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Fed Governor Wants Everyone To Remember That It's Not Just Banks That Are Too Big To Fail

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One reason that a lot of people are enamored with the Brown-Vitter approach to bank regulation is that it's very simple, and everyone deep down sort of thinks that the simple answer has to be better than the complicated one. "You don't need risk-based capital or stress tests or liquidity coverage ratios or VaR models or multiple tiers of capital or bail-in debt," Brown and Vitter promise. "You just need to make sure that big banks don't have assets of more than ~6x their common equity."

Somepeople disagree1 and by all means feel free to question those people's motives. Certainly some people benefit from complexity, bankers above all but also banking regulators, former regulators, and I suppose me too. Simple banking seems really boring, though maybe Brown-Vitter simple banking wouldn't be.

Anyway that seems like the background to this interesting speech by Fed governor Daniel Tarullo about financial stability, which you couldif you likeread as sort of the Fed's initial response to Brown-Vitter. And it's not not that; the speech engages with Brown-Vitter on the capital stuff, basically defending the status quo of risk-based regulatory capital while conceding a little to Brown-Vitter's call for higher capital.2

But he seems at least as focused on another source of systemic risk: not banks but wholesale funding markets, not capital but liquidity. You could see why the Fed might be focused there. For one thing, while the Fed is a capital regulator, it's also a liquidity provider. A liquidity provider of last resort, you might even say. And while of course weak capitalization leads to liquidity problems, liquidity problems are what lead directly to bailouts.3 The big risk posed by too-big-to-fail banks is not really that their assets will drop in value so far that their creditors lose money on a liquidation - a risk that can be solved by requiring more capital. The big risk is that there'll be a liquidation at all - a risk that capital can help solve, but that is perhaps addressed more directly through funding.

Equally important, Brown-Vitter is mostly about "eww banks we hates them," so hating non-banks is reserved for other venues. Liking non-banks might even be part of the motivation: here you can read an AlterNet article arguing that Brown-Vitter will have the effect, and perhaps has the intent, of shifting financial risk from banks to insurers. Shifting to capital-arb hedge funds, etc., also seems likely.

That seems risky? As Tarullo says:

At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs [securities financing transactions, i.e. repo etc.] are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalization by market actors of the systemic costs of this intermediation.

And the risks, and potential bad consequences, are not particularly limited to banks:

Even if an intermediary's book of securities financing transactions is perfectly matched, a reduction in its access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary's customers are likely to be highly leveraged and maturity transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high.

And so they can't be solved by bank regulation:

The obvious questions are whether [banks] at present occupy enough of the wholesale funding markets that [liquidity and capital] standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle.

Sadly it's not so clear what the fix is. Tarullo points to a few suggestions, including "a universal minimum margining requirement applicable directly to SFTs" in which "all repo lenders, for example, could be required to take a minimum amount of over-collateralization as determined by regulators (the amount varying with the nature of the securities collateral), regardless of whether the repo lender or repo borrower were otherwise prudentially regulated." Sort of the opposite of the Brown-Vitter approach: instead of a high capital requirement on big banks, a lower requirement on small banks, and no capital regulation at all on non-banks, this would require a certain minimum level of equity (in securities, not entities) for everyone, regardless of status.

Tarullo mentions some other incremental improvements to wholesale funding markets, like the Fed's work on reducing intraday credit risk in the triparty repo markets, and potential limits on rehypothecation of collateral. (Perhaps relevant, though unmentioned, is the SEC's slooooow work on run-proofing money market funds.) He also throws out the possibility of imposing higher capital requirements on banks that use a lot of short-term secured funding, which I guess is its own sort of too-big-to-fail surcharge. But he concludes:

As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets ... But I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place.

And that seems to be what he wants to work on. While the speech contains lots of proposed tinkering with capital levels and metrics, it reads to me like Tarullo thinks the capital-regulatory framework we have - Basel risk-based capital backstopped by a leverage ratio minimum, with stress tests and unsecured/bail-in debt - is basically the right one. The liquidity, wholesale-funding and shadow-banking regulatory framework we have, such as it is, is where a lot more work is needed.

Evaluating Progress in Regulatory Reforms to Promote Financial Stability [Fed]
Tarullo’s speech on capital and regulation [FTAV]
Fed eyes enhanced capital requirements [FT]
Fed Governor Pushes for Measure Aimed at Strengthening Large Banks [DealBook]
US Fed's Tarullo calls for higher bank capital levels [Reuters]

1.Others prefer the (counterintuitive) approach of claiming that Brown-Vitter isn't as simplistic as it seems:

[W]hat Brown, Vitter and Fine express isn’t populist anger, but rather a thought-out plan for making the financial system safer. Read the bill and the section-by-section guidance (available here). Brown-Vitter blends some powerful thinking. For example, it reflects the ideas of Richard Fisher and Harvey Rosenblum of the Dallas Federal Reserve on how to remove government guarantees; the critique of Basel III from Tom Hoenig of the Federal Deposit Insurance Corporation; and the lessons of Sheila Bair, a former chairman of the FDIC, on the failures of supposedly smart regulation ....

2.He suggests that the leverage ratio - 3% under Basel III, versus 15% in Brown-Vitter for the biggest banks - should perhaps be higher:

The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

And that capital surcharges on too-big-to-fail banks should also be higher:

The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms' failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms.8 Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

But he also defends more sophisticated capital regulation against the Brown-Vitter Hulk-smash call for less sophisticated regulation:

  • Forward-looking capital requirements are better than static ones: "I would observe that our stress tests and capital-planning requirements have already strengthened capital standards by making them more forward-looking and more responsive to economic developments."
  • Having Basel III, even though it's complicated, is better than getting rid of it:
    But opposing, or seeking delay in, Basel III would simply give an excuse to banks that do not meet Basel III standards to seek delay from their own governments. It would be ironic indeed if those who favor higher or simpler capital requirements were unintentionally to lend assistance to banks that want to avoid strengthening their capital positions.
  • Allowing a spectrum of loss-absorbing instruments is better than requiring only common equity capital: "There is clear need for a requirement that large financial institutions have minimum amounts of long-term unsecured debt that could be converted to equity and thereby be available to absorb losses in the event of insolvency."
  • There is a tradeoff between liquidity and capital and having more liquidity might be enough to avoid having more capital:
    A more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements. This approach would reflect the fact that the market perception of a given firm's position as counterparty depends upon the combination of its funding position and capital levels.

3."Losing enough money to burn through your capital" isn't what blows up a bank; losing confidence and thus short-term funding is. On an accounting basis, Citi had $71 billion in common stockholders' equity, or about 3.7% of its assets, at the end of 2008, when it had just received a $45 billion bailout (only ~$1.7bn of which went to common equity). Even Lehman was sort-of-solvent, on an accounting basis, when it filed for bankruptcy claiming $639bn in assets and $613bn in liabilities. (Oh not really that's as of May 31, 2008, "the latest available information" at the time of filing three and a half months later. Things had, obviously, deteriorated. Still on a sort of GAAP-leverage-ratio basis Lehman was at ~5.9%.) Those numbers aren't to be particularly trusted, but still: presumably in a 15%-capital-requirement world people would be pulling funding on a bank that got down to, like, 12%. Or just doing their banking through shadow banks in the first place.



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