Wednesday, January 30, 2013

Basel toff

Charles Calomiris is back, and loaded for bearish (on the likelihood of an improved banking regulation environment);
Unfortunately, I am not optimistic about the prospects for meaningful reform. Politically powerful market participants (borrowers and lenders) are short-sighted – more interested in the next few years of benefits they can extract than in the long-term efficiency of the banking system. 
This would be a good paper to read in conjunction with the recently reviewed The Fateful History of Fannie Mae, by James R. Hagerty. That book provides a wealth of detail (in a mere 200 pages) that supports many of Calomiris' assertions;
In the decades leading up to the recent banking crisis, regulators and supervisors consistently failed in three key areas: (1) they did not measure banks’ risks credibly or accurately, or set sufficient minimum equity capital buffers in accordance with those risks so that banks would be able to absorb potential portfolio losses reliably, (2) they failed to enforce even the inadequate capital requirements that they did impose because supervisors consistently failed to identify bank losses as they mounted, and thus allowed banks to overstate their levels of capital, and (3) they failed to design or enforce intervention protocols for timely resolution of the affairs of weakened banks to limit the exposure of taxpayers to protecting the liabilities of feeble, “too-big-to-fail” banks.
Calomiris is talking about banks in the above, but the same general complaint can be made about Fannie Mae and its regulators while it grew from insolvency in the 1970s into the dominant player in mortgage finance.  Fannie was 'a powerful market participant'.

At one time it was the largest borrower in the country, behind only the Treasury.  At the same time it was absurdly overleveraged, and got there (and stayed so) because of the short term incentives that Fannie executives, its regulators and major politicians faced to allow it.

It's easy to understand Calomiris' cynicism, but that hasn't stopped him from proposing a regulatory reform approach that might improve matters.  Which would be much different from the current Basel-centric ones;
The implicit theory behind these sorts of initiatives, to the extent that there is a theory, is that the recent crisis happened because regulatory standards were not quite complex enough, because the extensive discretionary authority of bank supervisors was not great enough, and  because rules and regulations prohibiting or discouraging specific practices were not sufficiently extensive.
Instead, Calomiris would opt for the virtue of the simpler, the more transparent;
The need is not for more complex rules, and more supervisory discretion, but rather, for rules that are meaningful in measuring and limiting risk, hard for market participants to circumvent, and credibly enforced by supervisors. These qualities are best achieved by constructing simpler rules that are grounded in an understanding of the incentive problems of market participants and supervisors/regulators. At the heart of the failure of regulatory discipline has been the failure to address the basic incentive problems of market participants –which benefit by gaming the system to increase the amount of risk they take at taxpayers’ expense – and supervisors and regulators – who are subject to acute short-term political pressures to keep credit flowing and long-term political pressures to favor the interests of particular borrowers and lenders. 
He goes on to propose 7 measures (click on the link to read them).  Calomiris fans will not be surprised to see that contingent capital (CoCos) are among them.

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