As Federal Reserve Chairman Ben Bernanke has indicated, too-big-to-fail remains a major issue that is not solved, but “there’s a lot of work in train.”
In particular, he noted efforts to institute Basel III capital standards and the orderly liquidation authority in Dodd-Frank. The capital standards seek to lower the probability of insolvency in times of financial stress, while the liquidation authority attempts to create a credible mechanism to wind down large institutions if necessary. The Atlanta Fed’s flagship Financial Markets Conference recently addressed various issues related to both of these regulatory efforts.
The Basel capital standards are a series of international agreements on capital requirements reached by the Basel Committee on Banking Supervision. They are referred to as “risk-weighted” because they tie the required amount of bank capital to an estimate of the overall riskiness of each bank’s portfolio.
The first iteration of the Basel requirements, known as Basel I, required only 30 pages of regulation. But over time, banks adjusted their portfolios in response to the relatively simple risk measures in Basel I, and these measures became insufficient to characterize bank risk. The Basel Committee then shifted to a more complex system called Basel II, which allows the most sophisticated banks to estimate their own internal risk models subject to supervisory approval and use these models to calculate their required capital. After the financial crisis, supervisors concluded that Basel II did not require enough capital for certain types of transactions. Basel III was born.
At the FMC, Andrew Haldane of the Bank of England went over his calculations, which show that the Basel accords have become more complex, with the number of risk weights applied to bank positions increasing from only five in Basel I to more than 200,000 in Basel III.
Haldane argued that this increase in complexity and reliance on banks’ internal risk models has unfortunately not resulted in a fair or credible system of capital regulation. He pointed to supervisory studies revealing wide disparities across banks in their estimated capital requirements for a hypothetical common portfolio. Further, Haldane pointed to a survey of investors by Barclays Capital in 2012 showing, not surprisingly, that investors do not put a great deal of trust in the Basel weightings.
So is the problem merely that the Basel accords have taken the wrong technical approach to risk measurement? The conclusion of an FMC panel on risk measurement is: not necessarily. The real problem is that estimating a bank’s losses in unlikely but not implausible circumstances is at least as much an art as it is a science. Til Schuermann of Oliver Wyman gave several answers to the question “Why is risk management so hard?” These included the fact that we (fortunately) don’t observe enough bad events to be able to make good estimates of how big the losses could become. As a result, he said, much of what we think we know from observations in good times is wrong when big problems hit.
David Rowe of David M. Rowe Risk Advisory gave an example of why crisis times are different. He argued that the large financial firms can absorb some of the volatility in asset prices and trading volumes in normal times, making the financial system appear more stable. However, during crises, the large movements in asset prices can swamp even these large players. Without their shock absorption, all of the volatility passes through to the rest of the financial system.
The problems with risk measurement and management, however, go beyond the technical and statistical problems. The continued existence of TBTF means that the people and institutions that are best placed to measure risk — banks and their investors — have far less incentive to get it right than they should. Indeed, with TBTF, risk-based capital requirements can be little more than costly constraints to be avoided to the maximum extent possible, such as by “optimizing” model estimates and portfolios to reduce measured risk under Basel II and III. However, if a credible resolution mechanism existed and failure was a realistic threat, then following the intent of bank regulations would become more consistent with the banks’ self-interest, less costly and sometimes even nonbinding.
Progress on creating such a mechanism under Dodd-Frank has been steady, if slow. The FDIC’s plans for resolving systemically important nonbank financial firms is to write off the parent company’s equity holders and then use its senior and subordinated debt to absorb any remaining losses and recapitalize the parent.
Importantly, though, the FDIC may exercise its new power only if both the Treasury and Federal Reserve agree that putting a firm that is in default or in danger of default into judicial bankruptcy would have seriously adverse effects on U.S. financial stability. And this raises a key question: Why isn’t bankruptcy a reasonable option for these firms? Keynote speaker John Taylor and TBTF session panelist Kenneth Scott — both Stanford professors — argued that, in fact, bankruptcy is a reasonable option, or could be, with some changes. They maintain that creditors could better predict the outcome of judicial bankruptcy than the FDIC-administered resolution.
Unfortunately, some of the discussion also made it clear Chairman Bernanke is right: TBTF has not been solved. The panel discussed major obstacles, including the complications of resolving globally active financial firms. Thus, the Atlanta Fed’s recent FMC highlighted both the importance of ending TBTF and the difficulty of doing so. The Fed continues to work with the FDIC on the remaining problems. But until TBTF is “solved,” what to do about these firms will remain on the front burner in policy circles.
Editor’s note: This is an edited version of a commentary that first appeared on the Atlanta Federal Reserve’s Macroblog
