Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

Despite the best efforts of the authorities in discouraging financial institutions from becoming systemic, some institutions will become so. Perhaps some will have special capabilities that enable them to dominate certain product markets or customer clienteles; others may just be highly efficient and thus big. Whatever the reason, once a systemically important institution becomes seen as such, it will automatically enjoy some advantages in funding and in selling its products. To offset these advantages, regulators can require these institutions to hold more capital. Equity capital is costly.13 The implicit tax on the institutions (because equity capital is a more expensive form of financing for financial institutions than debt) would serve to offset their financing advantage, and, by creating additional buffers, make it less likely that they will become a drain on the taxpayer.

  Precisely because equity capital is costly, regulators need to think of ways to achieve the necessary size of capital buffers without imposing huge costs that banks will try to evade. Regulators could put less emphasis on additional permanent-equity capital and more on contingent capital, which is infused when the institution or the system is in trouble. In one version of contingent capital, systemically important banks could issue debt that would automatically convert to equity when the bank’s capital ratio falls below a certain value.14 In another, systemically important levered financial institutions would be required to buy fully collateralized insurance policies (from unlevered institutions, foreigners, or the government) that would infuse capital into these institutions when they are in trouble.15

  Both convertible contingent debt and capital insurance are exposed to significant downside risk and, if properly priced by the market, will be the proverbial canary in the coal mine: they will reflect the market’s perception of the extent of risk taking by the firm. Of course, for the risk to be properly priced, everyone should know that the authorities will not bail out this class of claims, no matter how they treat the rest of the firm. One reason the authorities bail out financial-firm claim holders is that they do not know whether these claims are held by other financial firms: by letting the claims bear losses, they could be precipitating a cascade of failures. It is therefore important that regulators prohibit any levered financial firms from holding contingent convertibles or writing capital insurance (or, for that matter, holding unsecured long-term debt issued by other leveraged financial firms). Instead mutual funds, pension funds, and sovereign wealth funds should be the holders of choice.

  By requiring systemically important entities to have stronger buffers against failure, regulators would reduce the likelihood that they would take advantage of their status. If a firm is made near fail-safe by its equity cushion, the prospect of government protection against failure confers little advantage.

  Making Financial Firms Easier to Resolve

  In dire crises, some systemically important firms may eat through their capital and be close to failure no matter how good the prior supervision or how ample the equity buffers. If some of their activities are essential to overall economic health, we need to figure out how to “resolve” them—to keep the core businesses running while imposing appropriate costs on investors. One of the key objectives of a resolution mechanism is to impose appropriate losses on debt holders so that debt holders do not merrily acquiesce in equity holders’ tail risk taking without demanding an additional risk premium, confident they will be bailed out by the government if necessary.

  Regulators currently do not have resolution authority over nonbank financial firms or bank holding companies, and proceedings in ordinary bankruptcy court would take too long: the financial business would evaporate in the meantime. It is therefore essential for regulators to obtain resolution authority, which would effectively allow them to function as a bankruptcy court. One reason that bankruptcy proceedings are slow is that the court needs to determine all the assets and liabilities of a firm before it decides what can be preserved and who should bear the losses. With simple bank structures, all this information is readily available. But systemically important institutions generally have far from simple structures. Some of the complexity simply builds over time, as firms are put together through mergers or start businesses across borders; some comes from attempts to avoid taxes or hide activities from regulatory authorities; and some comes simply from untidy management. Lehman had more than six hundred subsidiaries when it filed for bankruptcy.

  Because it is a nightmare to resolve such an institution today, let alone do it quickly, bailouts may seem like the only practical option. One way out, however, is to put the onus of the task back on the financial institutions themselves. Every systemically important institution should meet with regulators periodically to review its “living will,” a plan that would enable it to be resolved quickly—ideally, over a weekend—in the event of imminent failure. Such a plan would require institutions to track and document their exposures much more carefully and in a timely manner, probably through a much better use of technology. To prevent this from becoming merely a cursory formality, much of the detail in a living will could be released to the public and markets in a form that is easy to digest.

  Because it might well be impossible to anticipate all contingencies, the living will might be of limited use in guiding the actual resolution of an institution. Nevertheless, it could be immensely useful in simplifying bank structures. Not only would the need to develop a plan give such institutions the incentive to work with regulators to minimize organizational complexity and improve the ease of resolution, but it might indeed force management to think the unthinkable during booms, thus helping it avoid the costly busts. Most important, it would convey to the market the message that the authorities are serious about allowing the systemically important to fail. As we leave the crisis behind, this will be the most important message to convey.

  Resilience

  Having discussed how we can reduce tail risk seeking, as well as the related problem of having entities that are considered too systemic to fail, let me turn to the possibility of unknown unknowns. Thus far, I have argued for ways to reduce the likelihood of crises stemming from acts of commission. But we also have to address the possibility of crisis stemming from events and circumstances that no one was aware of or could anticipate; we must acknowledge that even with the best incentives in the world, a combination of mistakes, irrational beliefs, and sheer bad luck could plunge us into crisis again. We have to find ways to make the system more resilient to acts of omission—indeed, to make it robust no matter what the source of the problem. Almost certainly, the trigger will not be subprime mortgage-backed securities the next time around.16 Put differently, we need not only to enforce the fire code to reduce the possibility of fires: we also need to install sprinklers.17

  Resources

  Clearly, resources are important to deal with any crisis. In the current crisis, one reason industrial economies did not suffer the typical fate of emerging markets is that their governments could promise to guarantee bank liabilities to quell a panic, and those promises were credible. However, the crisis has stretched the finances of industrial countries, with a number of governments having lost their top ratings. To be prepared once again for emergencies, they have to restore government financial health by paying down debt, using some combination of tax hikes and expenditure cuts in a manner that does not have too adverse an impact on growth. I discuss U.S. policies on these issues in more detail in the next chapter.

  Although it is important to have resources, making them readily available is not always a good thing. Proposals are currently being debated that would make resources easily available to the government and the central bank to carry out rescues, thus avoiding the kind of uncertainty that set off a near-panic in the weeks before Congress passed the Troubled Asset Relief Program in 2008.18Such a move would be a mistake because it would legitimize rescues. Would a treasury secretary ever let a large institution go under again if Congress had sanctioned rescues by providing ready access to funds? We should not make the process of a
ppropriating resources to carry out rescues any easier. As Walter Bagehot rightly felt, systemic financial firms and markets should have some uncertainty about what will happen if they get into trouble. Having Congress debate rescues certainly adds uncertainty and some oversight, and Congress has shown an ability to act when needed—though it may have taken the treasury secretary going down on bended knee before the Speaker of the House to make it happen!19 Having one or two large firms experience severe distress, or even fail, before the cavalry comes to the rescue is not a bad idea pour encourager les autres.

  Redundancy

  A system becomes fragile if it is overly reliant on any single institution, market, regulator, or regulation. We need real redundancy and variety—multiple pathways for providing any financial service, without too much reliance on any one path. For instance, as the subprime market heated up, too many investors started depending on ratings. It did not matter that different rating agencies provided those ratings or that the investors were diversified across a variety of mortgage-backed securities: what was compromised was the rating process itself. When suspicions rose about ratings, the entire market collapsed. To provide real redundancy and variety, we need not only multiple players at each level of the securitization process but also multiple ways of financing mortgages other than through securitization.

  One way to obtain variety is to impose uniform regulation across institutional forms. For instance, banks in Europe issue covered bonds, which are essentially bonds issued against a pool of mortgages. They are similar to mortgage-backed securities, except that the investor in these bonds can ask the bank to pay what is owed if the pool of mortgages proves insufficient to cover the bonds. Banks in the United States chose to securitize mortgages instead and held many of them in off-balance sheet vehicles that came back on their balance sheets in times of trouble. In retrospect, covered bonds might have been a more transparent way of holding mortgages and might have given banks more incentive to be careful. But capital requirements favored off-balance sheet vehicles. Lighter, more uniform regulation across institutional forms would allow for greater institutional variety and more efficient, less regulator-determined, ways of undertaking activities.

  We should, however, recognize that when more institutions come under the same regulatory umbrella, we open the door to a different mistake: if the regulator makes a mistake, she coordinates more institutions into following it. For example, because regulators around the world required very little capital to be held against super-senior mortgage-backed claims, banks around the world loaded up on them and took enormous losses together. By contrast, a number of large hedge funds stayed clear of these securities, partly because the hedge funds were not subject to capital regulation. Regulatory mistakes are particularly harmful because the regulator coordinates the regulated into following the mistake: the wider the ambit of the regulator, the more problematic the mistake.

  There is, therefore, a trade-off. By spreading the regulatory net uniformly, we ensure that no institutions are favored or disadvantaged and that the institution most suited to an activity undertakes it. But we also increase the impact of regulatory mistakes. One way to mitigate this effect is to reduce the extent to which regulators embed what are essentially judgment calls—such as the amount of capital to be held against a certain activity—in regulations. Light, effective regulation is less liable to have serious consequences in the event of mistakes.

  Phasing Out Deposit Insurance

  Finally, to ensure variety, we should not privilege any particular institutional form. An enormous source of privilege for banks is deposit insurance: if an institution happens to be funded with a certain form of demandable debt, that is deposits, the deposits are fully backed by the government’s deposit insurer on payment of a nominal fee. No other institutional form has its short-term debt thus insured.

  I asked earlier whether the activities of insured banks should be restricted. Perhaps a better question is whether banks should have deposit insurance at all. This may be a strange question to ask at a time when governments all over the world have guaranteed all the debt issued by their banks, not just the small, already insured deposits. But that is precisely the reason for my question. Deposit insurance is not meant to quell panics by preventing bank runs: the government, as we have recently seen, takes care of that. Instead, it merely protects individual banks from market discipline. Put differently, with implicit government guarantees all over the place, should we not strive to remove explicit government guarantees where we can?

  One reason for insuring deposits was to provide a safe means of savings to households where none existed. Today, this rationale is archaic—a money-market fund invested in Treasury bills can provide that safety. A well-diversified money-market fund invested in highly rated commercial paper and marked every day to market is almost as safe and should not experience the kinds of runs experienced by funds that were not marked to market during this crisis.20

  Another important reason for insuring deposits was to ensure that the payment system would be relatively safe: unregulated, unsafe, uninsured entities could not pollute it and cause the system to freeze. But now that technological advances, such as real-time gross settlement payments, make it possible to protect the payment system from the failure of any payer, even this rationale is weak.

  Deposit insurance does help keep small, undiversified banks in business. To the extent that these small banks are important in making loans in the local community—to the local bakery or toy shop—they have some economic and social value. One possibility is to retain deposit insurance for small and medium-sized banks in return for their paying a fair insurance premium, but to reduce it progressively for larger banks until it is eliminated.

  Clearly, if banks are seen as too big to fail, eliminating deposit insurance is moot, as the bank will be bailed out anyway. The United Kingdom deposit insurance system, which was partial, did not prevent Northern Rock from getting into trouble or the government from coming to the rescue. The point of eliminating deposit insurance, however, is to make depositors think before they make a bank too big. Unlike depositors in the United Kingdom (where all bank deposits were partially insured, and therefore depositing in a large bank was significantly safer), depositors in large banks under my proposal would have the choice between being fully insured in a small bank and largely uninsured in a large bank. Such a measure would place some constraints on the growth of seriously mismanaged larger banks while also leveling the playing field.

  Phasing out deposit insurance does not mean doing away with regulation. Because the government will continue to step in when the financial sector gets into deep trouble, it will have to regulate financial institutions. But it can regulate large institutions more uniformly, based on their capital structure (their capital and short-term debt) and the nature of their assets (their holdings in illiquid securities and, in illiquid loans) rather than on the basis of whether they have a banking license.

  It is not easy to contemplate doing away with deposit insurance. Few depositors today can recall a time when deposits were not insured. Yet uninsured banks existed for centuries. With alternative ways of ensuring the safety of household investments (such as money-market deposits) and safe payments, and with banks already protected enough from discipline because of recent events, perhaps it is time we did away with an archaic privilege.

  Caesar’s Wife

  Before concluding, I raise a final issue. I have focused on ways to ensure that the government is not easily drawn into supporting specific markets or private institutions. I have assumed that the government, like Caesar’s wife, is above suspicion. The public has widespread concerns that it is not, as a quick survey of the blogosphere and cable news networks (admittedly not an unbiased sample of the public) suggests, and some of these concerns are justified. When a U.S. Treasury employee goes directly from running the biggest bailout fund in history to work for a company that runs the biggest bond fund in the world, and when another Treasury employee g
oes from organizing financial-sector rescues directly to running one of the banks that is most in need of rescue, the public’s trust is strained. No matter how honorable the intentions of the individuals in question (and I have no doubt that they are honorable) or how careful the new employer in avoiding conflicts of interest, the deals, to put it mildly, stink.

  Even as the private financial sector has displayed a tin ear for the political consequences of such behavior, its alumni in the government apparently fail to understand the difficulty. In normal times, the revolving door between government and the private sector has enabled governments around the world to attract tremendous talent, even while underpaying grossly. And in normal times, the conflicts of interest inherent in the revolving door are small. In downturns, however, they may be enormous: the government’s coffers are fully open, and a stroke of a pen or a key can send billions of dollars of public money in one direction or another. The rules governing the revolving door have to be reexamined.

  There is a broader question of whether government action is influenced excessively by Wall Street. I believe that when Wall Street alumni occupy powerful positions in the government or the Federal Reserve, they do what they think is best for the United States. But what they think accords with their Wall Street training and with the opinions of the people they talk to—and these people also are all largely from the Street. Cognitive capture is a better description of this phenomenon than crony capitalism.21 The nexus needs to be broken, possibly by recruiting talent from outside Washington and New York, and even from outside finance, to staff critical positions in the Treasury—former career regulators, corporate executives with finance experience, and, dare I say, academics. Diversity will be key to improving trust.