Making Debt Holders into Watchdogs

The Dodd financial reform bill, which awaits the Senate after its two-week break, is loaded with good intentions. But does it do enough to keep banks from going out on a limb for profits?

The type of risks that put banks in the greatest jeopardy—and led to the recent crisis—are called tail risks. They have a small probability of turning out badly but are extremely costly if they do. Banks took on two kinds of tail risks prior to the crisis. One was economywide default risk, the risk that a broad portfolio of assets, such as mortgages, would suffer deep losses. The other was liquidity risk, essentially the way they financed the first kind of risk.

Some banks—such as Citibank (C), Lehman Brothers, and Royal Bank of Scotland—loaded up on both risks, holding enormous quantities of mortgage-backed securities on the asset side and paying for them with short maturity debt on the liability side. Why did they do it? The simple answer: It was very profitable, provided the tail events did not materialize. Think of insurers that write a lot of earthquake policies (another tail risk). If you didn't know they were writing earthquake insurance and not setting aside reserves, you would think they were enormously profitable until there's a quake. For banks, there was always the threat of a day of reckoning when liquidity dried up and defaults skyrocketed. But they set aside few reserves against that happening.

Some commentators, looking at the enormous stockholdings that CEOs such as Dick Fuld of Lehman had in their own firms, argue that perverse risk-taking had nothing to do with incentives. They miss the point that anyone who has an equity-like claim to all the upside of a firm's profits (and faces a fraction of the leveraged losses) has an incentive to take on tail risk because there are fat premiums for doing so. And if the tail risk does not hit for a long time, CEOs who are rewarded with stock and stock options can end up with enormous holdings. In fact, studies show that CEOs of banks that paid most aggressively took the greatest risks. It paid off during the 1990s, creating once-heroic CEOs like Jimmy Cayne of Bear Stearns (BSC) and Lehman's Fuld. The Fed came to their rescue, both in the turmoil of 1998 and after the dot-com bust in 2001. But the panic of 2007-08 was an order of magnitude larger.

Particularly worrisome, as my colleague Douglas Diamond and I have argued, is that once banks are leveraged enough that they will be severely distressed if economywide liquidity dries up, they double down on risky bets. This appears to be what a number of banks did as the crisis loomed. Stockholders and boards are in the same position as the CEO when a bank is thinly capitalized and have little reason to curb risk-taking. This is why proposals to increase capital requirements are critical; they give equity holders something to lose.

What about the debt holders? Theoretically, they bear the bulk of downside risk. The intervention by the government and the Fed in 2008, however, confirmed their belief that they'll be bailed out when a panic arises. This banishes their fears about bank risk-taking. But there's a way to line up their self-interest with regulators' presumed goal of protecting the economy from the adverse effects of tail risks.

Here's the drill: To make it harder for tail-risk-taking banks to grow, all banks should be required to issue a minimum level of debt (say, 10% of assets) that is automatically impaired—either converted to equity or written down—if the bank suffers sufficient losses. This will quickly change debt holders' views on risky expansion. Moreover, no financial institution should be allowed to hold this debt. This will lessen the need for bailouts to avoid contagion. It also makes sense to phase out deposit insurance as a bank's deposits hit a certain level so that the government doesn't subsidize size (or risk-taking). By strengthening proposals to bring debt holders into the equation, the Dodd bill will add up to a much more powerful corrective.

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