Friday, January 30, 2009

Preventing Future Bank Failures

Lasse Pedersen and Nouriel Roubini have an interesting proposal to prevent future systemic banking failures. The general concept is this: while regulators can manage risks at individual banks, there is no regulation of systemic risks. That is, if one bank makes stupid loans, regulators can step in and whack them. If everyone runs in the same direction trying to outdo each other making money by handing out bad loans, there is no way to stop it. Roubini and Pedersen recommend a systemic insurance policy for the entire banking industry.
First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off).
I'm not sure I see how this would have worked in this crisis. First off, the risk ratings agencies like Moody's performed horribly. Remember, many of those real estate-backed bonds that went belly up were rated AAA. Second, much of this crisis was precipitated by government entities encouraging risks as Fannie Mae and Freddie Mac bought up risky mortgages in the hopes of encouraging more home ownership. When attempts were made to regulate them, essentially the systemic regulation Roubini talks about, they were protected by their allies in Congress like Barney Frank.

The idea has theoretical merit, but I can't see how it would work since it doesn't address the root cause of the problem, a culture that refuses to earn what it wants to receive.

1 comment:

Anonymous said...

I think the fundamental problem with any scheme that requires regulators, is that being a regulator pays poorly and garners very little respect, and yet the people acting as regulators are expected to be relentless, vigilant, and incorruptible.

Plus, people who become regulators are frequently people who wanted to work in the business that they are regulating, but aren't good enough to really make it in the field.

Meanwhile, they are trying to regulate people who: (1)*are* good enough to make it in the field (which means they are cleverer about manipulating things than the regulators are about catching them at it); (2) have a great deal of money (which means that they are in an excellent position to corrupt the regulators); and (3) are often practically amoral themselves (because otherwise, they wouldn't need to be regulated).

Given all this, the regulators are pretty much doomed to be too little, to late, and largely irrelevant. They don't have the ability, resources, or in many cases the motivation to fight the war. All they can do is come out on the battlefield afterwards and bayonet the wounded. Like they are doing now.