Dennis Jones is a Jamaican-born international economist, who has lived most of the time in the UK and USA, and latterly in Guinea, west Africa. He moved back to the Caribbean in 2007. This blog contains his observations on life on this small eastern Caribbean island, as well as views on life and issues on a broader landscape, especially the Caribbean and Africa.







**You may contact me by e-mail at livinginbarbados[at]gmail[dot]com**

Friday, January 29, 2010

Constrain Banks In Booms

My ever-busy fellow economist also now living in Barbados, Avinash Persaud, has produced another thought-provoking piece about financial crises and their regulation. This time, in a round table discussion on The Economist 'free exchange' (see article). I take the liberty of reproducing the piece here:

Bail-in roundtable: Address the boom

Avinash Persaud is Chairman of Intelligence Capital Limited, and Chairman of the Warwick Commission on Financial Regulation. For an explanation of this roundtable, click here.

DESPITE the mantra that banking is a global industry needing global regulation, what has emerged instead has been a series of national responses and regional perspectives. In Europe, perhaps belying an instinctive mistrust of markets, the emphasis has been on how to regulate financial markets to avoid future crises. Credit mistakes are made during the boom, not during the crash. Besides, it is impossible to do good policy during a crash. Ideas around counter-cyclical charges and minimum liquidity buffers have traction. In the US, perhaps reflecting an instinctive mistrust of government, the emphasis is on resolving a crisis only once it has emerged. Booms are impossible to stop, so lets minimise the impact of the inevitable bust. Dominating the US debate are issues of “TBTF” (too big to fail) and “contingent capital”. Paul Callello’s and Wilson Ervin’s interesting “bail-in” proposals fit most neatly with this “American perspective”.

Messrs Callello and Ervin have focused on how we avoid an enormous liquidity crisis that stems from a more modest capital shortage. Quickly forcing the conversion of a limited amount of unsecured debt into equity might shore up capital and so forestall a liquidity crisis that, left unchecked, would create a bigger capital problem. There is merit in this idea from the perspective of the individual firm and its stakeholders. Instead of a bankruptcy that would wipe out the shareholders and much of the unsecured lenders, a middle path is chosen, of organised haircuts of the unsecured creditors, that allows everyone to survive. This is not dissimilar to provisions in the US bankruptcy code for industrial companies. However Messrs Callello and Ervin rightly argue that financial firms need a more immediate response. It is also not dissimilar from the idea of contingent capital, but Mr Callello and Mr Ervin believe the voluntary market for debt-that-can-become-equity would not be sufficiently large—which should give us pause for thought.

The problem with these and other contingent instruments are clearer from a macro perspective. What we are essentially doing is adding a forced option to unsecured lenders to banks, to convert their credit into something they do not want (a piece of equity), at some future date. In market parlance we are forcing a “put” onto unsecured debt. Markets and private rating agencies are better than governments at most things, but one thing they have consistently proven to be bad at is pricing risk through the economic cycle. Recall that the markets gave Bear Sterns, Lehman Brothers and Northern Rock higher equity ratings (p/e ratios) than they gave HSBC, JPMorgan and other survivors. This “put” will be underpriced during the boom, but when the first whiffs of bust are smelled, the price will shoot up and short-term subordinated credit to banks will dry up. This could bring forward a crisis.

One way to address this may be to give a pre-determined limit to the size of the put—perhaps a maximum of 15% of the unsecured debt can be forced to be converted into equity, limiting the panic in the unsecured market when it becomes clear that these options will be exercised by the regulators. The unsecured creditor is essentially now providing a limited facility to allow a bank to work through its problem. Should the bank survive, this equity could be re-converted into debt.

But there is a second more fundamental problem with these market mechanisms. Crashes are not random. They always follow booms. Appropriately defined, busts cannot be systematically smaller than the preceding booms. Consequently, proposals to reduce the severity of the crash will always be inadequate if they do nothing to address the boom. This proposal does nothing to the boom at best and potentially makes it worse. Booms are both caused and prolonged by the market’s underestimation of risk—often triggered by a new technology that appears to permanently improve the risk-return trade-off, such as railways, motor cars, electricity, the Internet and financial innovation. In the boom, the risk of unsecured debt is and will be systematically underestimated. The rise of under-priced unsecured debt could be perceived as less of a risk to the bank because it is now a form of contingent capital. This allows a bank to expand its balance sheet even more than otherwise. It will not curb the boom and could even add fuel to its flames. By doing nothing to the boom, all we may be doing is lessening the immediate severity of the crash by prolonging the downturn as banks find it very costly to raise unsecured debt in the aftermath of the crash. The history of financial crises is littered with good intentions.

The problem we need to address is a market underestimation of risk that feeds the boom. We require non-market mechanisms that raise the amount of capital banks are carrying as the boom progresses. Having more capital will be far more expensive for banks than this form of convertible debt, but it would provide the same buffer for the emergence of boom-fed credit mistakes and better constrain the boom in the first place. These non-market mechanisms can include the minimum funding liquidity and time varying capital adequacy requirements currently being worked on by the Financial Stability Board and Basel Committee. Alongside these initiatives, improving the power, scope and speed of resolution authorities may help to contain a crisis, but doing this on its own is not an adequate alternative to the main task of offsetting the market's systematic underestimation of risk in booms.

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