Showing posts with label banks. Show all posts
Showing posts with label banks. Show all posts

Sunday, April 17, 2016

The Great Recession Blame Game - Banks took the heat, but it was Washington that propped up subprime debt and then stymied recovery

The Great Recession Blame Game

Banks took the heat, but it was Washington that propped up subprime debt and then stymied recovery.

By Phil Gramm and Michael Solon
WSJ, April 15, 2016 6:09 p.m. ET

When the subprime crisis broke in the 2008 presidential election year, there was little chance for a serious discussion of its root causes. Candidate Barack Obama weaponized the crisis by blaming greedy bankers, unleashed when financial regulations were “simply dismantled.” He would go on to blame them for taking “huge, reckless risks in pursuit of quick profits and massive bonuses.”
That mistaken diagnosis was the justification for the Dodd-Frank Act and the stifling regulations that shackled the financial system, stunted the recovery and diminished the American dream.

In fact, when the crisis struck, banks were better capitalized and less leveraged than they had been in the previous 30 years. The FDIC’s reported capital-to-asset ratio for insured commercial banks in 2007 was 10.2%—76% higher than it was in 1978. Federal Reserve data on all insured financial institutions show the capital-to-asset ratio was 10.3% in 2007, almost double its 1984 level, and the biggest banks doubled their capitalization ratios. On Sept. 30, 2008, the month Lehman failed, the FDIC found that 98% of all FDIC institutions with 99% of all bank assets were “well capitalized,” and only 43 smaller institutions were undercapitalized.

In addition, U.S. banks were by far the best-capitalized banks in the world. While the collapse of 31 million subprime mortgages fractured financial capital, the banking system in the 30 years before 2007 would have fared even worse under such massive stress.

Virtually all of the undercapitalization, overleveraging and “reckless risks” flowed from government policies and institutions. Federal regulators followed international banking standards that treated most subprime-mortgage-backed securities as low-risk, with lower capital requirements that gave banks the incentive to hold them. Government quotas forced Fannie Mae and Freddie Mac to hold ever larger volumes of subprime mortgages, and politicians rolled the dice by letting them operate with a leverage ratio of 75 to one—compared with Lehman’s leverage ratio of 29 to one.

Regulators also eroded the safety of the financial system by pressuring banks to make subprime loans in order to increase homeownership. After eight years of vilification and government extortion of bank assets, often for carrying out government mandates, it is increasingly clear that banks were more scapegoats than villains in the subprime crisis.

Similarly, the charge that banks had been deregulated before the crisis is a myth. From 1980 to 2007 four major banking laws—the Competitive Equality Banking Act (1987), the Financial Institutions, Reform, Recovery and Enforcement Act (1989), the Federal Deposit Insurance Corporation Improvement Act (1991), and Sarbanes-Oxley (2002)—undeniably increased bank regulations and reporting requirements. The charge that financial regulation had been dismantled rests almost solely on the disputed effects of the 1999 Gramm-Leach-Bliley Act (GLBA).

Prior to GLBA, the decades-old Glass-Steagall Act prohibited deposit-taking, commercial banks from engaging in securities trading. GLBA, which was signed into law by President Bill Clinton, allowed highly regulated financial-services holding companies to compete in banking, insurance and the securities business. But each activity was still required to operate separately and remained subject to the regulations and capital requirements that existed before GLBA. A bank operating within a holding company was still subject to Glass-Steagall (which was not repealed by GLBA)—but Glass-Steagall never banned banks from holding mortgages or mortgage-backed securities in the first place.

GLBA loosened federal regulations only in the narrow sense that it promoted more competition across financial services and lowered prices. When he signed the law, President Clinton said that “removal of barriers to competition will enhance the stability of our financial system, diversify their product offerings and thus their sources of revenue.” The financial crisis proved his point. Financial institutions that had used GLBA provisions to diversify fared better than those that didn’t.

Mr. Clinton has always insisted that “there is not a single solitary example that [GLBA] had anything to do with the financial crisis,” a conclusion that has never been refuted. When asked by the New York Times in 2012, Sen. Elizabeth Warren agreed that the financial crisis would not have been avoided had GLBA never been adopted. And President Obama effectively exonerated GLBA from any culpability in the financial crisis when, with massive majorities in both Houses of Congress, he chose not to repeal GLBA. In fact, Dodd-Frank expanded GLBA by using its holding-company structure to impose new regulations on systemically important financial institutions.

Another myth of the financial crisis is that the bailout was required because some banks were too big to fail. Had the government’s massive injection of capital—the Troubled Asset Relief Program, or TARP—been only about bailing out too-big-to-fail financial institutions, at most a dozen institutions might have received aid. Instead, 954 financial institutions received assistance, with more than half the money going to small banks.

Many of the largest banks did not want or need aid—and Lehman’s collapse was not a case of a too-big-to-fail institution spreading the crisis. The entire financial sector was already poisoned by the same subprime assets that felled Lehman. The subprime bailout occurred because the U.S. financial sector was, and always should be, too important to be allowed to fail.

Consider that, according to the Congressional Budget Office, bailing out the depositors of insolvent S&Ls in the 1980s on net cost taxpayers $258 billion in real 2009 dollars. By contrast, of the $245 billion disbursed by TARP to banks, 67% was repaid within 14 months, 81% within two years and the final totals show that taxpayers earned $24 billion on the banking component of TARP. The rapid and complete payback of TARP funds by banks strongly suggests that the financial crisis was more a liquidity crisis than a solvency crisis.

What turned the subprime crisis and ensuing recession into the “Great Recession” was not a failure of policies that addressed the financial crisis. Instead, it was the failure of subsequent economic policies that impeded the recovery.

The subprime crisis was largely the product of government policy to promote housing ownership and regulators who chose to promote that social policy over their traditional mission of guaranteeing safety and soundness. But blaming the financial crisis on reckless bankers and deregulation made it possible for the Obama administration to seize effective control of the financial system and put government bureaucrats in the corporate boardrooms of many of the most significant U.S. banks and insurance companies.

Suffocating under Dodd-Frank’s “enhanced supervision,” banks now focus on passing stress tests, writing living wills, parking capital at the Federal Reserve, and knowing their regulators better than they know their customers. But their ability to help the U.S. economy turn dreams into businesses and jobs has suffered.

In postwar America, it took on average just 2 1/4 years to regain in each succeeding recovery all of the real per capita income that had been lost in the previous recession. At the current rate of the Obama recovery, it will take six more years, 14 years in all, for the average American just to earn back what he lost in the last recession. Mr. Obama’s policies in banking, health care, power generation, the Internet and so much else have Europeanized America and American exceptionalism has waned—sadly proving that collectivism does not work any better in America than it has ever worked anywhere else.

Mr. Gramm, a former chairman of the Senate Banking Committee, is a visiting scholar at the American Enterprise Institute. Mr. Solon is a partner of US Policy Metrics.


Saturday, March 12, 2016

A New Tool for Avoiding Big-Bank Failures: ‘Chapter 14.’ By Emily C. Kapur and John B. Taylor

A New Tool for Avoiding Big-Bank Failures: ‘Chapter 14.’ By Emily C. Kapur and John B. Taylor

Bernie Sanders is right, Dodd-Frank doesn’t work, but his solution is wrong. Here’s what would work.

WSJ, Mar 11, 2016

For months Democratic presidential hopeful Bernie Sanders has been telling Americans that the government must “break up the banks” because they are “too big to fail.” This is the wrong role for government, but Sen. Sanders and others on both sides of the aisle have a point. The 2010 Dodd-Frank financial law, which was supposed to end too big to fail, has not.

Dodd-Frank gave the Federal Deposit Insurance Corp. authority to take over and oversee the reorganization of so-called systemically important financial institutions whose failure could pose a risk to the economy. But no one can be sure the FDIC will follow its resolution strategy, which leads many to believe Dodd-Frank will be bypassed in a crisis.

Reflecting on his own experience as overseer of the U.S. Treasury’s bailout program in 2008-09, Neel Kashkari, now president of the Federal Reserve Bank of Minneapolis, says government officials are once again likely to bail out big banks and their creditors rather than “trigger many trillions of additional costs to society.”

The solution is not to break up the banks or turn them into public utilities. Instead, we should do what Dodd-Frank failed to do: Make big-bank failures feasible without tanking the economy by writing a process to do so into the bankruptcy code through a new amendment—a “chapter 14.”

Chapter 14 would impose losses on shareholders and creditors while preventing the collapse of one firm from spreading to others. It could be initiated by the lead regulatory agency and would begin with an over-the-weekend bankruptcy hearing before a pre-selected U.S. district judge. After the hearing, the court would convert the bank’s eligible long-term debt into equity, reorganizing the bankrupt bank’s balance sheet without restructuring its operations.

A new non-bankrupt company, owned by the bankruptcy estate (the temporary legal owner of a failed company’s assets and property), would assume the recapitalized balance sheet of the failed bank, including all obligations to its short-term creditors. But the failed bank’s shareholders and long-term bondholders would have claims only against the estate, not the new company.

The new firm would take over the bank’s business and be led by the bankruptcy estate’s chosen private-sector managers. With regulations requiring minimum long-term debt levels, the new firm would be solvent. The bankruptcy would be entirely contained, both because the new bank would keep operating and paying its debts, and because losses would be allocated entirely to the old bank’s shareholders and long-term bondholders.

An examination by one of us (Emily Kapur) of previously unexplored discovery and court documents from Lehman Brothers’ September 2008 bankruptcy shows that chapter 14 would have worked especially well for that firm, without adverse effects on the financial system.

Here is how Lehman under chapter 14 would have played out. The process would start with a single, brief hearing for the parent company to facilitate the creation of a new recapitalized company—a hearing in which the judge would have minimal discretion. By contrast, Lehman’s actual bankruptcy involved dozens of complex proceedings in the U.S. and abroad, creating huge uncertainty and making it impossible for even part of the firm to remain in business.

When Lehman went under it had $20 billion of book equity and $96 billion of long-term debt, while its perceived losses were around $54 billion. If the costs of a chapter 14 proceeding amounted to an additional (and conservative) $10 billion, then the new company would be well capitalized with around $52 billion of equity.

The new parent company would take over Lehman’s subsidiaries, all of which would continue in business, outside of bankruptcy. And the new company would honor all obligations to short-term creditors, such as repurchase agreement and commercial paper lenders.

The result: Short-term creditors would have no reason to run on the bank before the bankruptcy proceeding, knowing they would be protected. And they would have no reason to run afterward, because the new firm would be solvent.

Without a run, Lehman would have $30 billion more liquidity after resolution than it had in 2008, easing subsequent operational challenges. In the broader marketplace, money-market funds would have no reason to curtail lending to corporations, hedge funds would not flee so readily from prime brokers, and investment banks would be less likely to turn to the government for financing.

Eventually, the new company would make a public stock offering to value the bankruptcy estate’s ownership interest, and the estate would distribute its assets according to statutory priority rules. If the valuation came in at $52 billion, Lehman shareholders would be wiped out, as they were in 2008. Long-term debtholders, with $96 billion in claims, would recover 54 cents on the dollar, more than the 37 cents they did receive. All other creditors—the large majority—would be paid in full at maturity.

Other reforms, such as higher capital requirements, may yet be needed to reduce risk and lessen the chance of financial failure. But that is no reason to wait on bankruptcy reform. A bill along the lines of the chapter 14 that we advocate passed the House Judiciary Committee on Feb. 11. Two versions await action in the Senate. Let’s end too big to fail, once and for all.
Ms. Kapur is an attorney and economics Ph.D. candidate at Stanford University. Mr. Taylor, a professor of economics at Stanford, co-edited “Making Failure Feasible” (Hoover, 2015) with Kenneth Scott and Thomas Jackson, which includes Ms. Kapur’s study.

Sunday, November 29, 2015

The Fed: shortcomings in policies & procedures, insufficient model testing & incomplete structures & information flows for proper oversight

The Fed Is Stressed Out. A WSJ Editorial
What if a bank had the same problem the regulators have?Wall Street Journal, Nov 28, 2015

Almost nobody in Washington cares, and most of the financial media haven’t noticed. But the inspector general’s office at the Federal Reserve recently reported the disturbing results of an internal investigation. Last December the central bank internally identified “fundamental weaknesses in key areas” related to the Fed’s own governance of the stress testing it conducts of financial firms.

The Fed’s stress tests theoretically judge whether the country’s largest banks can withstand economic downturns. So the Fed identifying a problem with its own management of the stress tests is akin to an energy company noticing that something is not right at one of its nuclear reactors.

According to the inspector general, “The governance review findings include, among other items, a shortcoming in policies and procedures, insufficient model testing” and “incomplete structures and information flows to ensure proper oversight of model risk management.” These Fed models are essentially a black box to the public, so there’s no way to tell from the outside how large a problem this is.

The Fed’s ability to construct and maintain financial and economic models is much more than a subject of intellectual curiosity. Given that Fed-approved models at the heart of the so-called Basel capital standards proved to be spectacularly wrong in the run-up to the last financial crisis, the new report is more reason to wonder why anyone should expect them to be more accurate the next time.

The Fed’s IG adds that last year’s internal review “notes that similar findings identified at institutions supervised by the Federal Reserve have typically been characterized as matters requiring immediate attention or as matters requiring attention.”

That’s for sure. Receiving a “matters requiring immediate attention” letter from the Fed is a big deal at a bank. The Journal reported last year that after the Fed used this language in a letter to Credit Suisse castigating the bank’s work in the market for leveraged loans, the bank chose not to participate in the financing of several buy-out deals.

But it’s hard to tell if anything will come from this report that seems to have fallen deep in a Beltway forest. The IG office’s report says that the Fed is taking a number of steps to correct its shortcomings, and that the Fed’s reform plans “appear to be responsive to our recommendations.”

The Fed wields enormous power with little democratic accountability and transparency. This was tolerable when the Fed’s main job was monetary, but its vast new regulatory authority requires more scrutiny. Congress should add the Fed’s stressed-out standards for stress tests to its oversight list.

Tuesday, July 15, 2014

The Citigroup ATM - Jack Lew and Tim Geithner escape mention in the bank settlement.

The Citigroup ATM, WSJ Editorial
Jack Lew and Tim Geithner escape mention in the bank settlement.The Wall Street Journal, July 14, 2014 7:37 p.m. ET

The Department of Justice isn't known for a sense of humor. But on Monday it announced a civil settlement with Citigroup over failed mortgage investments that covers almost exactly the period when current Treasury Secretary Jack Lew oversaw divisions at Citi that presided over failed mortgage investments. Now, that's funny.

Though Justice, five states and the FDIC are prying $7 billion from the bank for allegedly misleading investors, there's no mention in the settlement of clawing back even a nickel of Mr. Lew's compensation. We also see no sanction for former Treasury Secretary Timothy Geithner, who allowed Citi to build colossal mortgage risks outside its balance sheet while overseeing the bank as president of the New York Federal Reserve.

The settlement says Citi's alleged misdeeds began in 2006, the year Mr. Lew joined the bank, and the agreement covers conduct "prior to January 1, 2009." That was shortly before Mr. Lew left to work for President Obama and two weeks before Mr. Lew received $944,518 from Citi in "salary, payout for vested restricted stock," and "discretionary cash compensation for work performed in 2008," according to a 2010 federal disclosure report. That was also the year Citi began receiving taxpayer bailouts of $45 billion in cash, plus hundreds of billions more in taxpayer guarantees.

While Attorney General Eric Holder is forgiving toward his Obama cabinet colleagues, he seems to believe that some housing transactions can never be forgiven. The $7 billion settlement includes the same collateralized debt obligation for which the bank already agreed to pay $285 million in a settlement with the Securities and Exchange Commission. The Justice settlement also includes a long list of potential charges not covered by the agreement, so prosecutors can continue to raid the Citi ATM.

Citi offers in return what looks like a blanket agreement not to sue the government over any aspect of the case, and waives its right to defend itself "based in whole or in part on a contention that, under the Double Jeopardy Clause in the Fifth Amendment of the Constitution, or under the Excessive Fines Clause in the Eighth Amendment of the Constitution, this Agreement bars a remedy sought in such criminal prosecution or administrative action." We hold no brief for Citi, which has been rescued three times by the feds. But what kind of government demands the right to exact repeated punishments for the same offense?

The bank's real punishment should have been failure, as former FDIC Chairman Sheila Bair and we argued at the time. Instead, the regulators kept Citi alive with taxpayer money far beyond what it provided most other banks as part of the Troubled Asset Relief Program. Keeping it alive means they can now use Citi as a political target when it's convenient to claim they're tough on banks.

And speaking of that $7 billion, good luck finding a justification for it in the settlement agreement. The number seems to have been pulled out of thin air since it's unrelated to Citi's mortgage-securities market share or any other metric we can see beyond having media impact.

If this sounds cynical, readers should consult the Justice Department's own leaks to the press about how the Citi deal went down. Last month the feds were prepared to bring charges against the bank, but the necessities of public relations intervened.

According to the Journal, "News had leaked that afternoon, June 17, that the U.S. had captured Ahmed Abu Khatallah, a key suspect in the attacks on the American consulate in Benghazi in 2012. Justice Department officials didn't want the announcement of the suit against Citigroup—and its accompanying litany of alleged misdeeds related to mortgage-backed securities—to be overshadowed by questions about the Benghazi suspect and U.S. policy on detainees. Citigroup, which didn't want to raise its offer again and had been preparing to be sued, never again heard the threat of a suit."

This week's settlement includes $4 billion for the Treasury, roughly $500 million for the states and FDIC, and $2.5 billion for mortgage borrowers. That last category has become a fixture of recent government mortgage settlements, even though the premise of this case involves harm done to bond investors, not mortgage borrowers.

But the Obama Administration's references to the needs of Benghazi PR remind us that it could be worse. At least Mr. Holder isn't blaming the Geithner and Lew failures on a video.

Friday, March 21, 2014

The Responsible Way to Rein in Super-Fast Trading - by Gary Cohn

The Responsible Way to Rein in Super-Fast Trading. By Gary Cohn
At Goldman Sachs, we would back these measures to limit the risk and instability that technology gains brought.
WSJ, March 20, 2014 8:05 p.m. ET

Equity-market structure in the U.S. has made important advances over the past 20 years, promoting greater transparency and liquidity. Three powerful forces have been at work: technology, regulation and competition. The result has been narrower spreads, faster execution and lower overall explicit costs to trading stocks.

With the overwhelming majority of transactions now done over multiple electronic markets each with its own rule books, the equity-market structure is increasingly fragmented and complex. The risks associated with this fragmentation and complexity are amplified by the dramatic increase in the speed of execution and trading communications.

In the U.S., there are 13 public exchanges and nearly 50 alternative trading systems. Regulation NMS (National Market System), adopted in 2007, requires that market participants route their orders to the exchange that displays the best public price at any given time. This has increased both the number of linkages in the market and the speed at which transactions are done. The Securities and Exchange Commission has correctly called for an "assessment of whether market structure rules have kept pace with, among other things, changes in trading technology and practices."

In the past year alone, multiple technology failures have occurred in the equities markets, with a severe impact on the markets' ability to operate. Even though industry groups have met after the market disruptions to discuss responses, there has not been enough progress. Execution venues are decentralized and unable to agree on common rules. While an industry-based solution is preferable, some issues cannot be addressed by market forces alone and require a regulatory response. Innovation is critical to a healthy and competitive market structure, but not at the cost of introducing substantial risk.

Regulators and industry participants, including asset managers, broker-dealers, exchanges and trading firms, have all put forth ideas and reforms. We agree with a number of their concerns and propose the following four principles:

• First, the equity market needs a stronger safety net of controls to reduce the magnitude and frequency of disruptions. A fragmented trading landscape, increasingly sophisticated routing algorithms, constant software updates and an explosion in electronic-order instructions have made markets more susceptible to technology failures and their consequences.

We propose that all exchanges adopt a stringent set of uniform, SEC-mandated execution controls to reduce errors. In addition to limit-up, limit-down rules that prevent trades from occurring outside a specified price band, pre-trade price and volume limits should be implemented to block problematic orders from entering the market. Mechanisms should also be introduced to halt a firm's, market maker's or other entity's trading when an established threshold is breached, thus minimizing the uncontrolled accumulation of trades.

• Second: Create incentives to reduce excessive market instability. The economic model of the exchanges, as shaped by regulation, is oriented around market volume. Volume generates price discovery and liquidity, which are clearly beneficial. But the industry must recognize how certain activities related to volume can place stress on a market infrastructure ill-equipped to deal with it.

Electronic-order instructions connect the objectives of buyers and sellers to actions on exchanges. These transaction messages direct the placement, cancellation and correction of orders, and in recent years they have skyrocketed. In the 2010 "flash crash," a spike in the volume of these messages exacerbated volatility, overwhelming the market's infrastructure.

According to industry analysis, since 2005 the flow of these order instructions sent through U.S. stock exchanges has increased more than 1000%, yet trade volume has increased by only 50%. One consequence of the enormous growth in order-message traffic is that increasingly the quote that an investor sees isn't the price he or she can transact, as orders often get canceled at lightning-quick speeds.

Currently there is no cost to market participants who generate excessive order-message traffic. One idea would be to consider if regulatory fees applied on the basis of extreme message traffic—rather than executions alone—are appropriate and would enhance the underlying strength and resiliency of the system. Regulators in Canada and Australia have adopted this approach.

• Third: Public market data should be disseminated to all market participants simultaneously. Exchanges currently disseminate prices and transaction data to the SEC-sanctioned distributor for all investors, but exchanges may also send this information directly to private subscribers. While the data leave the exchange simultaneously, the public data are delayed because they go through the intermediary's processing infrastructure. The public aggregator should release information to all market participants at the same time.

Removing the possibility of differentiated channels for market data also reduces incentives that favor investment in the speed of one channel over the stability and resiliency of another. Instability creates and compounds market disruptions. Stable and accurate market data is one of the most important elements of market safety; it is the backbone of the market that must weather the most extreme periods.

• Fourth: Give clearing members more tools to limit risk. A central clearing house with strong operational and financial integrity can reduce credit risk, increase liquidity and enhance transparency through enforced margin requirements and verified and recorded trades. But because clearing members extend credit, the associated risks must be recognized. Tools like pre-trade credit checks and being able to monitor positions and credit on an intraday basis are essential. Clearing firms use various tools like margin and capital adequacy to manage their risk, but exchanges should also provide uniform mechanisms for clearers to set credit limits and to revoke a client's ability to trade immediately upon request, when necessary.

U.S. markets today are the deepest, most liquid in the world and serve an indispensable role in allocating capital. That means the companies that have the greatest potential to innovate and grow will get the capital they need to create jobs, build new industries and ensure a vibrant economy. Investors have benefited significantly from technology and innovation, but the speed and complexity at which our markets operate aren't being matched with the operational and control environment to support them.

Mr. Cohn is president and chief operating officer of Goldman Sachs

Tuesday, March 4, 2014

Shedding Some Light on Shadow Banking - Don't let a vaguely sinister label for this useful financing prompt harmful regulations

Shedding Some Light on Shadow Banking. By Tony James
Don't let a vaguely sinister label for this useful financing prompt harmful regulations.
WSJ, Mar 04, 2014

The term "shadow banking" is one of those Orwellian terms that can undermine critical thought. It has a negative, vaguely sinister connotation about a source of financing that is an essential and desirable part of the financial system. As discussion about the regulation of nonbank entities begins in earnest, it's time to clear the air about what these institutions are and how they operate.

Shadow banking—or more accurately, market-based financing—is simply the provision of capital by loans or investments to some companies by other companies that are not banks. Examples include insurance companies, credit investment funds, hedge funds, private-equity funds, and broker dealers. These institutions do not operate in the dark. Market-based finance in the U.S. amounts to trillions of dollars and is significantly larger than the country's entire banking system.

Mark Carney, Governor of the Bank of England, has correctly noted the role of shadow banking in "diversifying the sources of financing of our economies in a sustainable way." For example, traditional bank financing is not always available for many small- and medium-size companies. Market-based financing has fueled the creation of companies (and thousands of jobs) in many industries. It has rescued companies on the edge of bankruptcy and saved the jobs associated with them. And market-based financing has built warehouses, manufacturing plants and hotels, such as the Four Seasons Hotel and Residences in downtown New York City, when traditional banks could not, or would not, provide capital.

Large banks concentrate risk in relatively few hands, which can pose a risk to the economic system. That is not the case for market-based financing. Risks are safely dispersed across many sophisticated investors who can readily absorb any potential losses. Unlike traditional banks, market-based funds do not borrow from the Federal Reserve, nor do they rely on government-guaranteed deposits. Substantially all their capital comes from well-advised institutional investors who know what they are getting into, and understand the associated risks. Bank depositors (and taxpayers) on the other hand, do not typically know what a bank's investments are or how risky they may be.

Typically, market-based funds also lack the elements that are sources of systemic instability, including high leverage and interdependence. Each investment within a fund is independent and not cross-collateralized or supporting a common debt structure. Losses in any one fund are without recourse to any other fund or to the manager of the capital.

In addition, investors in many market-based funds, including credit investment funds, hedge funds and private-equity funds often cannot instantly withdraw their capital, unlike depositors in banks. Large, sudden withdrawals can lead to runs on the bank or force "fire sales" of assets. With stable, in-place capital, these funds can provide a critical source of liquidity to trading markets in times of turmoil.

Of course, some regulation may be appropriate for nonbank entities that present bank-like risks to financial stability or that lend to consumers. But let's not forget that it was the regulated entities that were the source of almost all the systemic risk in the financial crisis.

Regulations are far from a panacea and would need to be carefully constructed to ensure that the enormous economic benefits of market-based financing are not lost through inappropriate and stifling regulatory policies established for large, deposit-taking banks.

While banks in the U.S. are better capitalized and much safer today than before the financial crisis, market-based financing—shadow banking, if you prefer—still brings enormous economic advantages to a wide range of businesses and employees, and fills a real gap in the market.

In Europe, where banks are less well capitalized, the need for market-based financing is even more critical. As the G-20's Financial Stability Board noted in its policy framework last August, market-based financing creates "competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction."

It is critical that any misunderstanding of the shadow banking system does not result in regulations that undermine the many thousands of companies and jobs that need market-based financing to survive and grow.

Mr. James is president and chief operating officer of Blackstone, a global investment and advisory firm.

Saturday, February 22, 2014

Diversify Europe's Financial Grid. By Alberto Gallo

Diversify Europe's Financial Grid. By Alberto Gallo
Euro-zone lenders hold assets worth more than €30 trillion, three times the output of the euro area.
WSJ, Feb 20, 2014

European banks remain vulnerable to another financial crisis. Capital buffers are too small, creditor bail-ins too low and emergency resolution mechanisms still inadequate to insulate governments from losses that could arise from a system-wide failure. In short, we need a new formula for financial stability.

A banking crisis today would still cost European sovereigns between 2% and 10% of GDP. The final bill would depend on many factors, the size of the initial loss being only one. Others include how much is mitigated by the banks' own capital reserves, by pre-existing government backstops and by any money that can be recouped by bailing-in bondholders.

The size of a country's banking system is also critical. By that measure, Europe's banks remain too big to fail.

Euro-zone lenders have shrunk their balance sheets by a total of €4.4 trillion since the second quarter of 2012, but still hold assets worth more than €30 trillion, according to the European Central Bank. That's three times the output of the euro area and far outstrips the U.S., where bank assets are less than GDP.

And if European banks are too big, they're also still undercapitalized. Capital is adequate relative to risk-weighted assets, against which "capital ratios" are measured, but falls short as a proportion of the banks' total asset base and of potential losses.

To make their capital ratios look better, many banks have reduced their risk-weighted assets over the past few years, often by "optimizing" their internal risk models. More than one-third of European banks now have less than 30% risk-weighted assets over total (RWA), some as low as 20%. This means a bank's "10% capital ratio" is effectively equal to €2 of capital for every €100 of assets (20% RWA times 10% equals €2). That's too low, especially for systemic banks whose balance sheets are as large as a country's GDP.

Regulators recognize the issue and are trying to introduce an absolute floor on capital: the Basel committee's 3% leverage ratio prescribes a minimum €3 of capital over assets. But even this would not have helped troubled banks such as Dexia or Anglo Irish, which lost the equivalent of 4% and 20% of their assets during the 2008-09 crisis, respectively.

We estimate that to stand on their own feet, banks need a leverage ratio of about 5.8% of capital over assets. This is consistent with the approach of Swiss and U.S. regulators, who recommend a 6% leverage ratio. It means euro-zone banks would need to raise an additional €492 billion of capital—more than six times the €80 billion that the European Banking Authority says they raised in 2013.

Another solution would be to increase bail-in requirements or state backstops. German Finance Minister Wolfgang Schäuble recently proposed speeding up the formation of Europe's Single Resolution Fund, a bank-financed pool of money planned to help wrap up or restructure failing banks. But the proposed €55 billion that would be available in the fund pales in comparison to the potential losses generated by bank failures, even if a bail-in were to be implemented first. We estimate the fund could help one large or two mid-sized institutions withstand failure, at best.

These backstops are also very difficult to put into action—the decision to restructure or resolve a bank has to pass through national committees, the European Commission, the Single-Resolution Mechanism (whose fine-print is still being drafted), and various other boards. Not a weekend job.

Regulators need a more comprehensive approach to making banks safe. It must encompass the total size of capital reserves, the size and structure of banking systems, and rules that can efficiently bail-in bondholders. Regulators are moving in the right direction, but they have not gone far enough.

Ultimately, I believe that Europe will be free from the threat of failing banks only once it has a smaller banking system and a more diversified supply of credit.

Think of credit like an energy grid: In Europe, 80% to 90% of the energy comes from banks—the coal or nuclear plants of the system. If something goes wrong with them, the costs will be high, the collateral effects toxic, and the damage could take years to clean up.

We need more "renewable energy" in the form of non-bank sources of credit. That means bonds, securitizations, and lending from insurance companies and asset managers. Only then will Europe be free from its banks.

Mr. Gallo is the head of macro-credit research at the Royal Bank of Scotland. The views expressed are his own.

Thursday, February 13, 2014

How Dodd-Frank Doubles Down on 'Too Big to Fail'

How Dodd-Frank Doubles Down on 'Too Big to Fail'
Two major flaws mean that the act doesn't address problems that led to the financial crisis of 2008. 
By Charles W. Calomiris And Allan H. Meltzer WSJ, Feb. 12, 2014 6:44 p.m. ET

The Dodd-Frank Act, passed in 2010, mandated hundreds of major regulations to control bank risk-taking, with the aim of preventing a repeat of the taxpayer bailouts of "too big to fail" financial institutions. These regulations are on top of many rules adopted after the 2008 financial crisis to make banks more secure. Yet at a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.

Dodd-Frank's approach to regulating bank risk has two major flaws. First, its standards and rules require regulatory enforcement instead of giving bankers strong incentives to maintain safety and soundness of their own institutions. Second, the regulatory framework attempts to prevent any individual bank from failing, instead of preventing the collapse of the payments and credit systems.

The principal danger to the banking system arises when fear and uncertainty about the value of bank assets induces the widespread refusal by banks to accept each other's short-term debts. Such refusals can lead to a collapse of the interbank payments system, a dramatic contraction of bank credit, and a general loss in confidence by consumers and businesses—all of which can have dire economic consequences. The proper goal is thus to make the banking system sufficiently resilient so that no single failure can result in a general collapse.

Part of the current confusion over regulatory means and ends reflects a mistaken understanding of the Lehman Brothers bankruptcy. The collapse of interbank credit in September 2008 was not the automatic consequence of Lehman's failure.
Rather, it resulted from a widespread market perception that many large banks were at significant risk of failing. This perception didn't develop overnight. It had evolved steadily and visibly over more than two years, while regulators and politicians did nothing.

Citibank's equity-to-assets ratio, measured in market value—the best single comprehensive measure of a bank's financial strength—fell steadily from about 13% in April 2006 to about 3% by September 2008. And that low value reflected an even lower perception of fundamental asset worth, because the 3% market value included the value of an expected bailout. Lehman's collapse was simply the match in the tinder box. If other banks had been sufficiently safe and sound at the time of Lehman's demise, then the financial system would not have been brought to its knees by a single failure.

To ensure systemwide resiliency, most of Dodd-Frank's regulations should be replaced by measures requiring large, systemically important banks to increase their capacity to deal with losses. The first step would be to substantially raise the minimum ratio of the book value of their equity relative to the book value of their assets.

The Brown-Vitter bill now before Congress (the Terminating Bailouts for Taxpayer Fairness Act) would raise that minimum ratio to 15%, roughly a threefold increase from current levels. Although reasonable people can disagree about the optimal minimum ratio—one could argue that a 10% ratio would be adequate in the presence of additional safeguards—15% is not an arbitrary number.

At the onset of the Great Depression, large New York City banks all maintained more than 15% of their assets in equity, and none of them succumbed to the worst banking system shocks in U.S. history from 1929 to 1932. The losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.

Bankers and their supervisors often find it mutually convenient to understate expected loan losses and thereby overstate equity values. The problem is magnified when equity requirements are expressed relative to "risk-weighted assets," allowing regulators to permit banks' models to underestimate their risks.

This is not a hypothetical issue. In December 2008, when Citi was effectively insolvent, and the market's valuation of its equity correctly reflected that fact, the bank's accounts showed a risk-based capital ratio of 11.8% and a risk-based Tier 1 capital ratio (meant to include only high-quality, equity-like capital) of about 7%. Moreover, factors such as a drop in bank fee income can affect the actual value of a bank's equity, regardless of the riskiness of its loans.

For these reasons, large banks' book equity requirements need to be buttressed by other measures. One is a minimum requirement that banks maintain cash reserves (New York City banks during the Depression maintained cash reserves in excess of 25%). Cash held at the central bank provides protection against default risk similar to equity capital, but it has the advantage of being observable and incapable of being fudged by esoteric risk-modeling.

Several researchers have suggested a variety of ways to supplement simple equity and cash requirements with creative contractual devices that would give bankers strong incentives to make sure that they maintain adequate capital. In the Journal of Applied Corporate Finance (2013), Charles Calomiris and Richard Herring propose debt that converts to equity whenever the market value ratio of a bank's equity is below 9% for more than 90 days. Since the conversion would significantly dilute the value of the stock held by pre-existing shareholders, a bank CEO will have a big incentive to avoid it.

There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank's losses on banks and their owners. Dodd-Frank institutionalizes too-big-to-fail protection by explicitly permitting bailouts via a "resolution authority" provision at the discretion of government authorities, financed by taxes on surviving banks—and by taxpayers should these bank taxes be insufficient. That provision should be repealed and replaced by clear rules that can't be gamed by bank managers.
Mr. Calomiris is the co-author (with Stephen Haber ) of "Fragile By Design: The Political Origins of Banking Crises and Scarce Credit" (Princeton, 2014). Mr. Meltzer is the author of "Why Capitalism?" (Oxford, 2012). They co-direct (with Kenneth Scott ) the new program on Regulation and the Rule of Law at the Hoover Institution.

Wednesday, December 18, 2013

The Volcker Ambiguity - The triumph of political discretion over financial clarity

The Volcker Ambiguity. WSJ Editorial 
The triumph of political discretion over financial clarity.
Wall Street Journal, Updated Dec. 11, 2013 3:52 p.m. ET

Just in time for Christmas, financial regulators have come down the chimney with a sackful of billable hours for securities lawyers. Truly a gift that keeps on giving, the Volcker Rule adopted on Tuesday by five federal agencies will create a limitless supply of ambiguity and the need for experienced counsel.

We supported former Federal Reserve Chairman Paul Volcker's simple idea: Don't let federally insured banks gamble in the securities markets. Taxpayers shouldn't be forced to stand behind Wall Street trading desks. What we can't support is the "Volcker Rule" that was first distorted in the 2010 Dodd-Frank law and has now been grinded and twisted into 71 pages of text plus 882 more pages of explanation after three years of agency sausage-making.

The general idea is to prevent "proprietary trading," in which a bank makes trades not at a customer's request but simply for its own account. Or at least some trades. The rule's new trading restrictions do not apply when Wall Street giants are trading debt issued by the U.S. government, state and local governments, government-created mortgage giants Fannie Mae and Freddie Mac, and in some circumstances foreign governments and even local or regional foreign governments.

You'll notice a pattern here. Like so many recent financial regulations, the Volcker Rule offers banks and investors big incentives to lend money to governments rather than private businesses. One Wall Street objection to the Volcker Rule has been that it will reduce liquidity in America's capital markets. And fear of a lack of liquidity in the market for government debt—especially Treasurys and European sovereign debt—is precisely the reason politicians and regulators have gone to such lengths to exempt government bonds from Volcker. Maybe Wall Street has a point.

What we don't know about the new rule are important details that will only become clear over time. At least that's according to Commissioner Daniel Gallagher of the Securities and Exchange Commission, who dissented on Tuesday along with fellow Republican appointees Michael Piwowar of the SEC and Scott O'Malia of the Commodity Futures Trading Commission.

Mr. Gallagher said the vote occurred in "contradiction of our procedural rules for voting on major rule releases, including the longstanding guideline that Commissioners should be given thirty days to review a draft before a vote." He added, "Not until five days ago did we have anything even resembling a voting draft, giving us less than a week to review the nearly one thousand pages of the adopting rule. In short, under intense pressure to meet an utterly artificial, wholly political end-of-year deadline, this Commission is effectively being told that we have to vote for the final rule so we can find out what's in it."

Lawyers will certainly find plenty of opportunities for judgment calls that will generate all those billable hours. Banks are still allowed to make markets in securities and to underwrite the issuance of new stocks and bonds, all of which often requires them to hold securities in anticipation of customer demand.

Banks also retain some ability to hedge—to make trades for the purpose of offsetting other risks that they've taken on for clients. The work required to define the difference between legal market-making, underwriting and hedging on the one hand and illegal proprietary trading on the other will now be ample enough to spark a new building boom at downtown D.C. law offices.

Rest assured banks will find loopholes. And rest assured some of the Volcker rule-writers will find private job opportunities to help with that loophole search once they decide to lay down the burdens of government service.

The long, convoluted Volcker process and result illustrate the central problem of Dodd-Frank: the belief that regulators given ever more discretion to craft ever more complicated regulations will yield a safer financial system. The Bank of England's Andrew Haldane and Vasileios Madouros have shown the opposite is true. The complexity of banking rules before the crisis failed to prevent catastrophic risks and made the job of addressing the crisis harder by obscuring the true condition of giant banks.

Especially with banking regulation, simple rules that are difficult for lobbyists and bankers to game are likely to work far better. Bankers would know what to expect and couldn't cry ambiguity if they crossed a line. And regulators would be far more likely to spy violations. The danger with this Volcker Complexity is that we'll get litigation, investing loopholes, and greater financial costs, but not a safer system.

Tuesday, November 12, 2013

Bailouts and Systemic Insurance. By Giovanni Dell'Ariccia and Lev Ratnovski

Bailouts and Systemic Insurance. By Giovanni Dell'Ariccia and Lev Ratnovski
IMF Working Paper No. 13/233
November 12, 2013

Summary: We revisit the link between bailouts and bank risk taking. The expectation of government support to failing banks creates moral hazard—increases bank risk taking. However, when a bank’s success depends on both its effort and the overall stability of the banking system, a government’s commitment to shield banks from contagion may increase their incentives to invest prudently and so reduce bank risk taking. This systemic insurance effect will be relatively more important when bailout rents are low and the risk of contagion (upon a bank failure) is high. The optimal policy may then be not to try to avoid bailouts, but to make them “effective”: associated with lower rents.


When banks expect to be supported in a crisis, they take more risk, because shareholders, managers, and other stakeholders believe they can shift negative risk realizations to the taxpayer. So the expectations of support increase the probability of bank failures that governments want to avoid in the first place.

This paper highlights that when there are risks beyond the control of individual banks, such as the risk of contagion, the expectation of government support, while creating moral hazard, also entails a virtuous “systemic insurance” effect on bank risk taking. The reason is that bailouts protect banks against contagion, removing an exogenous source of risk, and this may increase bank incentives to monitor loans. The interaction between the moral hazard and systemic insurance effects of expected bailouts is the focus of this paper.

The risk of contagion is one of the reasons that makes banks special. While a car company going bankrupt is an opportunity for its competitors, a bank going bankrupt is a potential threat to the industry, especially when the failing bank is large. Banks are exposed to each other directly through the interbank market, and indirectly through the real economy and …nancial markets. While banks have some control over direct exposures, the indirect links are largely beyond an individual bank’s control. The threat of contagion affects bank incentives. The key mechanism that we consider in this paper is that when a bank can fail due to exogenous circumstances, it does not invest as much to protect itself from idiosyncratic risk. Indeed, would you watch your cholesterol intake while eating on a plane that is likely to crash? Or save money for retirement when living in a war zone? Moreover, making the threat of contagion endogenous to the risk choices of all banks generates a strategic complementarity that ampli…es initial results: banks take more risk when other banks take more risk, because risk taking of other banks increases the threat of contagion. [While we focus on the risk that a bank failure imposes on other banks, other papers have focused on the potential bene…ts for competing banks that can buy assets of a distressed institution at …resale prices, possibly with government support to the buyer.]

Under these circumstances, when the government commits to stem the systemic effects of bank failure, it has two effects on bank incentives. The …rst is the classical moral hazard effect described in much of the literature. The second is a systemic insurance effect that increases banks’incentives to monitor loans (this is similar to the effect identi…ed for macro shocks by Cordella and Levy-Yeyati, 2003, and to that of IMF lending to sovereigns in Corsetti et al., 2006). The promise of bailout removes a risk outside the control of a bank and increases its return to monitoring. Going back to our risky ‡ight parable, how would your choice of meal change if you had a parachute?

Formally, we develop a model of financial intermediation where banks use deposits (or debt) and their own capital to fund a portfolio of risky loans. The bank portfolio is subject to two sources of risk. The fi…rst is idiosyncratic and under the control of the bank. Think about this risk as dependent on the quality of a bank’s borrowers, which the bank can control through costly monitoring or screening. The second source of risk is contagion. Think about this, for example, as a form of macro risk. When a bank of systemic importance fails, it has negative effects on the real economy, possibly triggering a recession. A deep enough recession can lead even the best borrowers into trouble and, as a consequence, can cause the failure of other banks independently of the quality of their own portfolio. The risk of contagion is exogenous to individual banks (it cannot be managed or diversi…ed), but it is endogenous to the …nancial system as a whole, since it depends on risk taking by all banks.

These two sources of risk are associated to two inefficiencies. First, banks are protected by limited liability and informational asymmetries prevent investors from pricing risk at the margin. As a result, in equilibrium banks will take excessive idiosyncratic risk. As in other models, this problem can be ameliorated through capital requirements. The second ine¢ ciency stems from externalities. When individual banks do not take into account the effect of their risk taking on other banks, they take too much risk relative to the coordinated solution. And since banks are also affected by the externality, this exogenous source of risk reduces the private return to portfolio monitoring/screening. Bank increase idiosyncratic risk, increasing also the contagion externality. Capital requirements cannot fully correct this problem: even a bank fully funded by capital will take excessive risk when exposed to risk externalities.

Against this background, government intervention in support of failing banks has two opposite effects on incentives. It exacerbates the moral hazard problem stemming from limited liability, but reduces the externality problem associated with contagion. The extent of moral hazard depends on the rents that the government leaves to bailed out banks, while the importance of the "systemic insurance" effect depends on the probability of contagion. Thus, there are parameter values .low bailout rents and a high risk of contagion -- for which the promise of government intervention leads to lower bank risk and better ex ante outcomes.

The "systemic insurance" effects continue to be present when we allow banks to correlate their investments. The threat of contagion may induce banks to excessively correlate their portfolios, because contagion discourages strategies that pay off when other banks fail. Such correlation may be undesirable for a number of reasons .ine¢ cient distribution of credit in the economy, lower bank profits, or an increased probability of simultaneous bank failures (which are socially costly; Acharya, 2009). We show that the expectations of government support may reduce banks'incentives to correlate their investments by decreasing the risk of contagion. It is important to interpret our results with caution. First, they should not be seen as downplaying the moral hazard implications of bailouts. Rather, we argue that such implications have to be balanced with systemic insurance effects. Systemic insurance may be important for some, but not all parameter values. The best illustration for the case where systemic insurance effects might dominate would be a financial system on the brink of the crisis (with weak banks and high probability of contagion) with well-designed bank resolution rules (which minimize bailout rents). Second, we focus on ex ante effects of policies. Ex post considerations may be different and depend e.g. on the difference between the economic costs of bank bankruptcy and that of the use of public funds. Third, and most critically, we assume that the government is able to commit to a given bailout strategy. In a richer model with potential time inconsistencies in the government reaction function, outcomes may be more complex. In particular, banks may find it optimal to take correlated risks if they believe that bailouts will be more likely when many of them fail simultaneously.

Several recent papers have explored the effects of expected government support on bank risk taking. In these papers, bailouts increase risk taking and generate a strategic complementarity among banks when the probability of bailouts increases with the share of the banking system that is in distress. We add to that literature by introducing a risk externality in the form of an undiversi…able contagion risk. This risk externality creates an additional strategic complementarity in risk taking, one that does not result from government policy. In contrast to the existing literature, by preventing contagion, bailouts can reduce the strategic externalities and bank risk taking. The paper relates to the literature on government intervention as a means of preventing contagion. The observation that by removing exogenous risk the government can improve banks’ monitoring incentives was …first made by Cordella and Levy-Yeyati (2003), in the context of macroeconomic shocks. Our model builds on their work by making these shocks endogenous to the banking system, thus offering a link between individual bank risk taking and systemic risk. [Orszag and Stiglitz (2002) use the creation of fire departments as a parable to describe how risk taking incentives are affected by externalities and public policy. In their model (like here), individuals do not take into account the effects of reproof houses on reducing the risk of fire damage to their neighbors’homes, and invest too little in fire safety. The introduction of a fire department reduces the risk of a fire, but further worsens individual incentives, as it reduces the probability that a fire spreads from one house to another. To extend their parable, our paper is more about condo buildings rather than single-family houses. If the rest of the building burns down and collapses, a condo owner gets little benefit from having …reproofed her own apartment. Then, the introduction of a fire department makes individual safety measures more valuable as it reduces the probability of total meltdown.]

Monday, November 11, 2013

Rules of Thumb for Bank Solvency Stress Testing. By Daniel C. Hardy and Christian Schmieder

Rules of Thumb for Bank Solvency Stress Testing. By Daniel C. Hardy and Christian Schmieder
IMF Working Paper No. 13/232
November 11, 2013

Summary: Rules of thumb can be useful in undertaking quick, robust, and readily interpretable bank stress tests. Such rules of thumb are proposed for the behavior of banks’ capital ratios and key drivers thereof—primarily credit losses, income, credit growth, and risk weights—in advanced and emerging economies, under more or less severe stress conditions. The proposed rules imply disproportionate responses to large shocks, and can be used to quantify the cyclical behaviour of capital ratios under various regulatory approaches.


Motivated by the usefulness of rules of thumb,
this paper concentrates on the formulation of rules of thumb for key factors affecting bank solvency, namely credit losses, pre-impairment income and credit growth during crises, and illustrates their use in the simulation of the evolution of capital ratios under stress. We thereby seek to provide answers to the following common questions in stress testing:
  • How much do credit losses usually increase in case of a moderate, medium and severe macroeconomic downturn and/or financial stress event, e.g., if cumulative real GDP growth turns out to be, say, 4 or 8 percentage points below potential (or average or previous years') growth?
  • How typically do other major factors that affect capital ratios, such as profitability, credit growth, and risk-weighted assets (RWA), react under these circumstances?
  • Taking these considerations together, how does moderate, medium, or severe macro-financial stress translate into (a decrease in) bank capital, and thus, how much capital do banks need to cope with different levels of stress?


A variety of evidence is presented on the “average” pattern of behavior of financial aggregates relevant to solvency stress testing banks based in EMs [emerging market economies] and ACs [advanced economies], and, with some limitations, also for larger LIC banks. Table 10 provides an overview of some main results.

Typical levels of credit loss rates, pre-impairment income, and credit growth were estimated under moderate stress (a one-in-10/15-years shock), medium stress (worst-in-20-year), severe stress (a 1-in-40-years shock), and extreme stress (1-in-100 years). All three variables react in non-linear fashion to the severity of stress, which means that effects under severe conditions is manifold the effects under moderate conditions. Also, a substantial “tail” of poorly performing banks is likely to be much more affected than the median bank.

Comparing ACs on the one hand and EMs/LICs on the other, loss levels are found to be substantially higher in the latter, compensated for by higher returns. It was found that 1-in-20 year stress loss levels usually lead banks to report some net losses, especially in ECs, and thereby lose some capitalization (1 to 3 percentage points if they are under Basel I or the Basel II standardized approach), but only a macroeconomic crisis approaching severe intensity would normally bring down typical well-capitalized banks (unless there are other issues related to confidence and financial sector-generated sources of strain).

Further evidence is presented on macro-financial linkages, and specifically on defining rules of thumb of how a change in GDP growth triggers credit losses, income, and credit growth effects under different levels of stress. While such rough satellite models are more complex than the descriptive solvency rules, they allow the development of scenarios based on an explicit story. As such, the rules make allowance for national circumstances, such as the expected severity of shocks.

While the study has found general patterns, country-specific and/or bank-specific circumstances may differ widely from the average. Hence, the rules of thumb elaborated in this study serve as broad guidelines, particularly to understand benchmarks for worst-case scenarios, but do not fully substitute for detailed analysis when that is possible. The rules of thumb with explicit focus on macro-financial linkages cover only some of the main macroeconomic risk factors that may affect a banking system, namely those captured by GDP. It would be worthwhile to investigate whether analogous simple rules can be formulated that link specific elements of banks’ balance sheets and profitability to such other sources of vulnerability. Relevant macroeconomic variables could include (i) interest movements, including an overall shift in rates and a steepening or flattening of the yield curve. Effects are likely to depend crucially on how frequently rates on various assets and liabilities adjust; (ii) inflation and especially unexpected movements in the inflation rate. A rapid deceleration could strain borrowers’ ability to repay; (iii) exchange rate movement, especially where a large proportion of loans are denominated in foreign currency; and (iv) shocks affecting sectoral concentration of exposures or certain business lines.

The rules of thumb can be used to compute minimum levels of capitalization needed to withstand shocks of different severities—even those far from a country’s historical experience. Also, the regulatory approach used by banks matters: whether a bank adopts an IRB approach to estimating risk-weighted assets or relies on a standardized approach is shown to make a substantial difference to the magnitude and also the timing of when the effects of shocks are recognized, provided that banks’ risk models reflect changes in risk on a timely basis. Thus, the results are relevant to recent policy discussions centered on the robustness of regulatory capital ratios, especially on the computation of RWAs (e.g., BIS 2013, BCBS 2013, Haldane 2012, 2013) and the design of (countercyclical) capital buffers (e.g., Drehmann and other 2009). The results echo the call for (much) longer samples to be used in the calibration of models used for RWA computation and the “right” choice of the regulatory capital ratio (e.g., BCBS 2013, BIS 2013).

Wednesday, October 9, 2013

Maurice Greenberg: State and federal agencies are hurting shareholders and undermining confidence in the banking system

The Regulatory Attack on J.P. Morgan Feels Familiar. By Maurice Greenberg
State and federal agencies are hurting shareholders and undermining confidence in the banking system.
The Wall Street Journal, October 3, 2013, on page A13

A thriving financial-services sector requires a delicate balance of regulation and risk management. Realizing how vital this industry's health is to the economy, regulators and private businesses have spent the past century trying to create a system that ensures stability while encouraging investment. Responsible regulators understand just how difficult this is to accomplish. Others who ignore that reality often keep markets from functioning properly.

Regulators can help minimize risk to the investing public by learning from past regulatory mistakes. But it doesn't appear that they have. Now they're after J.P. Morgan Chase Co., a great American company led by arguably the best chief executive on Wall Street.

I experienced regulatory overreach first-hand at AIG. For nearly four decades, I led a team that included some of the most honorable and competent professionals in the insurance industry. We built the world's largest and most respected insurer, employing more than 90,000 people and opening markets across the world. That made AIG an attractive target for Eliot Spitzer, then New York's attorney general, in 2005.

Displaying an astonishing lack of knowledge of the insurance industry, Mr. Spitzer, by threatening to criminally indict the company, succeeded in separating the industry's most accomplished group of executives from a company that insured virtually every business sector across 130 countries. The replacement management took steps that made AIG vulnerable to the world-wide financial collapse of 2008. That provided a set of federal regulators with the opportunity to seize tens of billions of dollars from AIG's shareholders.

Nearly all of Mr. Spitzer's original allegations of accounting irregularities have been discarded or quietly dismissed by him and his successors. The remaining claims—on which no damages are sought—involve the accounting for reinsurance transactions that were not material to AIG. The real scandal, of course, is the fact that the attorney general brought this lawsuit and continues to prosecute it even today.

History seems to be repeating itself with the case of J.P. Morgan. The global bank is now under siege by federal and state regulators. The most ironic claim against J.P. Morgan is an allegation from current New York Attorney General Eric Schneiderman of mortgage fraud at Bear Stearns that allegedly took place prior to J.P. Morgan's acquisition of that firm. J.P. Morgan acquired Bear Stearns at the urging of federal officials who feared that fallout from Bear's collapse would damage the entire economy.

Like AIG, J.P. Morgan plays a central role in both the U.S. and world economies. There are no more than a handful of executives with the requisite experience, talent and intelligence to lead that bank. Its chief executive, James Dimon, is one of those rare individuals. By diverting his attention from his responsibilities, government officials are hurting shareholders, pension funds, countless employees, the City of New York, and the national and global economy—not to mention undermining confidence in our banking system.

Those regulators have pushed their dubious claims to the point of requiring the bank to pay over $11 billion in fines. I hope the board of directors at J.P. Morgan will have the wisdom and courage to support their CEO and not cave to demands from regulators that can only harm the company and its stakeholders. That would send a strong message to the nation's business community and allow J.P. Morgan to continue to benefit from Mr. Dimon's leadership.

I have spent my entire career opening markets in China, Eastern Europe and across the world. When we took AIG public in 1969, we chose New York as the company's place of business because the state offered a predictable regulatory environment. And yet what I see in New York and Washington is a regulatory culture that seems manifestly determined to make this state and nation the last places where any responsible CEO would want to do business. Incredible as it seems, federal and state regulators are now negotiating for their share of the "credit"—their cut of the cash—for the damage they are currently inflicting on J.P. Morgan, competing with one another to inherit Spitzer's "Sheriff of Wall Street" title. Some people never learn.

Mr. Greenberg is chairman and CEO of C.V. Starr & Co.