Until recently, the regulation of bank capital has been designed to limit a bank’s risk of default, viewed narrowly. Bank capital was set in the same way that a margin lender sets the amount of equity to require of a borrower who purchases a security. This is not the point of regulation, even if the goal is to makes banks safer, said Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance and Neubauer Family Faculty Fellow.
The goal should not be to make each bank safe, but to protect the financial system. Capital regulation should be “…about making sure that banks avoid the excessive use of certain asset and liability portfolios, particularly the excessive use of short-term debt financing illiquid assets,” Diamond said during the inaugural presentation of the Deutsche Bank Speaker Series at Harper Center on February 9. Short-term debt is an important part of banking, but individual banks often have an incentive to use too much of it, and not just because there is a government safety net. “Regulation should focus on trying to have the right amount, without having too much,” he said.
Diamond is a member of the non-partisan Squam Lake Working Group, 15 academics who assembled to offer guidance on the reform of financial regulation. The group has proposed focusing bank capital regulation on various attributes of a bank’s debt and assets and on creating “regulatory hybrid securities” that would convert a bank’s debt to equity under certain circumstances.
Diamond said Squam Lake’s members, including John Cochrane, AQR Capital Management Professor of Finance; Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance; and Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance; believe banks that have the following characteristics should face larger capital requirements:
- Larger banks, which are more likely to be deemed too big to fail and more likely to wield political influence with regulators. “They actually will be truly expensive to resolve, if allowed to fail,” he said.
- Banks with a large percentage of illiquid assets, because of the risk major losses in a fire sale of these assets, the systemic risk associated with fire sales, and the difficulty of valuing illiquid assets after they are on the books (making the future level of bank capital more difficult to measure and update).
- Banks issuing a higher percentage of short-term debt due to their susceptibility to runs, which can cause asset fire sales and systemic risk.
Regulatory hybrid securities are a form of contingent capital that provides a buffer of extra capital in certain circumstance, Diamond said. The capital is contingent because the debt converts to equity in certain specified circumstances. “If a bank is over-levered, and the debt converts to equity, then the bank is not as over-levered,” he said.
With these proposed securities, debt converts to equity only when both of two triggers occur, Diamond said. The first is when a particular’s bank “own capital” gets low, he said. “So if you want to make sure your bank’s debt doesn’t convert to equity, just keep your capital high,” Diamond said. The second required trigger is a regulatory declaration of low aggregate bank capital or a systemic crisis, he said. This declaration would be automatic, and not subject to regulator’s discretion, if the aggregate market value of bank capital was very low and aggregate book value of bank capital was also low.
Diamond’s proposed use of contingent capital, or “saving money during good times in case of bad times,” sounds like a good business idea, said Jakub Mleczeko, a first-year student in the Full-Time MBA Program. “It’s probably less interventionist than some of the other government proposals out there right now,” Mleczeko said. “It’s kind of like combining the best of both worlds. Still, there is a lot of work to be done, a lot of uncertainty, and a lot of ideas being floated around. But at least people are talking about it.”