How Financial Regulation Can Be Market Friendly

June 1 (Bloomberg) -- The structure of financial regulation in the U.S. resembles sedimentary rock: Each layer is the legacy of a crisis, but there is nothing binding the layers together.

The Federal Reserve was created in 1913 to address the liquidity problems that occurred during the panic of 1907. The Federal Deposit Insurance Corporation was instituted in 1933 to prevent the kind of bank runs that had forced more than 5,000 banks to close in the early 1930s. The Securities and Exchange Commission came into being in 1934 to prevent the stock-market manipulations of the 1920s. The Office of Thrift Supervision was created in 1989, after the savings-and-loan crisis of the late 1980s. And the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which brought us the Financial Stability Oversight Council, was the result of the most recent financial crisis.

So it’s not surprising that the current regulatory system runs into problems with coordination and the communication of information. This lack of coordination can tempt industry to avoid regulation entirely. For example, state insurance regulators never oversaw credit-default swaps -- even though they were essentially insurance products -- because they were called “swaps,” which made them sound like standard derivatives.

Poor Condition

As for communication of information, consider what happened during the collapse of Bear Stearns Cos. The Fed was late learning about the extent of the bank’s poor financial condition or the risks that its failure would pose to the entire banking system because the central bank didn’t regulate investment banks -- that was the SEC’s job.

The way to fix these problems is to allocate financial regulation and supervision to three different agencies, each responsible for only one of the three principal goals of financial-system regulation.

One agency would be in charge of price stability, more or less conducting the traditional monetary policy of the Fed. A second agency would focus on protecting the little guys, whether they are investing in stock, depositing funds at a bank, borrowing from a bank, or buying an annuity or other insurance product. A third would be tasked with systemic considerations, absorbing some of the extraordinary roles that the Fed has taken on during the current crisis, together with other solvency issues (often overseen by state insurance regulators).

The main challenge of such a design would be striking compromises across agencies and communicating crucial information among them. A new board could be set up consisting of the heads of the three agencies, together with a small number of other Senate-appointed representatives. The minutes of this new board would be publicly released (possibly with a delay), so that the trade-off decisions were transparent and the responsibility for them clearly allocated.

Monetary policy: Let’s examine the three goals of financial regulation, starting with price stability. The relevant agency here is the Fed, which is charged with making the monetary policy that keeps prices stable.

During the 2008 financial crisis and its aftermath, the Fed overstepped its boundaries by acting to ensure the stability of the financial system. It has been under severe attack by Congress, which would like to limit its discretion.

Bad Design

Congress is correct, though the Fed’s missteps are the fault not of its governors but of bad institutional design. By dividing the three major responsibilities of financial regulation among three separate agencies, my proposed architecture allows for having a fully independent monetary-authority board and a politically accountable financial-stability board.

Curbing risk: The market should be able to assess the risks of large financial institutions. But it cannot do so if market players know that those institutions will be bailed out in a crunch. Simply outlawing the “too big to fail” policy might prove very costly one day, preventing Congress from acting as catastrophe looms.

Fortunately, there may be another solution. The government’s reason for bailing out large financial institutions isn’t that they are so large that their demise would bring down the whole system. Rather, it is that they have such extensive interconnections with other financial institutions -- through their various transactions, obligations and contracts -- that a default might trigger losses among an enormous number of counterparties.

To function properly, the financial system needs to operate under the assumption that certain assets, such as deposits, are worry-free. But this trust can be sustained only if people don’t question the prompt and full repayment of so-called sensitive or systemically relevant obligations. People need to know that even if their banks collapse, not just deposits but also short-term interbank borrowing and the network of derivative contracts are secure.

Once we understand that the issue is the interconnectedness of large financial institutions, and therefore the stability of the larger system, we can make some important distinctions. Not all of the debt issued by large financial institutions and not all of the transactions they engage in are systemically relevant or in need of comprehensive protection. Specifically, long-term debt isn’t systemically relevant, because it is mostly held not by large financial institutions but within the massive portfolios of mutual and pension funds, which can absorb losses.

Systemically Relevant

The solution is regulation that protects the systemically relevant obligations of large financial institutions -- making sure that these institutions, not the taxpayers, would repay the obligations in case of bankruptcy.

But that leaves open the possibility that nonsystemically relevant obligations wouldn’t be protected. Under this new system, banks would be required to hold two layers of capital to protect their systemically relevant obligations. The first would be basic equity. This isn’t very different from today’s standard capital requirement, except that the amount of equity required would be determined not by an accounting formula but by a market assessment of the risk contained in the second layer.

That second layer would consist of so-called junior long-term debt, which means that the institution would repay it only after making good on its other debt. This debt would therefore involve more risk for those who bought it, as well as higher rates of return. It would provide an added layer of protection because, in the event the institution defaulted, it could be paid back only after other, more systemically relevant obligations had been repaid. Perhaps most important, because this layer of debt would be traded without the assumption that it would always be protected by federal bailouts, it would make possible a genuine market assessment of its value and risk --and therefore of the value and risk of the financial institution itself.

The crucial innovation of the approach I proposed with Oliver Hart, of Harvard University, is that the second layer of capital would allow for a market-based trigger to signal that a company’s equity cushion was thinning, that its long-term debt was potentially in danger, and that the institution was taking on too much risk. If that warning mechanism provided accurate signals and the regulator intervened in time, even the junior long-term debt would be paid in full. If not, the institution might burn through some of the junior debt layer, but its systemically relevant obligations would generally still be secure.

Large banks would have to show the regulator that they had enough collateral (in the form of equity) to ensure that all of their debt -- not just the systemically relevant part -- could be paid in full. And if declines in the value of their underlying assets put the banks’ debt at greater risk, the regulator could force them either to post additional capital or to submit to liquidation. Either way, debt would be repaid.

Swift Response

The success of this system rests, of course, on the timely intervention of the regulator. Thus it is essential to have an effective mechanism that assesses risk and triggers a swift response.

Such a trigger would be market-based, tied to the price of a security traded in a market with a lot of liquidity and therefore stability. And its price should be closely linked to the financial event we want information about: whether an institution’s long-term debt is at risk.

There is one security that is linked to bond prices but remains very liquid -- the credit-default swap, essentially an insurance claim that pays off if the underlying entity fails and creditors aren’t paid in full. Since a CDS is basically a bet on the odds of a particular company’s failure, its price reflects the market’s assessment of how likely it is that the debt won’t be repaid in full. Under our system, the CDS price for a bank’s long-term debt would be used to gauge the risk of the equity cushion’s being devoured by losses. If the price were to rise above a critical threshold, the regulator would force the institution in question to issue equity by offering new stock for sale. If the price then didn’t fall below that threshold within a predetermined period, the regulator would intervene.

Credit-default swaps are often cited as a cause of the financial crisis. The problem, though, wasn’t with CDSs but with the way they were traded: in opaque markets in which companies could sell the swaps without posting the proper collateral. When traded in an organized exchange with proper collateral, the CDS is a useful instrument for reducing exposure to credit risk.

Fortunately, there is a clear trend toward moving credit-default swaps onto exchanges, which will require better collateralization to protect exchange members.

What form should the regulator’s intervention take? If the trigger were set off by a CDS price that was too high, the regulator would be required to subject the financial institution to a stress test. If the bank failed the test, the debt was found to be at risk, and issuing equity didn’t improve its situation, then the regulator would replace the institution’s chief executive officer with a receiver or trustee. This person would be required to recapitalize and sell the company, guaranteeing in the process that shareholders were wiped out and junior creditors took a “haircut,” meaning that the value of what they were owed would be reduced by a set percentage.

This regulatory receivership would avoid bankruptcy’s worst cost: the possibility that one company’s failure could take down the entire financial system.

(Luigi Zingales is professor of entrepreneurship and finance at the University of Chicago Booth School of Business, a contributor to Business Class and a contributing editor of City Journal. This is the last of three excerpts from his new book, “A Capitalism for the People: Recapturing the Lost Genius of American Prosperity,” which will be published in June by Basic Books, a member of The Perseus Books Group. The opinions expressed are his own. Read Part 1 and Part 2.)

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