One of the roles of a financial stability authority – the central bank perhaps – is to reassure the market in crisis that an institution under stress is indeed solvent albeit not liquid. They do this in part by words and in part by deeds: by lending. The communication of solvency to the market is so important the most lenders of last resort are required to separate in form lending to the solvent-but-illiquid from capital injections or other solvency support. This role of an impartial arbiter of solvency is important, and indeed existed in the US before the FED. As Bernanke describes in a recent speech during the panic of 1907
the New York Clearinghouse, a private consortium of banks, reviewed the books of the banks under pressure, declared them solvent, and offered conditional support
I have a question. Can those readers more knowledgeable of the history of financial crises that I, please give me any examples of where this hasn’t worked? That is, where a third party has during a crisis assessed the solvency of stressed institutions, declared them to be solvent, but the market has not believed the statement and a panic was not prevented? I am guessing that the provision of liquidity helps, in that the liquidity may put stress off for long enough that the institution can recover. Equally, sometimes words have been enough. When weren’t they?
This is definitely in Caspar David Friedrich territory.
Update. Talking of being out in the cold, the Cyprus depositor bail in is generating a lot of comment this morning. The general view seems to be that haircutting uninsured deposits, while painful, would be reasonable; but the current proposal to also haircut insured deposits is a bank run generator. I tend to agree, but it seems that the former was the IMF position, while the latter was chosen by the Cypriots themselves (HT Coppola Comment for the link). Even if that is true, it’s dreadful policy. As Tim Duy says, it is hard to see the assault on Cypriot depositors as anything but a step backwards for financial stability in Europe.
An article from a little while ago about a speech by Michael Cohrs, a former Goldman Sachs banker who now sits on the Financial Policy Committee, has one good idea.
He suggested that “too big to fail” banks should be forced to pay “penalties or taxes to create insurance funds” to be used to cover the costs of a major bank collapse “and to create an economic incentive for the firms to downsize”.
The “penalty” should be “in addition to the 2.5pc capital surcharge” global regulators have recommended. In addition, he said: “We must accept that both shareholders and debt holders should suffer losses when a financial company goes into receivership.”
I like the idea that bigger banks are harder to resolve, with likely higher costs, and hence they should pay more. At first I was musing on the idea of a compulsory issuance of `write down on resolution’ instruments — something that I do think would help — but these don’t benefit from the small measure of diversification in the situation, so perhaps a government run insurance fund would be better, with premiums based on some `resolvability index’ which measures the cost and complexity of the process. In any event, thinking about how to pay for failures before they happen may be more sensible than increasingly stringent economy-destroying regulations which aim to prevent failure (and don’t succeed).
Benoît Cœuré, Member of the Executive Board of the ECB, recently gave an important speech. It has quite a lot in it so even the bullet point version isn’t that short, but I promise you that it is worth thinking about his essential argument.
- Money markets around the world came under severe stress during the recent financial crisis and in the subsequent sovereign debt crisis, with interest rate spreads jumping to unprecedented levels and market activity declining significantly in many market segments.
- Opacity in banks’ balance sheets, coupled with uncertainty about the real valuation of their assets, led to acute tensions in the markets for credit instruments… Off-balance sheet entities became unable to roll over short-term financing in the US asset-backed commercial paper market. These events reinforced each other and generated uncertainty about both the solvency and liquidity of money market participants. Counterparties could not distinguish good banks from bad.
- Liquidity was no longer flowing from cash-rich banks to cash-poor banks.
- The Eurosystem introduced a fixed-rate full allotment regime in its refinancing operations, offering unlimited liquidity to banks at predictable cost against an expanded set of eligible collateral. The rise in the liquidity deposited with the Eurosystem after October 2008 was a direct consequence of this new regime and a symptom of a malfunctioning money market.
- Stress in the Euro unsecured money market continued beyond 2008, with a reduced turnover and preference for lending at shorter maturities.
- Dispersion in banks’ access to funding increased considerably in the euro area, with banks domiciled in countries under sovereign strains facing severe constraints even in obtaining secured funding.
- Deep and liquid money markets, not unlike other markets in the economy, play an important part in information aggregation and price discovery. They also help to ensure market discipline.
- Money markets play a central role in monetary policy transmission in the euro area.
- It is important that the Basel 3′s new liquidity regulations do not hamper the functioning of funding markets. This applies in particular to the calibration of the run-off rates for interbank funding and to the asymmetrical treatment of liquidity facilities extended to financial firms.
- The regulators’ welcome push to OTC derivatives towards CCPs may also have an effect on both the unsecured and secured money market segments. Such a move will lead to an increased need for high-quality collateral. The supply of safe assets is finite and the pool of “good” collateral is dwindling as the creditworthiness of certain sovereigns is questioned by market participants. The more good collateral is pledged to the CCPs, the less is left to use in the secured money market, and the fewer assets are available to other creditors in the event of default, making it difficult to obtain unsecured refinancing. This strengthens the need to find ways to identify or produce new assets that can be used as collateral and to mitigate the pro-cyclical consequences of credit ratings and of market valuation.
Acharya, Mehran, Schuermann and Thakor have an interesting but ultimately flawed idea. They suggest:
a special capital account in addition to a core capital requirement. The special account would accrue to a bank’s shareholders as long as the bank is solvent, but would pass to the bank’s regulators — rather than its creditors — if the bank fails.
This part is not so bad. It does rather imply that all banks will be rescued/resolved rather than giving supervisors the option to go through bankruptcy, but that is perhaps the new reality anyway. The problem comes in how they suggest that the level of the account is set:
the quantifcation of the capital requirement need not depend exclusively on the use of historical data for calibration of the bank’s risks; instead, it would rely on several different approaches, such as market-based signals of bank-level and systemic risk as well as regulatory intelligence gathered through periodic stress tests of the fnancial sector.
This is reasonable from a financial stability perspective, but less so from a capital planning one. Banks need some certainty about their capital requirements whether direct or in a new capital account. Moreover ‘market-based signals’ risk being hugely procyclical.
A better approach would be to force banks to issue a fixed fraction of their earnings to the central bank as equity call options. This would have several big advantages:
- It is anti-cyclical at both the systemic and the individual bank level;
- The supervisor could accrue a cash by hedging these calls. This hedging activity would also be anticyclical, shorting bank equity as equity prices go up, and buying back the short when prices fall.
- Those banks who profited most from the financial system would contribute the most.
- Banks would have a clear idea of the size of the buffer, facilitating capital planning.
- Supervisors would make more money hedging the calls just when it is most needed, that is in times of increased bank equity volatility.
Now of course the idea of a central bank having an equity derivatives hedging activity is new and perhaps radical. But radical ideas are not always wrong.
The St. Louis FED map of bank failures clearly suggests buying banks based in New England against shorting those in the rest of the US.
I’m joking of course, but it is interesting – and I am sure this map gave someone in the Boston FED a good day.
My talk at the LSE which was postponed due to the strike in November will now (if the Gods are willing) happen on Wednesday.
Title: Post crisis Bank Regulation and the Rôle of Capital
Time and date: 6-8pm, Wednesday 8th February
Location: Room NAB 1.04, New Academic Building, London School of Economics (entrance from the West side of Lincoln’s Inn Fields)
The slides are here.
A major cause of systemic risk in the financial system is things that are mostly one thing, but occasionally another. Unlike Gremlins – where you are safe provided you don’t get them wet* – these things change without your intervention. Euro-periphery government bonds are one example; AAA RMBS during the crisis are another.
These things are dangerous precisely because you are lulled into thinking that they are always safe, when in fact they mostly are. A shortage of things that are always safe, plus perhaps a touch of greed, causes folks to buy the almost-safes. And we all know how that ends: a flight to (genuine) quality and contagion as investors exit all assets that might even possibly be risky.
There are two reactions to this. FT alphaville nicely sets out the positions in relation to uninsured bank deposits. You can say folks should grow up, and understand the risk; or you can say the risk ought to be removed. For me, the ‘grow up’ position is naïve. Just saying people should not be mistaken solves nothing. At least the ‘do something’ school (represented by Amar Bhidé) recognises the risk that investors will fail to recognise the risk, then flee when bad things happen. If those same investors are forced to pay now for the protection they will need later, maybe stability is enhanced.
Now, of course, there are lots of issues with this, and lots of potential to get the design of the solution wrong. But just throwing your hands up in the air and saying people should be smarter – well, that’s as dumb as a fish trying to swim up Kingston Falls.
(For a further discussion of the importance of genuinely safe assets, see here.)
* Or feed them after midnight, or expose them to sunlight.
Timing June 25, 2009 at
Willem Buiter has a typically intelligent post on Northern Rock. He ends, as one might expect, with a discussion of moral hazard:
Future Northern Rocks will be encouraged to fund themselves recklessly and to lend and invest recklessly. Their creditors are after all the beneficiaries of a free government guarantee. If their bets come off, management, super-employees shareholders and creditors benefit. If they fail, the shareholders may still lose (I hope), but taxpayer picks up the tab for the rest.
At first sight, this seems reasonable. But there are things that can be done to mitigate this moral hazard.
- We need a new insolvency regime for banks, which allows regulators to intervene at an early stage [and obviously includes intervention due to liquidity as well as solvency]. It should ensure that equity holders only get something once everyone else, including the lender of last resort, has been paid back at market rates. This mitigates moral hazard for equity holders as they do not benefit from the rescue. In order to get this right we may need to reduce some of the statutory rights of equity holders, so perhaps we will end up with a new instrument, bank stock, which grants the holder less control than ordinary equity.
- Revisions to compensation practices should ensure that employees, particularly senior employees, are paid in shares that lock up for an extended period. This combined with the above encourages employees to avoid the need for a rescue.
- Enforced liquidity ratios are needed to limit the amount of debt the bank has compared with deposit funding. That means that although debt holders benefit from government intervention, there at least aren’t too many of them. Obviously this regime should apply to off balance sheet liabilities too, including derivatives contracts in the trading book.
- There is little moral hazard with retail depos as most of them are government guaranteed anyway. We could force banks to buy insurance against interbank and commercial deposits too if need be.
I am not necessarily suggesting all of the above is a good idea. But it does make it clear that moral hazard can be mitigated if you are willing to make enough changes.
Oh to be a litigator today. There are so many delicious cases to sate yourself on. Should you take on one of the ‘significant legal challenges which will hold up the resolution of the monoline issues for years‘? Sue the State of New York perhaps, or something in Wisconsin? Or maybe you want to represent CPDO investors in a suit against the banks who ran them, the ratings agencies who rated them, or both? With the current deleveraging, these cases may well be filed soon. Or perhaps you fancy having a go at Citigroup over their suspension of hedge fund redemptions? Then of course there are the hedge funds who own significant positions in Northern Rock. And that’s just one day’s news.
Update. A nice take on subprime-related litigation is here.
Good grief, Alistair, there was no need to react that way. One minute I’m calling him a wimp and the next he’s nationalised a bank. That, to be fair, does show backbone, and is probably the best thing for the public purse. Certainly if the Virgin and management bids did not offer value to the senior creditors, notably the Bank of England, Darling was right to nationalise the bank. Undoubtedly there will be lawsuits from shareholders who are still under the (mistaken) impression that the stock has any value, and there may well be a judicial review of the tripartite authorities’ actions, which could provide further embarrassment to FSA. But for the moment Darling has done the best thing he could to stem the flow of public funds into the rock. Further coverage from the FT is here and Darling’s statement is here. The crock is dead: long live the crock.
Update. It appears that the government is going to let an independent assessor decide what shareholders in the Crock are going to get. How about this for a way of making the assessment: shareholders can either take max(0,PV(current assets) – PV(current liabilities)) [which is probably zero], or they can hang on to their shares until the son of the Crock is floated in two, three, four or whatever years time. Anything more than that is simply a taxpayer subsidy to the hedge funds. As Martin Wolf says
Shareholders live and die by the judgment of the market. In this case, they have died. That is what “risk capital” means.
The Treasury select committee report on Northern rock has some criticism for a range of targets from Alistair Darling, through the board of the bank itself, to FSA. While none of it boils down to ‘hang them from the nearest telegraph pole’, FSA in particular comes in for considerable censure.
According to the FT:
Sweeping new powers to oversee financial stability and prevent a repetition of the Northern Rock crisis should be handed to the Bank of England, a parliamentary committee proposes on Saturday in a report that lambasts the Financial Services Authority for systemic failure in its duty as a regulator.
I don’t know the details of what FSA did or didn’t do, so I won’t comment on the specifics. But a few general remarks about financial supervision might be appropriate.
- Firstly it is utterly inappropriate for a regulator to comment on bank strategy. Yes the Rock had a strategy that turned out to be flawed, but provided the necessary statutory disclosures were made and the bank was capitally adequate, what could FSA do about it even if they understood the issue? Having regulators comment on strategy is tantamount to them writing a put to shareholders.
- Regulators have to be careful about calling wolf, especially given the impact any public intervention would have on the market. The balance between intervening too early and too late is a very difficult one, especially for a public body that is necessarily bureaucratic (not least because its actions are susceptible to judicial review). Again I’m not suggesting that FSA didn’t get it wrong in this case, just that to make an informed judgment we also need information from the thousands of cases where banks did not fail. The skeptic might suggest that thousands of banks a year don’t get into trouble so doing nothing is usually safe, and I’d agree, but that just emphasises the difficulty of finding a true positive in a sea of negatives.
- What on earth makes the Treasury select committee believe that the Bank of England would be any better at bank rescues than FSA? Surely one lesson from this debacle is that the tripartite system has one (or perhaps two) legs too many. Having a part of the Bank for FSA to hand over problem cases to will just exacerbate the communications overheads and inter-institutional conflict in the system.
Few would suggest FSA is the perfect regulator. But having a single body responsible for banks, investment firms, insurance companies, and financial intermediaries is a good start. Fewer regulators not more would make a good motto, as the BIS recently pointed out. Why not make a merged Bank of England/FSA truly responsible for the whole thing from soup to nuts, including authorisation, regulation, deposit protection, rescues, rate setting and the operation of the discount window? Then nothing can fall between the cracks between institutions and if something goes wrong we will really know who to blame. That might be too controversial a suggestion for the Treasury select committee, but it would be better than yet another regulatory kludge.
Update. It seems Alistair Darling agrees. He rejected the committee’s advice, saying that plans put forward by a committee of MPs were flawed and would not deflect him from his own reforms of Britain’s system of financial regulation.
The news that bids for Northern Rock are considerably below the current share price is hardly surprising but it does remind us that equity is a residual interest. It only has value if the firm can pay its debt in a timely fashion. Every so often shareholders forget that. Then when a firm fails, they clamour for restitution, as with Metronet or Railtrack: doubtless it will be the same with Northern Rock. These claims undermine the financial system: the logic is totally spurious. If equity holders want the returns that come from owning a residual interest, then they should take the risk, and bear any losses in silence. If they don’t want that risk, they should not buy equity.
The priority now, as James Harding puts it in the Times, is first to depositors and the financial system, and last to shareholders. The best option may well be nationalisation. It certainly won’t be something that leaves tax payers with exposure and grants a return to shareholders.
Here is the edifice that houses the Lutine Bell in Lloyds of London. Traditionally the bell was sounded to signal bad (or good) news in the insurance market.
Talking of bad news, two Bloomberg reporters seem to have it in for Mervyn King:
Two days after King, 59, told lawmakers on Sept. 12 that central banks should avoid giving the impression they will help lenders that made bad decisions, the Bank of England provided emergency funds to Northern Rock Plc in the biggest bailout of a British bank in three decades.
Subsequently the Bank has been forced to guarantee all of Northern Rock’s depositors (as opposed to 100% of the first £2000 then 90% of the rest up to a maximum of £33,000* under the UK’s Financial Services Compensation Scheme).
“It’s a crisis of confidence, and the bank is confused,” said Patrick Minford, an economics professor at Cardiff University who advised former Prime Minister Margaret Thatcher. “They want to be hands-off, but in this situation they can’t be. I don’t think this has done King any good.”
Minford was Thatcher’s economist, a recognised hardliner and currently out of political favour. Perhaps he isn’t the most disinterested observer of the situation?
King’s credibility is in question for his refusal to emulate other central banks and take early action to help cash-strapped lenders. With Northern Rock’s failure, he is finding himself subject to the same charge of excessive caution being leveled at U.S. Federal Reserve Chairman Ben S. Bernanke, whose office adjoined King’s at the Massachusetts Institute of Technology in the 1980s.
Horror of horrors, two intellectuals. Your money cannot possibly be safe with anyone who went to M.I.T.
King held back until markets forced his hand. Last week he said that too much help “encourages excessive risk-taking, and sows the seeds of a future financial crisis.”
And he was right to do so. The only criticism of King I would offer is that he failed to engineer a takeover of Northern Rock by Lloyds or HSBC earlier in the week, something that would have represented the typical dirigiste approach of the Bank to a crisis (cf. ING’s purchase of Barings). But someone will come along sooner or later with an open pocket, and meanwhile King is rightly signalling to the market that institutions must bear the consequences of their own liquidity risk management decisions.
*One might argue having only a 90% guarantee introduces an incentive which encourages bank runs: no one wants to lose 10% of a chunky amount of money. Perhaps now we are actually seeing bank runs again HM Treasury, the Bank and FSA might like to redesign the scheme?
Update. Willem Buiter and Anne Sibert writing in the FT are wrong about liquidity premiums:
The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too.
This risks the Japanese problem of excess liquidity and a lack of liquidity premiums causing falling returns on illiquid assets, deflation, and a reluctance to invest. The Bank absolutely should not accept dodgy collateral at the window in ordinary conditions. It should widen the definition of eligible collateral when necessary to manage the three month swap spread but not otherwise.