Reigning Macro Model Failed in Banking Collapse

Published on September 25, 2009

Reform of banking industry regulations should aim to reduce the likelihood or costs of deleveraging and of bank failures, said Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance and Richard N. Rosett Faculty Fellow.

“The problems associated with deleveraging and high resolution costs stand out as not being handled well by existing rules,” Kashyap said during the 12th International Banking Conference at the Federal Reserve Bank of Chicago on September 25.

In addition to amending the bankruptcy code to better serve major financial institutions, Kashyap proposed four specific ideas to begin tackling the primary issues directly:

• Vary capital standards based on proportion of short-term debt, illiquidity of assets, and bank size. “The regulatory capital requirements during good times would have to be higher than the market requirements during bad times,” he said.

• Issue “capital forbearance certificates” that count as regulatory capital, are traded among banks, and are limited as substitutes for actual equity. “The price of these certificates would reveal to regulators that the shadow value of capital is rising,” Kashyap said.

• Require plans to convert some debt into equity in certain cases. Researchers have proposed this occur during single bank distress, when the aggregate system is in danger, or during an industry-wide capital shortage combined with a bank in distress, he said.

• Force banks to create “living wills” to consider how bankruptcy might proceed if necessary. These would fully describe ownership and organizational structure, liabilities, contractual obligations, and jurisdictions covering them. They would also cover cross-guarantees to securities, a list of major counterparties, and how to determine where collateral is pledged.

“The living will would include an estimate of how long it would take to gain control of the institution and begin the process of closing it,” Kashyap said. “Banks that require more time could also be required to hold more capital. The extra resolution time presumably would mean taxpayers face more risk if the bank were to fail. The capital charge would also give the bank’s management an incentive to reduce its complexity.”

These reforms are necessary because of the failure of three assumptions required for the Modigliani-Miller Capital Structure Irrelevance Proposition to prevail, he said:

• Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their current cash flows.

• There are no taxes, transactions costs, or issuance costs associated with security trading.

• A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

“Many of the unexpected and confusing aspects of the crisis came from underestimating the transaction costs associated with bankruptcy and from not appreciating how financing decisions do change cash flows,” Kashyap said. “The failure to understand the forces that contributed to a buildup of leverage in the financial system and the costs of unwinding the leverage was probably the biggest mistake we – academics, policymakers, practitioners, and the media – made.”

In reforming regulations, four guiding principles should be used:

• Special bankruptcy rules are needed for banks.

• Because failure is likely expensive, reduce those costs or the likelihood of failures.

• Because deleveraging is costly, proposals that lead banks to rebuild equity rather than sell assets are preferred.

• A “pro-cyclical” free market likely requires more capital during bad than good times.

                                                                                                                            — Phil Rockrohr