Securing Financial Stability: Systematic Regulation of Systemic Risk

Steven L. Schwarcz is Stanley A. Star Professor of Law & Business at the Duke University School of Law. This post is based on a recent paper by Professor Schwarcz. Related research from the Program on Corporate Governance includes Containing Systemic Risk by Taxing Banks Properly by Mark J. Roe and Michael Troege (discussed on the Forum here).

Regulators worry that the “macroprudential” regulation enacted since the financial crisis to protect financial stability may be inadequate to prevent another crisis. This paper examines that regulation with a decade of hindsight.

The primary focus of that regulation has been to protect against the failure of systemically important financial institutions (“SIFIs”) or to mitigate the systemic impact of their failure. This reflects concern that SIFIs may engage in morally hazardous risk-taking because they deem themselves “too big to fail” (TBTF). For example, capital requirements are intended to protect against the failure of SIFIs by requiring them to maintain specified levels of equity and the like. Resolution is intended to mitigate the systemic impact of a SIFI’s failure by reorganizing its capital structure or liquidating it with minimal systemic impact.

Post-crisis macroprudential regulation also focuses on regulating the transactions believed to be responsible for causing the crisis, such as securitization transactions. Securitization depends in part on an originate-to-distribute (OTD) model, in which banks or other lenders make loans with the intention of selling them off. Because the lenders don’t bear risk for the ultimate performance of the loans, this model is believed to foster morally hazardous lending (which is blamed for causing the high rate of loan defaults that contributed to the financial crisis).

These and other approaches to macroprudential regulation represent good faith and, in many cases, highly thoughtful efforts to control systemic risk. Nonetheless, regulators worry that vulnerabilities remain. The post argues that vulnerabilities may well remain, given the flawed post-crisis regulatory process which has been strongly influenced, for example, by unproved perceptions that wrongdoing and wrongdoers caused the financial crisis. These perceptions follow human intuition to assign blame for harm. In response, regulators have framed TBTF, moral hazard, and associated wrongdoing as a central target of post-crisis macroprudential regulation.

That framing, however, is questionable. Although SIFIs did take excessive risks, there is no evidence that was caused by moral hazard. Furthermore, there is evidence it was not, and other factors may better explain that risk-taking.

Some macroprudential regulation based on that questionable framing is problematic. For example, the Dodd-Frank Act strips the Federal Reserve Bank of much of its last-resort lending powers. Although intended to quash SIFI expectations of a government bailout, this virtually assures a crisis if a SIFI fails and the law’s resolution mechanisms are inadequate. That questionable framing may also be distorting capital requirements. For example, the Minneapolis Federal Reserve Bank has proposed a plan to solve TBTF by requiring SIFIs to maintain extremely high capital levels, without full vetting of the possible costs (such as unduly restricting bank lending).

The focus on TBTF, moral hazard, and associated wrongdoing has also produced regulation that seeks to correct non-existent wrongs. For example, in an effort to reduce morally hazardous lending caused by securitization’s OTD model, lenders are required to retain a minimum unhedged risk (usually 5%) in the loans they sell off. That requirement, however, ignores that it was always common practice for securitization sponsors to retain substantial risk on those loans. They did this to signal the quality of the securities they were selling to investors. We now understand that the signaling inadvertently created a novel information failure: not the typical asymmetric information but, instead, a mutual misinformation problem caused by complexity: neither the sponsor of the securitization, nor the investors, fully understood the risks—especially those associated with highly leveraged re-securitizations of the underlying loans.

Political pressure to find solutions also may have influenced politicians to apply old remedies to new problems without fully thinking through the consequences. The Federal Deposit Insurance Corporation, for example, now can put certain troubled SIFIs into receivership. Although the FDIC successfully used this type of approach for decades to resolve insolvent banks, its success has always depended on finding larger healthy banks to acquire troubled banks. If a SIFI becomes troubled, however, there may not always be a larger healthy firm available to acquire it—especially if multiple SIFIs become troubled around the same time.

The macroprudential regulatory process also has other flaws. Perhaps due to media and political pressure to react quickly, regulators have generally taken an ad hoc, rather than a systematic, approach to devising macroprudential regulation. They often view macroprudential regulatory measures as a loose assortment of “tools” in their “toolkit.” The result is unsystematic macroprudential regulation that, some argue, might even increase systemic risk.

In short, current macroprudential regulation has serious limitations. A more systematic regulatory framework could improve the design of macroprudential regulation in at least three ways. On a basic level, it would help to increase the transparency, and hence the legitimacy, of macroprudential regulation. The very existence of such a framework would also provide pushback to the political and media pressure that has flawed the post-crisis regulatory process. Perhaps most significantly, a more systematic framework would provide a coherent analytical approach to designing macroprudential regulation.

Constructing such a systematic framework should start by engaging the normative justification for financial regulation: to correct market failures. The justification for macroprudential regulation thus should be to correct market failures that could trigger and transmit systemic risk. To accomplish that, we need to identify and better understand those triggers and transmission mechanisms.

The paper identifies at least five types of market failures that could cause shocks that trigger a systemic economic collapse. It also observes that maturity transformation—the asset-liability mismatch that results from the short-term funding of long-term projects—could lead to a default if cash flows from those projects are insufficient to pay maturing short-term liabilities.

Conflicts, for example, represent one of those types of market failures because they can distort incentives. Scholars have long studied conflicts of interest between managers and owners of firms; post-crisis regulation attempts to fix this traditional conflict by better aligning senior executive pay with firm performance. However, post-crisis regulation overlooks the intra-firm problem of secondary-management conflicts. These conflicts arise because secondary managers are almost always paid under short-term compensation schemes, misaligning their interests with the long-term interests of the firm. Complexity exacerbates this problem by increasing information asymmetry between those managers, who often are technically sophisticated, and the senior managers to whom they report.

Regulation should require SIFIs to mitigate these conflicts by paying secondary managers under longer-term compensation schemes. In practice, that solution would confront a collective action problem: firms that offer their secondary managers longer-term compensation might be unable to hire as competitively as firms that offer more immediate compensation. Because good secondary managers can work in financial centers worldwide, regulation may also be needed to help solve this collective action problem not only within, but also across, nations.

The paper also addresses how to regulate maturity transformation. Although essential to finance, it could cause a default if long-term cash flows aren’t received in time to pay maturing short-term liabilities. Certain post-crisis liquidity requirements already help to reduce that default risk, but those requirements don’t apply to all financial firms. The paper suggests innovating on a low-transaction-cost approach used for years in structured finance to control the risk of maturity transformation. Financial firms, just like issuers of short-term structured finance securities, could carefully monitor and try to cover payment of their maturing securities with cash received from their long-term projects and from issuing new short-term securities. Financial firms, again like those issuers, could also enter into “liquidity” facilities with creditworthy banks that obligate the banks to purchase the newly issued securities if the financial firm/issuer remains solvent but, due to market disruptions, it cannot otherwise sell those securities. Because the banks only take the timing risk of a cash-flow mismatch and do not bear any credit risk, these liquidity facilities have been—and as applied to financial firms, should likewise be—low cost and practical.

The complete paper is available here.

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