Risk taking is central to the functioning of any financial system but the current crisis was brought on by excessive risk taking and a simultaneous decline in the risk absorption capacity of the financial system. Financial institutions have needed of billions of dollars of taxpayer funded public support because they did not have sufficient capital of their own.
Regulators allowed Capital, which acts as a shock absorber by absorbing losses, has been allowed to deteriorate over time both in quantity and quality. Even the discredited credit rating agencies have been using a more conservative definition of capital than lax regulators.
Under the current capital adequacy regime, regulatory capital requirements have been designed to converge towards the financial institutors’ own definition of capital adequacy based on dubious assumptions of institution self interest and market discipline. Since capital is costly, this regulatory complacence has driven a race to the bottom in capital holding by financial institutions.
Almost by definition, it is impossible to use market mechanisms to guard against market failure. Regulators need to make banks do something different to what they would do anyway; otherwise why regulate.
This erosion of capital is the other side of excessive leverage in the financial system which has the effect of amplifying both profits and losses and is responsible for the current fragility of the financial system and the speed of its collapse.
A parallel development has been the steady chipping away of mandatory liquidity requirements such as Statutory Liquidity ratios, which are still an integral part of the regulations in emerging markets such as India and have helped them withstand the worst impact of the crisis.
Because banks borrow short term and lend long term they are particularly susceptible to liquidity drying up. In this crisis, which arose out of excess liquidity in the financial system, liquidity disappeared both on the funding side as well as the asset side. That is why liquidity funding cushions and more conservative asset liquidity assumptions are part of the solution.
- Significantly increase the quantity of capital for financial institutions: The 8% risk weighted capital ratio for banks has proven to be completely insufficient in the event of the ongoing crisis. Other financial institutions such as investment banks and hedge funds, part of the ‘shadow banking system’ did not even have any minimum capital ratios. This meant that the financial system became increasingly fragile as the loss absorbency capacity and resilience that risk capital provides was eroded. There is an urgent need to increase the capital adequacy of banks and extend the minimum capital requirements to other financial institutions that perform bank like functions and/or could threaten the stability of the financial system. However this increase should be phased in gradually only when the worst of the financial crisis has been dealt with.
Adequate capitalisation of financial institutions in themselves is still insufficient to ensure that the financial system as a whole has enough capital to guard against systemic risk. That is why the macro prudential (systemic) regulator should assess a systemic risk multiplier over and above the capital deemed adequate by the micro prudential supervisors for individual institutions.
- Significantly increase the quality of the capital: Financial innovation, regulatory arbitrage and a strong quest to increase profitability led to a steady deterioration of the quality of capital where equity was replaced by forms of hybrid securities and debt. While equity can absorb losses for solvent institutions these other forms of capital can only absorb losses under insolvency so cannot protect financial institutions from collapse. That is why when capital adequacy standards are being revised upwards it is imperative that core Tier I capital (equity capital) ratios are increased substantially.
These higher levels of quantity and quality of risk capital in the financial system would not only make the financial system more resilient to shocks but it would also help dampen the kinds of asset price bubbles and volatility that trigger financial crisis in the first place.
Higher quantities and qualities of capital in the system also mean that financial actors and owners of financial institutions have more ‘skin in the game’ i.e. stand to lose more if their decisions impose losses so they are less likely to take excessive risks. This also helps reduce the likelihood of government rescue and the moral hazard that accompanies such rescues.
- Increase capital held against risks other than just credit risk: Most of the capital that banks and other financial institutions have had to hold has been to guard against credit risk i.e. the risk of non payment of loans and bonds. Even before the crisis there was a growing realization that the existence of financial institutions can materialize from a number of other channels which include market risk, operational risk, liquidity risk and reputation risk amongst others. This crisis has highlighted the role of liquidity risk in precipitating losses. This is why, financial institutions need to be made to hold higher capital not just against credit risk but against these other kinds of risk too.
Increase capital held against trading books: Old fashioned banking involved holding loans to maturity but changes to the financial system mean that an increasing amount of credit risk being carried by the banks has taken the form of tradable securities such as bonds, credit default swaps, structured securities etc which have become part of what banks call the trading book namely the securities held with an intention of on selling in the financial market. The current capital regime allows financial institutions to hold much less capital for equivalent assets held in the trading book compared to assets held in the banking book which has encouraged regulatory arbitrage so there is a need to increase trading book capital substantially.
Increasing capital held against these risks will not only make the financial system resilient to disturbances originating in many of these channels but will also help reduce the kind of regulatory arbitrage that has helped contribute to the ongoing crisis.
- Mandate minimum funding liquidity requirements: Financial institutions have become increasingly dependent on short term funding for financing their business. Banks play a critical role in the economy by transforming short term savings into long term assets and hence are susceptible to liquidity shortages. However, statutory liquidity ratios have been abolished by regulators in western financial systems leading to increasing financial fragility. There is now an urgent need to re-introduce stringent prudential liquidity requirements for financial institutions not just banks but other institutions such as investment banks and hedge funds etc which are susceptible to funding liquidity drying up. This liquidity requirement is especially important for financial institutions whose collapse can trigger systemic instability.
- Legislate for a more conservative approach to liquidity of assets: As financial markets expanded in scope and depth, the availability of a ready market for assets held by financial institutions has been increasingly taken for granted. As the current crisis which was characterized by a total disappearance of liquidity in many previously heavily traded assets demonstrated, this assumption breaks down in stressed markets. That is why there is an urgent need to account for these ‘liquidity black holes’ when assumptions on asset market liability are used for determining regulator mandated liquidity and capital structures.
- Strengthen support for provision of emergency liquidity to funding and assets: While liquidity problems may be mitigated by higher liquidity buffers and more conservative assumptions they will never be eliminated and the disappearance of liquidity will continue to pose risks of systemic instability. For such eventualities and to guard against systemic risk, there is a need to strengthen and formalize the kind of ‘lender of last resort’ role played by central banks in the ongoing crisis including offering such support to non banking financial institutions.
Handling the ongoing crisis has needed not just extensive funding liquidity support by more controversially significant amounts being pitched in to support markets for assets where buyers have disappeared. This may be needed again so there is logic to giving regulators, supported by treasuries, a mandate for such interventions in the future. It might even make sense to ring-fence a publically run fund which should operate on an opportunity cost recovery basis.
Banks play a fundamental role in modern economies through their maturity transformation function where they use short term savings to make long term loans. In doing so, they take a tremendous amount of liquidity risk which is potentially destabilizing. That is why there is a critical need to introduce liquidity buffers which can act as shock absorbers and doing this as suggested above would mitigate the effects of one of the biggest sources of financial instability.
By making realistic assumptions about the liquidity of asset markets, regulators will help make the financial system more robust to shock since financial market actors will be better prepared for events where liquidity dries up by having higher levels of capital and liquidity buffers. Moreover making provisions for public support ensures that there is yet another backstop against financial instability.
- Introduce absolute limits to leverage and contingent liabilities: Capital adequacy in the financial system is measured on a risk weighted basis where for example there is a requirement to hold higher amounts of capital against loans to more risky borrowers who are more likely to default. While this is efficient in normal financial times, the ongoing crisis has shown that default rates and other financial risks can spike and that even relatively safe investments can go bad spectacularly. That is why in addition to higher risk weighted capital requirements as suggested above regulators needs to mandate a maximum gross leverage ratio as a backstop discipline against excessive growth in absolute balance sheet size.
While risk in financial institutions is often measured on a ‘net’ basis in the event of widespread counterparty defaults in the system the gross exposure of financial institutions (their balance absolute sheet size) becomes the more relevant measure. Besides such absolute limits can provide a backstop against excessive risk taking if the risk modelling used in capital adequacy calculations is ‘gamed’ or turns out to be based on erroneous assumptions.
The crisis has also highlighted that contingent liabilities, obligations which have a small likelihood of materializing, can come due all at once in the event of a crisis so there is a need to both have higher capital held against them as well as a need to mandate absolute limits on how large a proportion of the balance sheet these can be.
Tackling absolute leverage and the total amount of contingent liabilities both act as a coarse but reliable backstop mechanism to guard against excessive risks that might build up in financial systems despite more stringent capital adequacy rules. Moreover such crude measures are much harder to manipulate
Sony Kapoor
Managing Director, Re-Define