex-CEO of BP, had of the hazards of his company’s ill-fated rig in the Gulf of Mexico?

Indeed, ignorance about what is actually at risk makes debates about the right formula for capital buffers surreal. Moreover, the use of mechanistic rules to determine capital adequacy has also inadvertently encouraged systemic imprudence.

Limits on borrowing that make it difficult to earn an adequate return on equity encourage banks to load up on riskier, high-profit-margin loans – and requiring banks to hold more capital for supposedly riskier categories of assets exacerbates the problem. For example, under the internationally-agreed Basel Committee rules that were in place before the 2008 crash, capital requirements for business loans were five times higher than for mortgage-backed securities that had AA or AAA ratings.

Banks naturally avoided traditional business loans (which would have to be backed by more capital), and instead loaded up on the highest-yielding – and thus riskiest – AA or AAA mortgage- backed securities that they could find. The global banking system and economy was thus vulnerable to the mistakes of the three main rating agencies and their flawed risk models.

Encouraging banks to turn loans kept on their books into securities also helped reduce the overall level of caution in the extension of credit. Additionally, strategies to circumvent the Basel rules made banks more complex and difficult to manage and supervise.

Smarter capital requirements – better Basel rules – aren’t the answer. Rigid, top-down uniformity is essential in the specification of weights and measures and the issuance of currency and coin. Bank lending and regulation, by contrast, must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help). The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.

We can no longer afford to rely on old-fashioned examination for mega-banks loaded with mass-produced risks. And because stockholders or raiders can’t force streamlining, governments  must require these banks to shed activities that no one can manage or regulate and stick to hands-on case-by-case lending. With huge profits and bonuses at stake, mega-banks won’t readily abandon their model-based businesses; but, unless that happens, placing most of our bets on top-down rules would be reckless folly.

Amar Bhidé is a professor at Tufts University’s Fletcher School of Law and Diplomacy and the author of A Call for Judgment.  This article is copyrighted by Project Syndicate, 2011, and was originally published as Bank Regulation’s Capital Mistake.  It is presented here by special arrangement with Project Syndicate.

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