Financial Reforms We Can All Agree On

By now we all know how the subprime mortgage market, government policies that encouraged riskier mortgage lending, and overleveraging led to the current financial crisis. But what do we do now to lower the odds of a similar financial meltdown in the future?

Here are some sensible policy reforms, many of which have been advocated by Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke and members of Congress, and are also reflected in the recent G-20 declaration on regulatory reform:

1) Limit the incentives for large, complex institutions to take advantage of their too-big-to-fail position. This can be accomplished by employing regulatory surcharges (e.g., requiring higher capital or liquidity for large, complex institutions), and by giving a financial regulator the authority to intervene and resolve the problems of large, complex, distressed financial institutions (banks and nonbanks), rather than simply bail them out.

Some critics are legitimately concerned that this could lead to incompetent or politically motivated interventions. Others worry that defining an institution as "large and complex" might actually encourage bailouts. The answer to both problems is to require such financial institutions to devise detailed and regularly updated plans to resolve their own problems.

Those plans would specify how control would be transferred to a prepackaged bridge bank if the institution became severely undercapitalized. They would also specify formulas for loss-sharing among the institution's international subsidiaries (and the arrangements would be preapproved by regulators in the subsidiaries' countries). Credible, preapproved plans would discourage financial institutions from taking advantage of their large size and complexity to avoid discipline.

2) Establish a "macro" prudential regulator. This regulator would vary capital and liquidity requirements over time in response to changes in macroeconomic and financial-system circumstances. For example, capital requirements during booms could be raised to discourage a protracted bubble from forming, and to create a larger equity cushion for banks if a bubble should burst.

3) Replace housing leverage subsidies with subsidies that carry less risk to low-income, first-time homebuyers. Democrats in the House, Senate and White House have not yet supported concrete measures that would reduce the vulnerability of housing finance going forward. Many Democrats have, however, stopped claiming that Fannie Mae and Freddie Mac were mere victims of the crisis. The Dec. 9, 2008, hearings in the House resulted in a bipartisan consensus that Fannie and Freddie had been major contributors to the crisis, and that these institutions (which are currently in conservatorship), must be reformed.

4) Use regulatory surcharges (capital or liquidity requirements) to encourage clearinghouses for over-the-counter (OTC) transactions in derivatives. For example, OTC exposures that are not cleared through clearinghouses could result in higher capital and liquidity requirements for participating counterparties than similar exposures cleared through a clearinghouse. The point here is to simplify and render transparent counterparty risk in the OTC market. Some derivatives products, like plain vanilla interest-rate swaps, are good candidates for centralized clearing; other, customized products are not. Regulatory surcharges, rather than mandates, allow the market to decide when the benefits of customization and clearing outside of clearing houses warrant paying those regulatory costs.

5) Reform the regulatory techniques for measuring risk. More capital alone is not an effective means of lowering the risks of overleveraging. Financial institutions can raise asset risk to offset higher capital requirement using various means, some of which are hard to detect. (For example, using complex derivatives contracts or leveraging positions in subsidiaries.) Existing techniques for measuring risk are based on rating-agency estimates and internally developed corporate models. But the current approach depends on bank reporting, supervisors' observations, and rating agencies' opinions. None of those three parties has a strong interest in accurate, timely measurement of risk. Bank employees on both the buy-side and the sell-side may prefer to hide risk to make their performance seem better than it is (which may lead to higher bonuses). Rating agencies earn fees from serving buy-side agents within and outside banks, and when those agents have incentive conflicts that encourage the hiding of risk, rating agencies tend to play along. Supervisors are often less skilled than the agents they supervise, have no direct stake in the proper estimation of risk, and may even face political pressure to hide risk.

But even if supervisors were extremely skilled and diligent, how could they successfully defend high-risk estimates that were entirely the result of their own models and judgment? Part of the solution is to bring objective information from the market into the regulatory process and to bring outside (market) sources of discipline in debt markets to bear on bank risk-taking. For example, some countries' prudential regulations use loan interest rates as measures of loan risk. That approach would have forced regulators to increase their risk assessments of subprime mortgages during the boom. Also, there is a large body of empirical literature showing that the yields of uninsured bank debts contain useful information about the overall riskiness of a bank. Many academics argued for incorporating such market measures into U.S. regulatory measures, but the Fed and Treasury blocked that approach in 1999 (in response to lobbying pressure from the big banks). To their credit, Fed officials seem more amenable now.

6) Avoid grade inflation in rating agencies' opinions. Lots of bad ideas are surfacing about how to accomplish that goal, one of which is to require that buyers, not sellers, pay for ratings. This would not improve the reliability of ratings. Regulated, buy-side investors (banks, pensions, mutual funds and insurance companies) pushed for ratings inflation of securitized debts to loosen restrictions on what they could buy. Giving these buyers more power would not discourage ratings inflation. Another bad idea gaining ground in Europe is to have regulators micromanage the ratings process, which would be destructive to the ratings' content.

There are better alternatives, one of which is to force ratings to be quantitative. Letter grades have no objective meaning that can be evaluated or penalized for inaccuracy. Numerical estimates of the probability of default (PD) and loss given default (LGD), in contrast, do have objective, measurable meanings.

The Nationally Recognized Statistical Rating Organizations (NRSROs) whose ratings are used by regulators should provide specific estimates of the PD and LGD for any rated instrument (they already calculate and publicly report the necessary statistics). Requiring these organizations to express ratings using numbers could alter the rating agencies' incentives dramatically. If they were penalized for systematically underestimating risk over a significant period of time--say, with a six-month "sit out" from having their ratings used for regulatory purposes--they would have a strong self-interest in correctly estimating risk.

7) Change corporate governance rules to encourage better discipline of bank management. Rather than deal with the symptoms of poor governance (e.g., compensation structures), it would be better to improve the ability of stockholders to discipline management. One such reform would be to eliminate ownership concentration limits imposed on regulated institutional investors who are stockholders of bank holding companies, and limits on which other investors are permitted to own controlling interests in bank holding companies. This would significantly improve the corporate governance of large bank holding companies.

While sensible legislative action may seem a long way off, one encouraging fact is the absence, so far, of truly terrible ideas. Even the discussion on regulating compensation has so far focused on the need to align management incentives with long-term performance, rather than trying to limit the overall size of compensation.

Charles W. Calomiris is a visiting scholar at AEI.

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