Finance + Investing

A Macroprudential Approach to Financial Regulation

Banks and regulators failed us in 2008. What could they have done differently?
A Macroprudential Approach to Financial Regulation

After decades of financial deregulation and libertarianism, industry professionals and academics in the United States of all political stripes concluded that stricter regulation was necessary in order to prevent further economic catastrophes following the 2008 crisis. That year, the chairman of the Federal Reserve, Ben Bernanke, stated the following at an annual economic symposium: “Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systematic risks and weaknesses as well [1].”

Mr. Bernanke’s statement became central to a paper published in the Journal of Economic Perspectives a couple years later by Samuel G. Hanson, a then-PhD candidate of business economics at Harvard University, and professors Anil Kashyap and Jeremy Stein who taught finance and economics at Brown University, the University of Chicago and Harvard University respectively. Titled “A Macroprudential Approach to Financial Regulation”, the authors provided a conceptual framework to strengthen the pre-crisis banking system in the United States by recommending numerous regulatory alterations [2].

In the years leading up to 2008, regulators took a microprudential regulatory approach through which they aimed to ensure robust balance sheets for individual banks. However, as evidenced by the financial crisis, there was a socially detrimental misalignment between the incentive for banks to generate profit and the incentive for banks to maintain the health of the overall economy; in particular, the capital ratio requirement exacerbated the problem.

“As evidenced by the financial crisis, there was a substantial and socially detrimental misalignment between the incentive for banks to generate profit and the incentive for banks to maintain the health of the overall economy.”

Banks are required to maintain a specific ratio between their capital and their risk-weighted assets, where capital consists of retained earnings, common stock and preferred shares. As per Basel III, this is known as the Capital Requirement Ratio. The reasoning behind the requirement is the following: In times of economic distress, it is common for the assets of banks, which consist of loans and various securities, to shrink as borrowers begin to default on their loan and mortgage payments. To ensure that banks do not take on excessive leverage to fund their operations, regulators require banks to hold adequate capital to absorb potential losses. This absorption is achieved by an increase to the loan loss provision account which is an expense, and represents a devaluation to the equity of the bank. Intuitively, a bank with less capitalization is more susceptible to bank failure (when the value of liabilities exceeds the value of assets) as there is less “buffer” to take losses.


Capital Requirement Ratio = Tier 1 Capital / Risk-Weighted Assets

A concern of regulators is to ensure that the capital ratio requirement is met by the banks. When a bank experiences a loss in assets such as loans, it will reduce the value of its assets and increase its loan loss provision expense to ensure that the accounts balance. This causes both the numerator (tier 1 capital) and the denominator (risk-weighted assets) of the capital requirement ratio to decrease by the same amount; however, given that the risk-weighted assets will always be larger than the tier 1 capital (assuming liabilities cannot be negative), any reduction to a bank’s assets will decrease their capital requirement ratio. 

Implicitly, regulators are indifferent as to whether the bank’s ratio is rebalanced by an increase in the numerator (more equity) or a decrease in the denominator (further reduction in assets). However, when banks are troubled and reporting losses, they tend to avoid the former method as generated returns from issuing more equity are often swiped by senior creditors. As a result, banks will choose to reduce their assets to rebalance the ratio.


The microprudential approach to banking regulation is logical and effective for banks that are sustaining losses due to idiosyncratic reasons such as poor lending practices; if a bank reduces assets by cutting loans, other banks will pick up the slack by issuing more loans. Competition between banks allows the assets of weaker banks to gradually siphon towards the larger, stronger banks. However, if several banks are forced to reduce assets simultaneously due to systematic reasons as was the case with the housing crisis, the economic repercussions can be severe. A mass reduction in assets such as securities and loans across the banking sector triggers two primary consequences: credit crunches and fire-sale effects. Credit crunches occur when the bank opts to decrease its assets by curtailing their lending. The economic ramifications involve lower levels of investment and therefore less economic stimulation. Fire sales occur when banks quickly offload large quantities of their assets by selling loans and other financial products in order to reduce their assets. This measure often causes negative externalities as a sudden increase in the market supply of the sold securities creates a downward pressure on the securities’ values; if other banks are holding the same securities, they suffer collateral damage.. In turn, the affected banks may be forced to rebalance their capital ratio by selling their securities which triggers a cascade effect whereby the value of assets across the banking sector plummet into a downward spiral.

“A mass reduction in assets across the banking sector triggers two primary consequences: credit crunches and fire-sale effect.”

The authors of the paper suggest multiple adoptable measures for regulators that serve to maintain the health of the banking system. The first recommendation was to replace the static, pre-crisis capital requirement with a dynamic, time-varying requirement which forces banks to maintain a higher ratio during “good times” than in “bad times.” Akin to the mechanism of automatic stabilizers on fiscal policy, a time-varying capital requirement creates a monetary buffer for banks during times of prosperity in order to offset the expected losses during an economic downturn. If the regulator is concerned with the liquidity of credit in times of crisis in addition to tempering excessive risk-taking by banks in times of prosperity, then the time-varying capital requirement is a fitting response. 

An additional macroprudential tool is the use of contingent capital which can be broadly divided into two categories: capital insurance and contingent convertibles. The former is an insurance that pays off in times of economic distress whereby the insurance provider places the full amount in a lockbox at the time the insurance is purchased. The latter is a debt instrument issued by banks which convert to equity upon a highly specific and pre-defined “trigger.” While the contingent convertible bonds, also known as “CoCos,” have been praised for their ability to quickly inject capital into a distressed banking system without straining the pockets of taxpayers, their robustness has yet to be fully stress-tested in times of market volatility. As was experienced by Deutsche Bank in 2016, the uncertainty surrounding these complex hybrid products are cause for significant investor uncertainty as the bank experienced substantial bond and stock selloffs following slightly unfavourable news regarding the state of their CoCos [3].  

A last point to consider is the maturity of the bank’s liabilities. While banks tend to fund themselves with short-term liabilities in the form of deposits and wholesale funding (commercial paper and repurchase agreements), broader economic uncertainty and idiosyncratic problems can trigger bank runs where creditors withdraw their savings on mass and on short notice. The paper notes that insufficient attention was given to this issue prior to the crisis which inevitably led to fire sales and sharp reductions in lending.

A common argument against higher capital requirements among bankers is that it bears high costs. They claim that higher capital requirements result in higher lending rates which reduce competitiveness as capital is a more expensive medium of financing than debt; however, after analyzing data on American banks between 1920 and 2009. the authors discerned that there is only a slight positive relationship between a bank’s loan rates and their capital structure. 

With loan loss provisions soaring into the billions of dollars in North America alone due to the economic ramifications of COVID, the recommendations proposed in the paper have never been as relevant as they are now. While the banking sector in North America is more tightly regulated than it was prior to 2008, it remains to be seen whether it is sufficiently robust to withstand the blows dealt by the disease. The financial crisis of 2008 might be in the rearview mirror of many, but regulators and policy-makers must take their learnings from the past decades to prevent history from repeating itself.  


References:

[1] Bernanke, B. (2008, August 22). Reducing Systemic Risk. Retrieved from https://www.federalreserve.gov/newsevents/speech/bernanke20080822a.htm

[2] Hanson, S. G., Kashyap, A. K., & Stein, J. C. (2011). A Macroprudential Approach to Financial Regulation. Retrieved from https://www.aeaweb.org/articles?id=10.1257/jep.25.1.3

[3] Board, E. (2016, February 12). The Trouble with CoCos. Retrieved from https://www.bloomberg.com/opinion/articles/2016-02-12/the-trouble-with-cocos

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