Market mechanisms for financial regulation

Steve Schwarzman has an op-ed more or less arguing that capital requirements magnify procyclical financial dynamics forcing banks to stop lending when the economy needs it the most. A lot of his points don’t seem wholly unreasonable – if a little unlikely, though we’re obviously talking about tail risk situations – though I find it implausible that this isn’t better than what we had before.

Regardless I want to offer a simpler framework to debate the topic. In short, we need market regulation of risk. This isn’t to say we need an unfettered free market as much as a market informed and credible policy towards regulation. In theory one could potentially achieve this by truly committing against any bailout. Actually achieving such a commitment seems impossible (short of a Rand Paul White House, Elizabeth Warren Senate, and Allen West House). Nothing I’m about to say is especially new, I’m sure it’s been written by a number of commentators before – but it is worth rehashing what a market-determined regulatory system would look like.

A pure market pricing of risk is hard, especially when noting that bank events don’t follow a normal distribution. (One could otherwise imagine banks facing a penalty if their CDS spread breaches a pre-set value). To keep it simple lets restrict acceptable capital to paid-in equity. The core of a market mechanism for regulation must somehow make it easy for a bank to issue equity in a liquidity crisis without paying a steep discount.

Of course there’s nothing free in this world and this discount must be financed by some haircut on the value of its debt as an insurance premium. Further, this discounting mechanism ought to kick in only in a “crisis” situation. One simple solution would require a bank to buy very far out of the money barrier puts on its shares struck at a reasonable measure of its value proportional to its risk-weighted debt.

“Reasonable measure” can be defined in any number of ways and doesn’t really change the theme of the framework. It could be a moving average of closing prices over the past two years. It could be some credible and formulaic measure of the capital it needs to finance its current liabilities. It could be some function of its price-to-book value. The measure doesn’t matter so long as it is well-correlated with general financial health, as the market will price and adjust for any relative discrepancies.

If the puts kick in at some predetermined, low fraction of the bank’s “reasonable value” it can sell its shares for a large premium to current prices – transferring wealth from insurers to shareholders in an elastic and predetermined manner. Because the number of puts it holds is proportional to its relevant, current liabilities, it can in principle finance itself through any liquidity shortages without systematic distortions.

Further, the maturity of the puts it sells should match one-to-one with the debt it issues (and hence, obviously, doesn’t work for deposits) – forcing the bank to constantly be cognizant that it finance its current liabilities without any problems.

These puts can even be traded between banks to stabilize and spread risk in an even and efficient manner. Since the writer of the put obligation owns the right to buy bank shares this – in a fundamental sense – represents high-quality equity (as they will be called upon only in the times when equity matters). So if the barrier kicks in at 50% of current value, and the bank’s “reasonable value” is its current value, the put represents (at worst) one share of the bank to its writer. (Since the bank would obviously sell it at a premium – though I still haven’t fully teased through this, it might be easier to consider as a convertibility clause though I’ll leave that for another post – in theory it really shouldn’t be very different. I can’t find it now but I think someone at either PIIE or AEI has written about this: links would be appreciated).

The government a requirement like the one outlined above would achieve three things:

• Dampen (maybe even counter) procyclicality.  Banks are able to issue shares at a premium in bad times compared to a steep discount they would face today. It becomes easier to raise capital in a crisis relative to balance sheet than any other time. The worse the crash the bigger the premium.
• Incentivize better risk allocation. Because banks are forced to buy puts that effectively gauge the probability the bank and financial system will fail to the extent that its share price falls below the barrier, they will actively mitigate risk in a manner convincing to markets (not just regulators) and hence be rewarded for prudence and punished for recklessness. Because of this, we wouldn’t need crazy Basal rules to judge “risk-weighted debt” and have meaningless Tiers of capital, as the market will discount each to the extent necessary. (And, so, limiting the actual procedure to equity capital doesn’t render the other stuff meaningless but channels their value through a simpler avenue).
• Actively reduce the need for outside (government) assistance during a crisis.

This doesn’t mean relegating any genuine regulatory decisions to the market, but rather only helps government policymakers to focus on the questions that matter: not how various assets should be discounted by risk, but what role is the government willing to take in financial stability and when will it act. In this sense, we can sort of explicate the too-big-too-fail subsidy. Therefore government can make important decisions such as what “reasonable value” means, and the extent to which a bank needs to be able to finance itself in any situation (that is the high level situation we are trying to answer now, anyway, but this leaves the hard work up to the competence of the market).

The government can even play simpler but more powerful role – require banks to hold capital in whatever manner such that the option-implied probability of crisis (as defined over the barrier range) is below some, small n percent. Indeed, perhaps this should be the inspiration for such regulation: banks issue disaster puts on its stock and by government diktat must keep the price of these low enough to keep the probability of said disaster below a socially acceptable level (which could be determined by correlation of failure – that, again, is for another post).