Our representative democracy espouses the principle that all men and women are equal under the law. During the housing bubble and the economic meltdown that the bursting bubble brought about, the interests of domestic and foreign financial institutions were much better represented than the interests of society as a whole.
Taxpayer interests were poorly represented because of regulatory capture. The financial industry sewed clever loopholes into the capital requirements and regulatory definitions of risk that --then and now-- are supposed to keep financial instability in check. Although it has some good features, The Dodd-Frank Act left the most knotty issues open. It did not try to define systemic risk operationally or try to confront the ongoing foreclosure mess and Fannie and Freddie loss-making disasters. Implementation of its strategy for dealing with regulation-induced innovation and for disciplining elite institutions is left for regulators to work out. The Keating 5 episode tells us how hard it will be for regulators to write and enforce rules that crack down on politically influential firms. Sadly, the same gaps and issues exist in the reform efforts unfolding in Basel and in the European Union.
The issue before us is to put reform on a more promising path. To me, this means Governments must redefine the supervisory missions of regulatory agencies, rework bureaucratic incentives at these agencies, and refocus reporting responsibilities for regulators and protected institutions on the value of taxpayer safety-net support. Regulators owe duties to taxpayers of loyalty, competence, and care. Unless these duties are explicitly honored and enforced in operational and accountable ways, it is unreasonable to believe that authorities can or will adequately measure and contain systemic risk during the next round of booms and busts.
A first step would be to strengthen training and recruitment procedures for top regulators. One's incentives are shaped in the first instance by one's sense of honor and duty. If it were up to me, I would establish an academy for financial regulators and train cadets from around the world. Among other things, students would be drilled in the duties they owe the citizenry and in how to overcome the political pressures that elite institutions exert when and as they become undercapitalized. It is striking how effectively training for crises prepares firemen and nuclear personnel to risk their lives without hesitation when emergencies arise.
Fed and Treasury Rescue Programs
The Public recognizes that Fed and Treasury rescue programs placed heavy--and less than fully acknowledged-- burdens on the citizenry. Evaluating Fed and TARP bailout programs against the senseless standard of doing nothing at all, high officials tell us that their bailout programs were necessary to save us from worldwide depression and made money for the taxpayer. Both claims are false, but in different ways.
Bailing out firms indiscriminately hampered rather than promoted economic recovery. It evoked reckless gambles for resurrection among rescued firms and created uncertainty about who would finally bear the extravagant costs of these programs. Both effects continue to disrupt the flow of credit and real investment necessary to trigger and sustain economic recovery.
The claim that the Fed and TARP programs actually “made money” for the taxpayer is half-true. The true part of the proposition is that, thanks to the vastly subsidized terms these programs offered, most institutions were eventually able to repay the formal obligations they incurred. But the other half of the story is that these rescue programs forced taxpayers to provide under-compensated equity funds to deeply troubled institutions, and that the largest and most influential of these firms were allowed to make themselves bigger and even harder to fail. Lifelines provided to an underwater firm are not truly loans; they are unbalanced equity investments whose substantial downside easily deserves to carry at least a 15% to 20% return.
Government credit support transferred to taxpayers the bill for past and fresh losses at protected financial firms. Authorities chose this path without weighing the full range of out-of-pocket and implicit costs of indiscriminate rescues against the costs and benefits of alternative programs such as prepackaged bankruptcy or temporary nationalization and without documenting differences in the way each deal would distribute benefits and costs across the populace.
Rethinking Systemic Risk
Going forward, the crucial problem is: How to relate capital requirements to systemic risk. Acting in concert, market and regulatory discipline force a firm to carry a capital position that outsiders regard as large enough to support the risks it takes. Taxpayers become involved in capitalizing major firms because creditors and other counterparties regard the conjectural value of the off-balance-sheet capital that government guarantees supply as a valuable option --a “taxpayer put”-- that serves as a partial substitute for on-balance-sheet capital supplied by the firm’s shareholders.
The root problem is that supervisory conceptions of capital and systemic risk fail to make government and industry officials accountable for the roles they play in generating adverse movements in either variable. Policymakers’ knee-jerk support of creative forms of risk-taking among the firms they supervise and officials’ proclivity for absorbing losses in crisis situations encourage opportunistic firms to foster and exploit incentive conflicts within the supervisory sector that make sure that tough decisions favor industry interests over those of other citizens.
Systemic risk may be likened to a disease that has two symptoms. The Dodd-Frank Act and the Basel III framework seek to use higher capital requirements to treat only the first of these symptoms: the extent to which institutions expose themselves in directly observable ways to credit risks that might transmit exposures to default across a chain of fragile counterparties. But to be effective, the medicine of capital requirements must be adapted to take fuller account of a firm’s funding patterns and to treat a second and more-subtle symptom. This second symptom is the ease with which actual or potential zombie institutions can use financial accounting tricks and innovative instruments to hide risk exposures and accumulate fresh losses until their insolvency becomes so immense that they can panic regulators and extort life support from them.
In good times and in bad, the existence of this “taxpayer put” allows elite private institutions to issue the equivalent of government debt and makes ordinary citizens uncompensated equity investors in such firms. Offering taxpayer support to zombie firms impedes macroeconomic recovery by making crippled institutions look stronger than they are and turns a blind eye to the ways in which their underlying weakness disposes such firms to seek out reckless long-shot investments instead of fostering flows of healthy business and consumer credit.
Recommendations for Reform
My recommendations for regulatory reform are rooted in the straightforward ethical contention that protected institutions and regulatory officials owe fiduciary duties to taxpayers. The existence of a safety net makes taxpayers silent equity partners in major financial firms. As de facto investors, taxpayers deserve to be informed at regular intervals about the value of their side of the taxpayer put. Consistent with US securities laws, managers of important financial firms should measure and report --under penalties for fecklessness, deception, and negligence-- the value of taxpayers’ stake in their firm on the same quarterly frequency that they report to stockholders and government officials should examine, challenge, aggregate, and publicize this information.
My two-piece conception of systemic risk clarifies that it is embodied in a coercive option-like equity investment by taxpayers in the firms the safety net protects. The value of taxpayers' position varies inversely both with the risk that an institution might sustain losses that exceed its ownership capital (i.e., the size of a firm's tail risk) and the percentage of this tail risk that the government is likely to absorb. If tail risks turn out favorably, the institution reaps most of the gains. But when things go disastrously sour, the management "puts" the losses to taxpayers.
Defining systemic risk as taxpayers' side of an unfavorably structured option claim also provides a metric for tracking systemic risk over time. Requiring authorities to calculate and disclose fluctuations in the aggregate value of the taxpayer puts enjoyed by elite institutions would make regulatory authorities operationally accountable for the quality of their supervisory performance in booms and recessions alike.
Although considerable disagreement exists about the best way to measure systemic risk, everyone agrees that it arises from mixing leverage with loan and investment strategies that create volatility in financial-institution returns. Most existing measurement strategies incorporate the pioneering perspective of Nobel Prize Winner Robert Merton. Studies using his approach show that regulators could have tracked the growing correlation of institutional risk exposures and used it as an early warning system for the increase in systemic risk that resulted in the current crisis. Expanding the format for collecting information from covered institutions in individual countries to include estimates of the potential variability of their returns (i.e., the "volatility" of their positions over different horizons) could improve the precision of systemic-risk estimates and officials' accountability for regulatory and supervisory performance.
Traditional Reporting and Incentive Frameworks are Inadequate
Accounting standards for recognizing emerging losses make evidence of an institution’s insolvency dangerously slow to surface Moreover, as the crisis unfolded, officials were reluctant to prepare and publicize timely estimates of the financial and distributional costs of bailing out firms that benefited from open-bank assistance.
By engaging in regulation-induced innovation, nurturing clout, and exerting lobbying pressure, a country’s systematically-important-financial institutions (SIFIs) have kept their tail risks from being adequately disciplined. The importance of political, bureaucratic, and career interests in regulatory decision- making allows such firms to screen regulatory appointments and to distort regulatory policies ex ante and to reshape their enforcement ex post.
In a world of derivative transactions, top regulators need special training to understand --and considerable mental toughness to discipline-- the incremental taxpayer exposures to risk that innovative instruments and portfolio strategies entail. Efficient safety-net management requires a more sophisticated informational framework than current methods of bank accounting and examination provide. To protect taxpayers and to enhance financial stability, examinations and bank accounting reports should not focus narrowly on measures of tangible capital. They should also develop and report explicit estimates of the intangible value of an institution's claim on taxpayer resources. To hold themselves accountable for carrying out these tasks conscientiously, regulators and protected institutions must accept a system of ethical constraints that would make them to reveal and defend the forward-looking assumptions they use in calculating their share of the taxpayer put.
Summarizing, regulators need to measure and publicize the costs taxpayers incur in supporting national and international safety nets. To help authorities to do this skillfully and conscientiously, governments need to change the way regulators are trained, recruited, and incentivized. I believe that a National or International Academy for Financial Regulators could assist in these tasks