October 23, 2013

Regulatory Capital: Enhanced Supplementary Leverage Ratio Standards for Certain Bank Holding Companies

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On August 20, the Federal Reserve Board, Office of Comptroller of the Currency, and Federal Deposit Insurance Corporation posted a proposed rule that would raise supplementary leverage ratio standards for large, systemically important financial institutions (SIFIs). The agencies solicited comments on a list of questions. This comment pertains primarily to question 2, “Would the proposed strengthening of the leverage ratio mitigate public-policy concerns about the regulatory treatment of banking organizations that may pose risks to the broader economy?” 

The answer is that this proposal would not mitigate the risks that these organizations pose. While the proposed increase in supplementary leverage ratios is a small step in the right direction, it would not protect taxpayers from risk or eliminate the advantage of “too big to fail” that is enjoyed by SIFIs. From the perspective of taxpayers, it would be preferable to have capital standards that are sufficiently high to induce SIFIs to sell off enough of their businesses so that they fall below the SIFI status. Note that, while such a policy may be justified by agencies as necessary for meeting the goals of existing legislation, it may be more appropriate for Congress to take up such a fundamental issue as restructuring the banking system.

The rest of this comment will elaborate on the challenge posed by SIFIs. It is impossible for policy makers to credibly commit not to back the debts of SIFIs during a crisis. This in turn leads investors to treat the debt of SIFIs as lower in risk than that of other financial institutions. This distortion creates an uneven playing field and exacerbates the fragility of the financial system even as public policy seeks to minimize it. No matter how hard the regulators try to prevent a crisis from emerging at any SIFI, eventually such regulatory prevention efforts are likely to fail. Thus, it would be better to break up SIFIs now, before a crisis develops. 

The Time-Inconsistency Problem

The fundamental issue involved in regulating SIFIs is the time-inconsistency problem. Time-inconsistency means that an agent may wish to commit today to do something tomorrow when in fact tomorrow the incentive to break that commitment will be too strong. If this is the case, then there is no credible way to make such a commitment. For example, someone who is addicted to smoking may not be able to credibly commit to quitting tomorrow. 

In the case of banks, there is no credible way for regulators to commit to not bail out SIFIs in the future. The incentives that regulators face during a crisis will exert a powerful influence not to keep any such commitment. 

When the banks appear to be sound, it is attractive to policymakers to issue statements to the effect that no bailouts will ever take place. Policymakers may attempt to commit to a plan where, if the banks get in trouble, then the institutions will be restructured according to prearranged procedures, such as “living wills.” 

Should a SIFI get in trouble, at that point the restructuring idea will appear to be fraught with danger. Regulators will prefer to opt for some sort of bailout rather than risk a potential meltdown of the financial system by undertaking an untested restructuring approach in the midst of a crisis. Regulators will be inclined to protect the creditors of a SIFI rather than allow potential domino effects to begin. 

The time-inconsistency problem creates perverse incentives before there is any crisis. Creditors and counterparties are aware that the commitment not to bail out is not credible. Convinced that some banks are “too big to fail,” creditors and counterparties will provide low-cost funds to such banks. This gives SIFIs an advantage in the market. In effect, large banks are subsidized because of the time-consistency problem. 

Time Inconsistency in 2008

The time-inconsistency problem was very much in evidence during the financial crisis of 2008. For example, when Lehman Brothers was allowed to fail, it became clear that the commitment not to bail out Lehman had not been credible in the market. Reserve Primary, a large money market fund, had loaded up on Lehman paper in the months prior to the failure. Apparently, Reserve Primary assumed that the regulators would resolve Lehman Brothers in a way that made its commercial paper risk free. Even though in this case the regulators kept their commitment, the time-inconsistency problem still mattered, because it affected the behavior of Reserve Primary and other creditors of Lehman. 

Time-inconsistency also was prevalent in the case of Freddie Mac and Fannie Mae. Until the spring of 2008, investors bought securities of Freddie Mac and Fannie Mae at very narrow spreads (less than 20 basis points) over the yields of comparable Treasury securities. Technically, Freddie Mac and Fannie Mae were backed by only a relatively small line of credit from the Treasury of $4 billion. However, as far as investors were concerned, the US government could not credibly commit to allowing Freddie Mac and Fannie Mae to default on their debts. As losses at Freddie and Fannie began to mount, investors became uncertain. By September of 2008, the GSEs were paying higher spreads, which had widened to over 100 basis points, and the Treasury decided that the US government was likely to take on all of the obligations of those companies. They determined that this policy needed to be conveyed immediately to markets, in order to reverse the widening of the interest-rate spreads that Freddie and Fannie were faced with. Thus, the two agencies were taken into conservatorship. 

In the case of Freddie and Fannie, the government engaged in time-inconsistent behavior. Prior to the crisis, it committed to supply only the $4 billion line of credit. During the crisis, the government instead chose to back all of the obligations of the two companies, which amounted to over $2 trillion in mortgage loan guarantees. 

In fact, Freddie Mac and Fannie Mae provide a clear lesson about SIFIs and the time-inconsistency problem. They were perceived as “too big to fail,” and this perception created a subsidy that allowed them to grow spectacularly while accumulating risks that were not adequately understood either by the markets or by their regulators. This contributed to distortions in the housing market (the large run-up in house prices from 2005–07), with adverse consequences for the financial system, the economy, and taxpayers. 

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