Wednesday, November 4, 2009

When Regulators Fail - 'Systemic risk' is not only for banks

When Regulators Fail. WSJ Editorial
'Systemic risk' is not only for banks.
WSJ, Nov 04, 2009

Financial Services Authority chief Adair Turner has finally stopped attacking bankers for their paychecks and started talking about the real issue—what to do about the banks deemed too-big-to-fail. Unfortunately, he's still worrying too much about how to prevent failure and not enough about how to facilitate it.

In his speech Monday to an international group of central and private bankers, Lord Turner identified three possible approaches to the problem:

• Make failure less likely by increasing capital requirements;
• Make banks smaller or less "systemic" by either narrowing what they can do or making them less interconnected;
• Or, finally, make failure easier by developing bankruptcy procedures or other "resolution" mechanisms for large financial institutions.

Of these, the last is the most important for reducing the moral hazard that did so much to contribute to the financial panic, as Bank of England Governor Mervyn King has persuasively argued. Even before the panic, systemically important banks enjoyed considerable advantages over their less "important" rivals, and many of these advantages were created by or made more acute by government regulation and rules.

As Lord Turner noted Monday, the Basel II standards on bank capital actually allowed large financial firms to hold less capital than their smaller brethren, on the theory that large meant diversified and sophisticated and so less risky. Looking back, this was clearly a crazy policy—but it's worth recalling that it was propagated by the same luminaries who are now proposing to prevent the next crisis by tinkering with the regime that contributed to the last one. At a minimum, this should be an occasion of some humility from the wise men of bank regulation.

We now know that this presumption of safety in size was false. We also know that the costs of being wrong about such things—both for the public fisc and the real economy as a whole—are much greater than was commonly assumed before the panic.

So the price that large banks pay for the privileges of size should be a great deal higher than it was before. Whether banks benefit from the explicit guarantees of deposit insurance or the implicit protection of being too-big-to-fail, or both, governments have a right to demand that banks not ride free on the backs of taxpayers.

But whether it's less leverage, more capital, or restrictions on banking activities, no one should be under any illusion that the same people who failed to detect the last bubble and crash will be able to design a system capable of catching the next one in time. The relative risks of being too lax or too restrictive may be hard to gauge, but either way the odds of getting it wrong are substantial if not overwhelming.

This is why putting the risk of failure back into the system should be the sine qua non of any effort at reform. If regulators around the world get nothing else right, the final backstop has to be bankruptcy and/or dissolution for firms that have earned it.

So it's too bad Lord Turner spent precious little time on this particular question, preferring to ruminate on the relative merits of really narrow banking vs. moderately narrow banking, and how to make capital requirements more countercyclical.

We understand that regulators find it uncomfortable to ponder what should happen when all their best laid plans fail. The bankruptcy of a systemically important bank is, necessarily, also a failure of the regulators who were overseeing it.