Why We Should Rethink Fixed Standards on Leverage, and Capital and the Volcker-Rule

by Adrian Ineichen

On March 22, the Senate Banking Committee sent to the floor its version of the financial regulatory reform bill which seems politically more feasible than other bills before (Washington Post, 2010, March 23; New York Times, 2010, March 23). This article analyzes three aspects of the bill, and raises some concerns on the specific approaches taken: First, section 619 includes the Volcker rule that prohibits deposit-taking financial institutions from proprietary trading (SCBHUA, 2010). Second, section 620 allows regulators to impose a size limit of 10% of all financial institutions’ liabilities on banks that grow through acquisitions, except if the target bank is in (danger of) default or if there is FDIC assistance. Third, tighter standards on leverage, liquidity and capital will be recommended by a regulatory council and enacted by the Fed.

These three regulatory measures are vague, ineffective and could be even counterproductive. I support measures for tighter rules, specifically involving leverage and capital, but such rules must be flexible and must take into account the specific circumstances of companies and markets to be useful.

The Volcker rule is a blunt and ineffective tool.
First, it is unclear how regulators define and measure proprietary trading. Banks’ trading for clients includes taking and holding balance sheet positions, so client trading crosses into proprietary trading (Crook, 2010). Second, the prospects to properly monitor such trading are bad, as costs are likely to be very high and high government interference to obtain the relevant information may hamper banks’ business. If monitoring is weak, the rule is meaningless and non-compliance will be pervasive.

Martin Wolf raised doubts about the workability and relevance of the Volcker rule in the Financial Times. If the government wants to make a real structural cut between shadow banking and deposit-taking institutions, then more radical and far-reaching steps would be required, as many financial institutions that promise to redeem liabilities on demand have deposit-taking characteristics and thus may resemble banks could be subject to runs and thus such institutions may also be considered for Volcker-rule applications (FT, 2010, January 26).

Third, the rule does not improve financial stability. Banks may still trade on behalf of clients, still have vast links to other financial companies and thus may have a high risk exposure. A credit crunch, liquidity problems and related spill-over effects do not differentiate between client and proprietary trading, so banks are likely to suffer anyway. Finally, proprietary trading contributes only a small share to commercial banks’ revenues and was not a major factor in the current crisis (far below 1% for JPMorgan Chase; FT, 2010, January 21). So why try to fix something (but causing harm), if it isn’t broke? Imposing pointless bans may induce financial institutions to move business overseas which reduces jobs and the attractiveness of the US financial markets, and may make international policy coordination even more difficult.

The size cap at 10% is arbitrary, half-hearted and does not solve the too-big-to-fail (TBTF) problem. Why should the rule only apply to banks that grow through acquisitions? Would banks that are already too large be broken up? If banks grow organically, we would still have potentially systemically important mega-banks, is that acceptable? Since the onset of the crisis, some US banks have grown even larger, exacerbating the TBTF-danger. Do we think those banks are less risky just because their acquisitions have been supported by the government?

Recall that, even if large banks may pose great risks, they contribute to the wide range of financial services and thus to an efficient capital allocation as well as to the attractiveness of our financial markets. If we really want to reduce the TBTF-risk, we would need to break up all large banks. But is size the key factor in measuring systemic risk? A better option would be to look at the TDTF-problem: Too dangerous to fail. For example, Long-Term Capital Management (LTCM) was not a big company but was highly leveraged, with links to major banks, and bailed out in 1998 by a concerted action of banks (Watkins, [no date]; Investopedia, 2010). Leverage and contagion matter, not just size. Hence, we should aim to improve market discipline and risk management, for example by expanding disclosure rules, improving the monitoring of lending standards and risk models. By solely focusing on size and neglecting other important considerations, we would be lulled in a false sense of security until the next crisis breaks out.

Tighter rules on capital, liquidity and leverage make sense, if implemented wisely.
The Senate bill leaves the details to be regulated by the Fed upon recommendations by the new regulatory council. Tighter rules are fine if they are not bluntly imposing some arbitrary ratios. Smart rules should meet the following two criteria. First, do no harm – rules should not be too strict, as otherwise they will choke financial markets, reduce loanable funds and make financial services more expensive. Ill-fated rules may also foster regulatory arbitrage and shadow operations which undermine prudential regulations and transparency. Second, rules should be flexible and tailored to the specific company’s circumstances. Fixed rules neglect the fact that innovations emerge and thus leverage may increase naturally. Likewise, reserve requirements today are much lower than a century ago, without additional risk. In addition, business cycles may lessen or increase the need for capital.

A reasonable approach to leverage and liquidity standards would use risk-weights similar to the Basel standards for risk-weighted capital. Included in the risk-pricing should also be consideration of the size of financial institution and possible implications of their failures for the financial system). This option could go in a similar direction as proposals that call for higher capital, liquidity and leverage standards for larger and more complex financial institutions (Pew, 2009). Regulators could require banks to maintain and continuously improve risk models for liquidity and leverage and could monitor their implementation.

This flexible system would still allow high leverage ratios, enabling companies to make profits, but incentivizing them to prize risk more systematically which could reduce excessive risk-taking. Another approach would require banks to sell contingent, convertible debt that would be transformed into equity in times of emergency (Mankiw, 2010; Pew, 2009). This mechanism may raise bank’s capital costs, but is probably far cheaper than another bail-out and involves private investors instead of public funds.

Flexible leverage and liquidity regimes are also under consideration abroad. The UK’s Financial Services Authority (FSA) published with Policy Statement 09/16its enhanced liquidity regime last October and will gradually phase it in (FSA, 2009, 2010). It aims to introduce individual liquidity adequacy standards (ILAS) which a bank must assess annually in addition to developing contingency funding plans (CFP) while the FSA reviews ILAS using a risk-based approach. This plan then will lead the FSA to issue individual liquidity guidance which is binding for banks (Bermingham, 2009). Meanwhile, the Basel Committee on Banking Supervision (at the Bank for International Settlements BIS) is in the process of gathering feedback until April 16 on its consultative documents on creating a framework for liquidity risks and standards as well as measures to strengthening banking sector resilience (BIS, 2009a, 2009b).

Epilogue
Improving prudential regulatory standard is a good idea, but it requires a great deal of thinking and balancing of competing ideas and interests. For sure, we want efficient financial markets, but we want to avoid predatory lending practices and excessive risk-taking. A viable approach to address the many trade-offs in regulating financial markets may lie in adopting more prudent rules that take into account business cycles, technological innovations and new forms of risk. Therefore, smart regulation has to be flexible to some degree and adjustable to changing market conditions. Simple ratios across the board won’t do that job. Even worse, they may lull us into false security, making us believe that we have abolished TBTF and other problems once and for all. The current crisis has shown that we are not good at regulating financial markets and institutions (Mankiw, 2010). We should look ahead, anticipate new trends and be aware that we may not be able to prevent future crisis. Prudence may need to be a more important part of our way of life.

References
Bermingham, C. (2009). FSA Liquidity Overview, Barclays Capital Presentation to ECB’s Money Market Contact Group. Retrieved March 26, 2010 from: http://www.ecb.int/paym/groups/pdf/mmcg/liquidity_regulationsUK.pdf?7d0d77b5b2e5e23f5e874090507b088e

BIS (2009a). International Framework for Liquidity Risk Measurement, Standards and Monitoring – Consultative Document. Retrieved March 16, 2010 from: http://www.bis.org/publ/bcbs165.htm

BIS (2009b). Strengthening the Resilience of the Banking Sector – Consultative Document. Retrieved March 16, 2010 from: http://www.bis.org/publ/bcbs164.htm

Crook, C. (2010). The Volcker Rule, Clive Crook Blog in the Atlantic. Retrieved March 10, 2010 from: http://www.theatlantic.com/business/archive/2010/01/the-volcker-rule/33961/

FSA (2009). Policy Statement 09/16: Strengthening Liquidity Standards. Retrieved March 26, 2010 from: http://www.fsa.gov.uk/pages/Library/Policy/Policy/2009/09_16.shtml

FSA (2010). Liquidity Advisory Group: Liquidity Calibration. Retrieved March 26, 2010 from: http://www.fsa.gov.uk/pubs/international/calibration.pdf

[FT] Financial Times (2010, January 21). Obama and US Banks. Retrieved March 11, 2010 from: http://www.ft.com/cms/s/3/02c1da72-069e-11df-b952-00144feabdc0.html

[FT] (2010, January 26). Volcker’s Axe Is Not Enough to Cut Banks to Size. Retrieved March 24, 2010 from: http://www.ft.com/cms/s/0/3169bb7a-0ab2-11df-b35f-00144feabdc0.html

Investopedia (2010). Long-Term Capital Management – LTCM. Retrieved March 29, 2010 from: http://www.investopedia.com/terms/l/longtermcapital.asp

Mankiw, G. N. (2010). Trying to Tame the Unknowable. Retrieved March 27, 2010 from: http://www.nytimes.com/2010/03/28/business/economy/28view.html?ref=business

New York Times (2010, March 23). Bank Panel Clears Bill on Overhaul. Retrieved March 24, 2010 from: http://www.nytimes.com/2010/03/23/business/23regulate.html

Pew (2009). Principles on Financial Reform: A Bipartisan Policy Statement, Pew Economic Policy Group, Financial Reform Project. Retrieved March 25, 2010 from: http://www.pewfr.org/admin/section_introductions/files/FRP-POLICY-STATEMENT-FINAL.pdf

[SCBHUA] US Senate Committee on Banking, Housing, & Urban Affairs (2010). Bill Restoring American Financial Stability.Retrieved March 16, 2010 from: http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf

Washington Post (2010, March 23). Senate Panel Passes Sweeping Financial Regulation Bill. Retrieved March 26, 2010 from: http://www.washingtonpost.com/wp-dyn/content/article/2010/03/22/AR2010032202151.html

Watkins, T. ([no date]). Long Term Capital Management. Retrieved March 29, 2010 from: http://www.sjsu.edu/faculty/watkins/ltcm.htm

Email Adrian Ineichen at aoi@georgetown.edu