Wharton emeritus finance professor Jack Guttentag analyzes three different approaches commonly brought up in discussions about taxpayer bailouts of firms considered “too big to fail.” Only one of those approaches, he says, is on the right track.
There seems to be almost universal consensus that using public funds to protect large institutions from failure, commonly called “bailout,” is bad policy. There is nothing like a consensus, however, on what should be done about it, and execution seems to be floundering. Three approaches have emerged, only one of which has much chance of being successful.
Approach 1: Commit That Bailouts Will Never Happen Again: Under this approach, the government adopts a policy that it will never again rescue a major bank faced with impending failure, regardless of what the consequences might be. This seems to be the favored policy position of those who have not thought through all the implications.
The problem is that as long as we have government agencies and public officials with responsibilities for promoting economic growth, price level stability and high employment, this approach cannot be implemented. The public officials who made the bailout decisions during 2007-2009 were forced to choose between using public funds to bail out an imprudent institution, or allowing the failure of that institution to destroy hundreds of innocent firms and the jobs of thousands of innocent workers. They properly chose the bailout as the lesser evil. If public officials ever have to face that horrible choice again, we will want them to make the same decision.
Approach 2: Prevent Systemically Important Firms From Failing by Imposing High Capital Requirements. This is the Dodd-Frank approach that federal agencies and legislators are now attempting to implement. Under this scheme, regulators would tag as “systemically important” (SI) every financial firm that is so large and inter-connected with other firms that its failure would destabilize the world’s financial system. Since failure results from losses that exceed a firm’s capital, SI firms would be subjected to capital requirements high enough to absorb the losses that might occur under the worst circumstances. Just as the ocean liner Titanic was built to be unsinkable, SI firms would be made “unfailurable.” The analogy is apt, even if the word doesn’t yet exist.
The first step in this approach is to identify SI firms, a process that has already started. Under Dodd-Frank, a super-committee of regulatory agencies has been compiling a list of banks and other major firms that are systemically important. While this requires some tough decisions, particularly as it applies to firms other than banks, it is clearly doable.
The problem is that capital requirements can be gamed by the SI firms subjected to them, and regulators cannot be depended on to prevent it.
What is not doable is using capital requirements to reduce the risk exposure of the SI firms to the point where these firms could survive any economic shocks to which they might be subjected. The problem is that capital requirements can be gamed by the SI firms subjected to them, and regulators cannot be depended on to prevent it. This will be discussed below.
Approach 3: Adopt a Better Regulatory System That Shifts the Cost of Bailouts to Systemically Important Firms: The major objection to bailouts is not so much that the firms affected don’t deserve it, but that public funds are used for the purpose. If we had a way to require SI firms as a group to pay the cost of bailouts, the too-big-to-fail problem becomes manageable.
A regulatory system that can not be gamed by SI firms already exists and has been rigorously tested in other markets. This system, discussed below, could be easily modified to shift the cost of any required bailout to SI firms.
The Intuitive Appeal of Capital Requirements
The capital of a firm is the value of its assets less the value of its liabilities. Insolvency occurs when asset values decline to the point where they are smaller than liabilities, meaning that capital is negative.
The larger a firm’s capital is at any time, the larger the shrinkage in asset values it can suffer before becoming insolvent. It seems intuitively obvious, therefore, that the way to make an SI firm completely safe is to raise its capital requirements to the point where the firm can withstand any shock to the value of its assets. But this view fails to account for the reactions of the firm to higher requirements.
Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario such as the financial crisis in 2007-2008. For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it. In a study of international banking crises, [Wharton finance professor] Richard Herring and I called this “disaster myopia.”
Disaster myopia is reinforced by “herding.” Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy and opening itself to a possible takeover.
Regulators have tried to shut down this obvious escape valve by adopting risk-adjusted capital ratios, where required capital varies with the type of asset.
Even when decision makers are prescient enough to know that a severe shock that will generate large losses is coming, it is not in their interest to hold the capital needed to meet those losses. Because they don’t know when the shock will occur, preparing for it would mean reduced earnings for the firm and reduced personal income for them for what could be a very long period. Better to realize the higher income as long as possible, because if they stay within the law, it won’t be taken away from them if the firm later becomes insolvent.
A capital requirement of, say, 6%, means that a firm will remain solvent in the face of a shock that reduces the value of its assets by 5.99%. How safe that is depends on the size of potential shocks that reduce the value of assets, which in turn depends on the riskiness of the assets the firm holds. SI firms can game the system by shifting into higher-yielding but riskier assets that are subject to larger potential shocks.
Regulators have tried to shut down this obvious escape valve by adopting risk-adjusted capital ratios, where required capital varies with the type of asset. SI firms must hold more capital against commercial loans, for example, than against home loans that are viewed as less risky. However, this does not prevent the firm from making adjustments within a given asset category. For example, during the years prior to the financial crisis, some mortgage lenders shifted into sub-prime home mortgage loans, which were subject to the same capital requirements as prime loans.
A given set of capital requirements may make SI firms safe in one economic environment, but not in another. In particular, if a bubble emerges in a major segment of the economy, as it did in the home mortgage market during 2003-2007, a massive shock to asset values will occur when the bubble bursts.
In principle, regulators can offset a shift toward riskier assets within given asset categories by breaking the categories down into even smaller sub-categories subject to different capital requirements. And they can adjust to emerging bubbles by raising requirements for the sector being impacted by the bubble. But such actions require a degree of intelligence, foresight and political courage on the part of regulators that history suggests we have no reason to expect.
The major advantage of TBR is that it applies to every transaction with a risk component, whether it is shown on the firm’s balance sheet or not.
Banks and other depositories have been subject to capital requirements since the 1980s. During the housing bubble, regulators did not set higher capital requirements for sub-prime mortgages, nor did they increase the ratios overall.
The need is for a regulatory system that cannot be gamed by SI firms; that does not require regulators to be smarter or more strongly motivated than the firms they regulate; and that in the event that an SI firm nonetheless fails and needs to be bailed out, the cost of bailout will be imposed on all SI firms rather than on taxpayers.
An Alternative to Capital Requirements: Transaction-based Reserving
Under transaction-based reserving (TBR), financial firms are regulated as if they were insurance companies that are obliged to contribute to a reserve account in connection with every asset they acquire. The portion of the cash inflows generated by the asset that is allocated to the reserve account depends on the potential future outflows associated with the asset.
If the asset is a loan or security, the required allocation to a contingency reserve would be, say, 50% of the portion of the income generated by the asset that is risk-based. If a prime mortgage was priced at 4% and zero points, for example, the reserve allocation for a 6% 2-point mortgage might be ½% plus 1 point.
Contingency reserves cannot be touched for a long period, perhaps 15 years, except in an emergency. Inflows allocated to reserves would not be taxable until they were withdrawn.
The major advantage of TBR is that it applies to every transaction with a risk component, whether it is shown on the firm’s balance sheet or not. It is similar to a capital requirement that is applied to every individual asset and risk-generating activity. The firm cannot game the system by shifting to riskier assets within the asset groups specified by the regulator, or by incurring new types of obligations that are not shown on the balance sheet, as they can with capital requirements.
Another advantage of TBR is that regulators need not make judgments about the riskiness of different assets – judgments they are not well-equipped to make. Such judgments are made by the firm itself in its pricing.
To some degree, TBR automatically dampens the excessive optimism that feeds bubbles. A shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums. To the degree that a euphoric SI firm underprices risk during such episodes, however, failure is possible, and with it the possible need for a bailout.
This points up another critical advantage of TBR, which is that it provides a mechanism for shifting the cost of a bailout to the SI firms. Part of the reserve allocation of SI firms (but not other firms) would accrue not to their reserve account, but to that of the FDIC. It would be held by the FDIC to cover any losses associated with the bailout of an SI firm, should that prove necessary.
Private mortgage insurance companies (PMIs) have been subject to TBR since their inception in the 1950s. They must allocate 50% of their premium income to a contingency reserve for 10 years. The system was not rigorously tested until the recent financial crisis, which devastated the industry and battered their shareholders. Yet the PMIs have been able to meet all their obligations in connection with the extraordinary losses suffered by lenders during the crisis. TBR allowed the PMIs to do exactly what they were chartered to do: cover losses out of their reserves. There were no bailouts of PMIs.