"Rajan roundtable: A response from the author
- Rajan roundtable
Raghuram Rajan is a professor at the University of Chicago Booth School of Business and a former chief economist of the IMF. His column on reforming the financial regulatory system sparked this dicussion, which can be followed in its entirety here.
FIRST, let me thank The Economist for hosting this debate and the many commentators who offered very useful thoughts on the ideas in my piece. Second, I would like to thank colleagues in the Squam Lake group (two of whom, Martin Baily and Hyun Shin, added their comments), with whom I have had enlightening exchanges on regulation. Finally, I should give credit to Mark Flannery of the University of Florida for first proposing the notion of contingent capital.
A short magazine page does not allow one to do full justice to the complexities of a problem. So if commentators rightly complain about my oversimplification of the issues, part of the blame lies with the space limitations in a magazine. But let me get to the comments. These fall into broadly three categories. Most commentators agree with the overall problem of pro-cyclical behaviour. Many express some concern about specific elements of the proposals. Finally, a few add their own suggestions.
On the overall diagnosis, the disagreements seem largely a matter of emphasis. These come from people who are either more sceptical of any regulation (Peter Wallison and some posts from Economist contributors) or from those who think the problem was deregulation driven by ideology (David Min). I agree that scepticism is the right initial stance, but given that we cannot promise not to bail out large firms in the future, and have indeed created substantial precedents for doing so, we have no option but to think of appropriate regulation. To do otherwise would be destructive of the free enterprise system that Mr Wallison cherishes, for it would entrench the power of large incumbent banks. While I sympathise with those who object to crude rules, I think Hyun Shin says it best when he argues that regulators rarely have the political or intellectual independence to exercise discretion, and “rules have a chance of success only when put in place at the outset, liberating the regulator to implement the consequences that flow from the rules”.
David Min rightly points out that the ideological cycle, which works on a longer timeframe than the usual business cycle, had a major role to play. But I would argue that the greatest danger is when the ideological cycle, reinforced by past deregulatory successes, merges with the business cycle. Indeed, overregulation in the bust plays into the hands of the ideologues, for the first attempts at eliminating senseless regulations, once the recovery takes hold, adds so much economic value that it further empowers the deregulatory camp. Eventually, though, the deregulatory momentum causes us to eliminate regulatory muscle rather than fat.
Turning to my specific proposals, start with contingent capital. Peter Wallison worries that it is an idea that “sounds good on first hearing but immediately collapses when subject to even limited analysis”. He makes some good points, but a moment’s reflection would suggest responses (which are contained in the more detailed analyses produced by the authors of the proposals) to his concerns. First, no one is proposing that levered financial institutions hold contingent capital claims on one another. That, as he and Annette Nazareth suggest, would be a disaster. It would, however, be simple to prohibit levered financial institutions (such as banks and insurance companies) from holding this class of claims, and easy to enforce such a prohibition. Who then would hold them? Typically unlevered institutions like mutual funds, pension funds, and sovereign wealth funds who like the added premium these kinds of instruments offer.
Would they hold these assets? We will not know until we try the proposals out. Yes, it would be painful for a mutual fund or a pension fund to suffer the loss. But on top of having obtained a substantial premium earlier on for taking the risk, as unlevered institutions they will also have the capacity to absorb the loss. More generally, these institutions hold equity, which is much riskier than the contingent capital proposed, both in normal times and in abnormal times. Equity has the advantage of being very liquid today, but if a sufficient amount of contingent capital is issued, it will become liquid also. Of course, if Wall Street protests too much against contingent capital, regulators can offer them the choice of issuing equivalent amounts of equity instead. I have little doubt which way financial firms will move, once their options are limited.
Some commentators object to the capital insurance proposal, arguing that insurers are likely to go broke precisely when banks are in trouble. The key therefore is for the insurance to be fully collateralised and hence fail-safe. Here is one way it could operate. Megabank would issue capital insurance bonds, say to sovereign wealth funds. It would invest the proceeds in Treasury bonds, which would then be placed in a custodial account in State Street Bank. Every quarter, Megabank would pay a pre-agreed insurance premium (contracted at the time the capital insurance bond is issued) which, together with the interest accumulated on the Treasury bonds held in the custodial account, would be paid to the sovereign fund. If the aggregate losses of the banking system exceed a certain pre-specified amount, Megabank would start getting a payout from the custodial account to bolster its capital. The sovereign wealth fund will now face losses on the principal it has invested, but on average, it will have been compensated by the insurance premium.
Turn finally to the closure proposal. Peter Wallison objects on grounds that the FDIC will not have the money to make good on the losses to depositors. I disagree. First, if the banks can be closed then they ought to be closed through prompt regulatory action way before the bank’s equity cushion, let alone its uninsured debt cushion, is fully eaten through. Second, a cursory study of past crises suggests that, typically, the longer regulators wait to close insolvent banks, the larger the eventual losses are to taxpayers. So I see quick closure as a benefit rather than a weakness.
Mark Thoma and a commentator from The Economist ask whether we will be able to ensure that such closure plans are serious. This is why regulators will have to stress test them periodically. Even if not perfect, the fact that banks have to produce the plans will force both banks and regulators to think about current weaknesses in legislation and regulation that prevent prompt closure, thus creating an impetus to remedy them. My sense is that if we set ourselves a goal to achieve weekend closure, automation, legislation, and organisational changes can get us a significant part of the way in a few years.
Martin Baily asks if we will impose too much of a tax on complexity with a closure plan. Perhaps! But I would rather we imposed a tax on (hopefully unnecessary) complexity than a tax on growth or variety. Alternatives like proposals to limit the size of financial institutions or to bring back Glass-Steagall-like separations would impose a far greater tax, and would be relatively ineffective to boot (see later).
Charles Goodhart raises the important point of cross-border operations. I am afraid that one outcome from this crisis may be that national authorities will insist that foreign banks conduct local operations through a separately incorporated local subsidiary. While this will impede efficiency, it could enhance stability and make closure easier. More generally, any bankruptcy plan will have to address knotty issues such as who has closure authority, what the loss-sharing arrangements between countries for closed banks will be, and how foreign operations of domestic banks will be treated. This is something that regulators have to pay far more attention to.
Finally, let me turn to alternatives. I was by no means suggesting that only these two regulations were needed, and that they could substitute for the whole host of regulations that are being contemplated. In particular, I am very sympathetic to the notion that compensation should be geared towards long-term performance, with bonuses paid out over time rather than immediately. I am also intrigued by Eugene Ludwig’s plea for greater reserving. Reserves are akin to the bank holding more capital, except that because reserves reduce profits and thus book capital, the capital does not really show up on the books so the bank cannot run it down by taking more risk. Similarly, the Geneva Report’s proposal of marking to funding deserves closer examination. I am not against countercyclical capital requirements, but I do not think they will be as effective as their fans suggest.
I find less compelling some of the more drastic regulatory measures that have been proposed. For instance, some have suggested that banks with insured deposits should not engage in trading for their own account, an activity known as proprietary trading. This would be a modern version of the 1933 Glass-Steagall act that separated commercial and investment banking in America. In addition to making the system more stable by pushing volatility-inducing activities away from areas that cannot be allowed to sustain losses, it might be argued that the separation is enforceable—because the lines are so clearly drawn, the public will know when they are being erased. Moreover, once in place, such separation will create pockets of rents that will generate defenders of the separation; the specialised proprietary traders will fight tooth and nail to prevent the commercial banks from encroaching on their turf. Finally, separation can create a variety of different players and strategies rather than a monolithic herd. This will lend stability to the system.
Yet these virtues may be more illusory than real. Glass-Steagall worked for a while only because there really was not much value to combining activities in the immediate post-Depression years. Over time, and long before the official repeal in 1999, it had been eroded in myriad ways. Not only are bright lines never so bright—for instance, how do you tell "illegitimate" proprietary trading from "legitimate" hedging—but also by standing in the way of private value creation, they generate enormous incentives to go around them. I would prefer uniform regulation to regulation that creates islands of regulation surrounded by uncharted oceans of the unregulated."Me:
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