Thursday, April 26, 2012

Systemic Bank Runs? Why Pure Regulatory Oversight Isn't the Answer

A Systemic Crisis, a Bank Run, or a Way to Regulate Both?

Modern finance is tightly coupled, and therefore prone to complex, unpredictable Black Swan events. This is not in dispute.  However, what should we do about it?  From a the introduction of a new Fed paper on systemic institutions:
There are at least two contesting views on the causes of systemic risk. In the so-called micro-prudential view, the systemic risk arises from contagion of the failure of a financial institution to the rest of the financial sector whereas in the so-called macro-prudential view, the systemic risk arises from the collective failure of many financial institutions because of their common risk factor exposures.
The microprudential approach is basically that of Dodd-Frank and its focus on "systemically important institutions", whereas the macroprudential approach looks at assets and overall market trends.  Before looking more closely at this discussion, it is important to give a historical snapshot of the financial crisis, namely the specific breakdown in the Money Market Funds that later led to the Lehman breakdown:
After the  Lehman Brothers’ bankruptcy filed on September 15, 2008,  its outstanding debt collapsed in price almost immediately.  Since one of the largest money market  mutual funds (MMMFs), the Reserve Primary Fund, was highly exposed to Lehman Brothers' collapsing short-term  debt, the next day its net asset value (NAV) fell below par. Since  MMMFs offer stable NAV and investors can redeem anytime at par, an immediate run on the Reserve Primary Fund occurred, causing it to shut down.  This failure opened up the possibility that other MMMFs were similarly exposed and a run on the MMMFs started. Since MMMFs are a primary source for the commercial paper market, this run opened up the possibility of capital shortfalls at many financial institutions that needed to roll over commercial paper. Only after the government guaranteed the MMMF deposits 100% the run came to a halt and the slide was stopped.
How should one interpret this history?  Did the crisis occur because Reserve was a systemically important institution, or was it because Reserve collapsed due to a systemically important asset?

Based on this description, Wallison and Cochrane find that the focus really should be put the assets, and not the firms.  For them, the problem was that too many firms were exposed to the same assets, and whether the firms themselves were coupled didn't play that much of a role.  Wallison and Cochrane also make an argument against the top-down nature of the current regulatory system; how does a regulator designate what qualifies as a "systemically important firm" ?  Since there's no firm guideline, the clauses about systemically important firms in Dodd Frank could easily result in over regulation and a mentality of "regulate everything that moves."

Interestingly, a recent Federal Reserve paper discussed by Yves Smith articulated a similar criticism of Dodd Frank.  According to the paper, Dodd Frank did not take a strong enough position on Repo agreements that carried a significant amount of counterparty risk.  These assets would create very tight connections between firms, as a failure for one firm to get overnight funding for their liabilities could cause insolvency and wipe out the assets of the next firm.  As a result, financial shocks were amplified and propagated themselves through the market.  Their answer to this problem is to change the paradigm of regulation to a macroprudential standpoint, as outlined in the paper:
What we propose is that  instead of attempting regulation of systemically important financial institutions (a “top down” approach to regulating systemically important assets and liabilities), prudential regulation be built  in the form of a “bottom up” approach  – one that works at the level of the SIALs rather than at the level of the SIFI that owns them. Under the “bottom-up” approach there would be an automatic stabilizer built  for each SIAL. The automatic stabilizers could be in the form of government-provided but appropriately-charged deposit insurance, centrally cleared SIALs with initial and variation margins or haircuts charged by a clearinghouse or dedicated resolution authority for those  SIALs, and in extreme cases, lender-of-last-resort from the central bank against eligible assets (but to avoid moral hazard, only to firms that pay a market-rate fee).  This way, when an SIFI fails, it is not the orderly resolution of an individual SIFI that has to be effected, but rather the resolution of its various SIALs; the parts of its capital structure that are not systemically important would be resolved by market-determined contracts and relevant bankruptcy procedures.  A particularly attractive feature of the “bottom up” approach is that it requires no uniform institution-level insolvency process and therefore might be the simplest way of achieving international agreement on resolving the financial distress of G-SIFIs (as long as there is global agreement on resolution mechanisms for SIALs).
Although Dodd Frank might focus on systemically important institutions, the proposed regulatory framework works on assets, much like the Wallison and Cochrane view on the crisis.  This recent paper from the federal reserve find that firms' importance is primarily determined by the extent that they own systemically important liabilities.  If this is the case, then their assets need to be regulated.  The authors go on to provide a very long list of possible ways to ensure the stability of the assets.  Via Yves:

The authors argue for reducing risk in each of these areas via a variety of mechanisms: central clearing with adequate margining, deposit insurance, resolution mechanisms targeted to each asset type. The advantage is that by addressing only the systemically dangerous parts of financial firm balance sheets, the other pieces can be handled through existing legal/regulatory mechanisms.

Under this system, large banks would not be penalized for simply being large, but rather they would be at a disadvantage because of their highly important assets.  Yet these new approaches to regulation could easily proliferate into something more.  How many tools do we need to be considered a "variety of mechanisms", and how do we calibrate each tool?

This is where policies to increase financial diversity become incredibly important.  The runs on the MMF's wouldn't occur if the funding sources of all the firms weren't the same.  While the MM theorem tells us funding sources don't matter, a world of uncertain parameters strongly favors diversification for long term stability.  As I've written before, a possible supplement to individual new authorities is a Pigouvian tax on "following the market".  Capital requirements could be different with banks that correlated with the market index in differently.  If a given fund had a very strong correlation with the market as a whole, then they would be put under stringent resolution that would thereby internalize the cost to complexity and financial monoculture.  This is the standard answer to externalities; why should the government opt for firm and asset specific command and control policies instead?  It would also help address bounded rationality, as neither the firms nor the regulators would be put in the position of evaluating the effect of every single asset on every other institution in the economy.  When it comes to specific numbers on financial regulations, we don't quite know what we're doing.  If there's a way to simplify the framework, we should pursue it.

Another powerful advantage of a tax to facilitate diversity is that it would help foster resiliency across borders.  The U.S. could even move forward unilaterally, and the benefits would not even depend on how important the U.S. is to global finance.  If the U.S. is a major player in finance, our move towards a more diverse system would be able to increase the diversity of global banking as a whole.  If the U.S. is not a major player, then forcing our firms to become more diverse also forces them to be more diverse from global finance.  This would limit the effect of systemic crises in other parts of the world on our economy. We may become more segmented, but also more robust.  In every way, diversity can help with the problem of financial fragility.

These ideas on diversity and debt then provide a template from which to guide policy.  For truly effective finance, more and more regulatory oversight is not enough; there needs to be a coherent framework to promote institutional diversity while limiting international spillovers.  The problems of a monoculture of systemically important assets needs to be addressed, and macroprudential policy is a key way to accomplish that goal.

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