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An interesting view on bank regulation
...there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that sub-prime was a poor risk – it is called sub-prime, after all.
Then it moves here:
The alternative model rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle – it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning (Goodhart and Persaud 2008).
The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on out-dated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated – if at all – and in particular would not be required to adhere to short term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivising long-term investors to behave long-term will mean that there will be more buyers when banks are forced to sell.
The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers.
Posted by Tyler Cowen on May 3, 2008 at 06:20 AM in Economics | Permalink
Comments
An insurance premium on excessive risk?
The constitution has a better method, slavery of the income tax. Increase progressive income taxes on the wealthy when the risk of failure increases. The effect will be that the super wealthy get government right. They will reduce their insurance premium by reducing the risk of government boondogle.
Posted by: Matt at May 3, 2008 8:34:37 AM
Good points -- I work in a small bank and have seen the credit crisis affect much larger institutions and not so much for my own, so I think it's a wonderful idea for regulation to not be "one size fits all," that is if a risk profile for a bank is constantly low (as it is for some traditional, community banks), they wouldn't have to jump through the same regulatory hoops as the big banks.
However, concerning pillar 3: Banks are already paying this. It's called FDIC insurance, and it's based on the bank's regulatory rating, that is a riskier bank based on its CAMELS score(scale goes from 1 to 5, low risk to high risk) is rated 4, it pays far more FDIC insurance premiums than a bank rated 1. But investment banks (read: Bear Stearns) don't pay these premiums, because of the lack of their FDIC insurance. Maybe a separate insurance fund is in order for investment banks. Or we could reinstate Glass-Stegall, and then if large investment banks fail it wouldn't affect the consumer banking system quite so dramatically.
Also- the problem with disclosure - the kind of people who got subprime loans probably weren't reading their loan docs, but loan officers (in many cases, where their compensation was based on making loans) were involved in what a colleague and former regulator called "thumb closings," that is conveniently using the thumb to cover certain derogatory or particularly bad terms of the loans when reviewing paperwork at closing.
Posted by: Joel at May 3, 2008 8:45:49 AM
"to whither away under rising insurance premiums"
Whither 'wither'?
Posted by: The Owner's Manual at May 3, 2008 2:28:14 PM
As a regular reader of VOX, I have respect for the quality of its content (usually).
Here we read:
"The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to whither away under rising insurance premiums paid to tax payers."
SURELY YOU JEST!
The third leg falls off this stool as the issue of setting premiums (let alone the lack of a truly willing [ask an average taxpayer]buyer to match the willing seller of "risk") is faced.
One is reminded of the the former Factory Mutual system of engineering risk assessment for setting premiums.
Go into a factory, look at the points where initiating conditions of a "disaster" exist; then determine how far the fire, blast or other force might travel (example: up to Firewall "A"; or a blast through 2 firewalls and out the exterior, etc. All that in addition to examining the probabilities of initiating conditions, plus follow up inspections for containment and prevention. What we would likely see as premium setting for the "insurance" proposed is something purporting to review potential initiating conditions. This is, in any true sense, not a risk that can be transferred via a premium that would match that risk.
But then, how would the transferees know; or ever find out?
Posted by: R. Richard Schweitzer at May 3, 2008 2:56:34 PM
So the solution to food shortages is to stop government policies that favor romantic small farms over efficient larger producers? And the solution to credit shortages is to create new government policies that favor romantic small lenders over efficient larger producers?
Posted by: anonymouse at May 3, 2008 9:05:10 PM
@anonymouse - "Romantic small lenders" are far more efficient than large banks - just look at closing costs for big bank mortgages v. rates for community bank mortgages in your community. The big lenders just have more ability to lend to riskier borrowers because of the amount of profits that they make. Small banks are also able to close on loans more quickly and often invest less time in the process because there isn't the churn in processors that there is with megabanks.
Posted by: Joel at May 3, 2008 10:01:24 PM
Well the smaller banks wind up selling the loans to the larger banks after taking a portion from the profits, so I don't see how that is more effective... unless the smaller bank can operate a profit margin less than the expenses the larger bank can operate had they just wrote the loan themselves to begin with. Plus, every hand hat touches the loan from the customer, to a broker to a pass through lender to the final bank... with each touch there lies the possibility, or in the case of sub-prime the probability that there will be undetected fraud in the loan somewhere. I am not so convinced closing loans more quickly ought to be the benchmark in the future. Maybe insuring that they are well underwritten should instead be. When things come back, as we all know they will... maybe we won't see 100% financing of a home to somebody who couldn't otherwise qualify for a revolving credit card.
Posted by: Earthceuticals at May 4, 2008 3:26:40 AM
@Earthceuticals - not all banks sell servicing, mine doesn't. Not in over 100 years of operation. I really think that there are 2 main causes of the current crisis:
1. Lax underwriting standards, mentioned by Earthceuticals. Some of the most profitable banks in my area operate on 20% down minimum, larger banks don't. Guess who had more foreclosures listed on the Sheriff's website? I fail to understand how a bank could have willingly given people the kinds of money they did.
2. Profit motive. Stock companies always have to churn a profit, so there is a lot of incentive in getting the loan closed, even if the borrower is risky. In non-profit or mutually held banks, there isn't this kind of pressure, so loan officers can afford to turn away riskier borrowers and save their loans for borrowers who are less risk.
Final thought - you mention fraud - what's wrong with meeting buyers face to face anymore? I know a great deal of realtors in our area who won't work with us because we don't take apps. over the phone or online. It's just good business to know who you're giving money to.
The industry has to change, but it won't. Let's just hope some of the smaller banks don't change what they are doing.
Posted by: Joel at May 4, 2008 8:15:26 AM
"The third pillar is requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out. "
What ever happened to PMI? Shouldn't this insurance be covering much of the problems in the mortgage crisis?
Posted by: Tom at May 5, 2008 9:58:52 AM
@Tom - yes, but some companies who provide PMI are failing, or otherwise the borrower didn't want to buy PMI, so the lender would split the loan up - 80-10-10 (80% first mortgage, 10% 2nd, 10% down) or 80-15-5 (80% first, 15% 2nd, 5% down) in order to subvert the requirement. Plus, they would lend at a higher rate for 2nd mortgages and (theoretically) gain more interest income/boost budget projections for $ of loans made.
Win-win, in a perfect world. But as I'm sure you know, banking is far from a perfect world.
Posted by: Joel at May 5, 2008 2:07:52 PM
