Paying for resolution May 28, 2012 at 10:31 am

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.

2 Responses to “Paying for resolution”

  1. […] how would this pay for resolution by writing calls thing […]

  2. Interesting. Srongly agree with the need for some certainty in capital planning – and remember that the degree of certainty is going to be a whole lot lower as the authorities learn the ropes of macroprudential regulation (and the regulated banks learn reaction functions of the authorities).

    On the original idea of a resolution lock-box of capital, not much different to risk-based deposit insurance premia, paid ex-ante not ex-post?