Financial regulation built on sand

Figure 2. US Primary Dealer Mean Leverage (June 1986 – Sept 2008)

Today’s financial regulation is founded on the assumption that making each bank safe makes the system safe. This fallacy of composition goes a long way towards explaining how global finance became so fragile without sounding regulatory alarm bells. This column argues that mitigating the costs of financial crises necessitates taking a macroprudential perspective to complement the existing microprudential rules.

I recommend this VoxEU article by Princeton economist Hyun Song Shin, who explains clearly how the regulatory framework creates an adverse feedback liquidity chase that has already brought down Bear Sterns and Lehman — through recoiling from risk. This is why the existing banking regulations are heavily pro-cyclical — exactly what we do not want.

I like their proposal for quantifying systemically high-impact banks via a measure analogous to Google’s page rank. This could be used to establish the baseline capital ratio required of each bank.

This is a lead article VoxEU’s Global Crisis Debate. The article is based on the The Fundamental Principles of Financial Regulation, a preliminary conference draft for the Geneva Reports on the World Economy 11. Excerpts:

The regulatory system stands accused of having failed to provide any check or barrier against the boom-and-bust cycle in the financial system. It was largely a bystander during the build-up of leverage and the erosion of credit standards in the credit boom and has been largely powerless as the boom has turned to bust with a devastating impact on the real economy.

How did we reach this state of affairs?

It was not for want of the quantity of financial regulation, if quantity be measured in terms of thickness of the rule books. The Basel II rules for banking regulation famously generated reams of paper, all the while sapping the energy and patience of the hapless cadre of dedicated officials locked in detailed discussions on the latest bell or whistle to be attached to the rules.

Microprudential versus macroprudential perspectives

Basel II rests on the principle that the purpose of regulation is to ensure the soundness of individual institutions against the risk of loss on their assets. Of course, it is a truism that ensuring the soundness of each individual institution ensures the soundness of the system as a whole. But for this proposition to be a good prescription for policy, actions that enhance the soundness of a particular institution should promote overall stability. However, the proposition is vulnerable to the fallacy of composition. It is possible, indeed often likely, that attempts by individual institutions to remain solvent can push the system to collapse.

Fallacy of composition

Fallacy of composition

Consider Figure 1 below. Bank 1 has borrowed from Bank 2. Bank 2 has other assets, as well as its loans to Bank 1. One day, Bank 2 suffers credit losses on these other loans, depleting its equity capital. The prudent course of action for Bank 2 is to reduce its overall lending, including its lending to Bank 1.

Figure 1. Prudent shedding vs a run

But a prudent shedding of lending by Bank 2 is a run when seen by Bank 1. Arguably, this type of run is what happened to the UK bank Northern Rock, which failed in 2007, as well as to the US securities houses Bear Stearns and Lehman Brothers, both of which suffered crippling runs in 2008.

In this simple setting, it is clear how misguided it would be to induce even greater recoiling from risk on the part of Bank 2 when faced with shocks. But a greater recoiling from risk is exactly what the Basel II rules have managed to hard-wire into the financial system.

For related essays, see also Financial innovation, regulation, and reform by Charles Calomiris

The financial crisis happened because the rules of the game – shaped by government policy – promote the wilful undertaking of excessive, value-destroying risks by managers who were not effectively disciplined by shareholders. This column outlines the six key areas where regulatory reform is essential to preventing a repeat.

And Money, Liquidity and Monetary Policy.