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A Magazine of Ideas

Regulating Risk

Thursday, April 11, 2013

An illustration of the impact of financial regulation on capital allocation is the extent to which the world's savings have been attracted to long-term instruments with low yields.

Many prominent economists have been disturbed by the extent to which in recent years the world's savings have been attracted to long-term instruments with low yields, particularly in the United States. In 2005, Federal Reserve Board Chairman Ben Bernanke dubbed this phenomenon a “global saving glut.” In a recent, widely read article, Ken Rogoff called it a “mystery.” Responding to Rogoff, Brad DeLong pronounced it a “catastrophic market failure.”

In fact, what I believe we are seeing is an illustration of the impact of financial regulation on capital allocation in the economy. If regulators designate certain financial instruments as “low risk” and offer clear incentives for financial intermediaries to invest in those instruments, then why should anyone be surprised to see strong demand for those instruments?

Since the late 1980s, one of the most important financial regulations has been the Basel Capital Accord. This was an international agreement among financial regulators to apply capital standards to banks based on risk.

The accord addressed two concerns. One was that without a common framework, regulators in individual countries would lose control of policy, because capital could go to countries with the friendliest (presumably loosest) regulatory environment. A second concern was that the savings and loan crisis and the Latin American debt crisis were viewed as having been exacerbated by capital standards that were independent of risk. As with the financial crisis of 2008, these crises resulted in bailouts of financial institutions that imposed costs on taxpayers, giving rise to demand for regulatory incentives to curb risk-taking. Prior to Basel, a bank with a high-yielding, risky portfolio was required to hold no more capital than an equivalent bank holding only low-risk assets.

The Basel Accord was not a regulation per se. Rather, it was an agreement among regulators to employ a common approach. Some countries, including the United States, were already moving in this direction before the accord was signed. Countries differed somewhat in the time frames and details of how they chose to implement the accord.

Any financial regulation, regardless of intent, is likely to affect capital allocation.

The first Basel approach was to apply different risk weights to assets. If the required ratio of capital to assets was 8 percent, then for each ordinary loan of $100,000 a bank would have to hold $8,000 in capital. A $100,000 financial instrument with a risk weight of 50 percent (as was initially the case with securities issued by Freddie Mac and Fannie Mae) would require only $4,000 in capital. Some instruments, notably government debt, were given a risk weight of zero, meaning that they required no capital.

The low risk weight for mortgage securities issued by Freddie Mac and Fannie Mae gave these instruments an enormous advantage in financial markets. Not surprisingly, this resulted in rapid growth in the demand for mortgage securities issued by the two agencies. Their total mortgage-backed securities outstanding went from $17 billion in 1980 to $604 billion in 1990 to $1,283 billion in 2000. Much of this growth came from overseas investors.

One of the implementation issues that arose under Basel was how to treat assets that a bank had sold but for which it might still be on the hook if the security were to default. In 2000, U.S. regulators issued a rule making it clear that banks would still need to hold capital on securities sold “with recourse,” as this is called. However, the “recourse rule” also included a provision sought by Wall Street firms and large banks frustrated by their inability to compete with the two behemoths, Freddie Mac and Fannie Mae. For the first time, mortgage-backed securities issued by ordinary banks or Wall Street firms could be given a low risk weight, provided that these securities could earn a AAA or AA rating from an agency like Moody's or Standard and Poor's.

Giving highly rated private securities the advantage of a low risk weight helped set off the boom in mortgage securities issued by Wall Street firms, backed by subprime mortgage loans, but structured to include AAA-rated “tranches.” Of course, these turned out to be the securities that blew up during the financial crisis of 2008. (See Jeffrey Friedman and Wladimir Kraus's Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation.)

If regulators designate certain financial instruments as 'low risk' and offer clear incentives for financial intermediaries to invest in those instruments, then why should anyone be surprised to see strong demand for those instruments?

Risk-based capital rules were not explicitly intended to steer capital into the U.S. mortgage market. But that is clearly what resulted from the Basel Accords. In fact, any financial regulation, regardless of intent, is likely to affect capital allocation. This is particularly true of regulations that affect the incentives of the world's banks, because in foreign countries banks dominate financial intermediation even more than is the case in the United States. It is especially true when regulations, such as risk-based capital requirements, present banks with clear and quantifiable financial rewards and penalties.

Ironically, risk-based capital rules do not seem to achieve their intended goal, which is to reduce risk. Recently, Thomas L. Hogan, Neil Meredith, and Xuhao Pan compared risk-based capital (RBC) measures with ordinary capital as a predictor of bank performance:

we find that the standard capital ratio is significantly better than the RBC ratio as an indicator of bank risk and performance and that using both ratios simultaneously does not produce better results. Taken in conjunction with the other available evidence, our findings indicate that RBC regulations lead to more risk-taking by individual banks, and more overall risk in the banking system, without improving the effectiveness of the Fed’s capital regulations.

It may seem counterintuitive that risk-based capital measures do no better than a capital measure that ignores risk. However, bear in mind that bankers are not passive in their response to capital regulations. Whatever measure is in place, bankers will seek to comply with the letter while dancing around the spirit. As we saw in the case of risk-based capital, bankers came up with the scheme of manufacturing AAA-rated mortgage-backed securities out of subprime mortgage loans. Whatever rules regulators come up with, the natural process of maximizing return will lead banks to try to game the system. Sooner or later, they will come up with something that works.

As Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, recently put it:

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm's return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This "leveraging up" has served world economies poorly.

Today, the biggest issue with capital regulations concerns sovereign debt. Debt issued by governments is still treated as risk-free by most bank regulators, even though default is a possibility for many countries and a reality for a few, such as Greece. For various reasons, regulators are loath to require their banks to start holding capital to back their sovereign debt securities. However, this means tolerating banks with very risky balance sheets.

So what accounts for the low interest rate on long-term bonds, particularly those of the U.S. government? It is not “quantitative easing.” It is not a mysterious shift in preferences among savers. It is that banks, which enjoy enormous advantages in attracting funds from savers due to actual and perceived protection offered by governments, have a strong incentive to direct these savings into financial instruments that their regulators have designated as having little or no risk. Risk-based capital regulations may be ineffective at promoting bank safety. But they are plenty effective at allocating capital away from productive private investments and toward government bonds.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He blogs here.

FURTHER READING: Kling also writes “The 'Two Drunks' Model of Financial Crises,” “What Do Banks Do?,” and “Reform Government Pay with Step Decreases.” Mark J. Perry and Robert Dell contribute “More Equity, Less Government: Rethinking Bank Regulation,” Perry explains “Why the U.S. Banking System Is So Dysfunctional vs. Canada’s,” and Abby McCloskey notes “The Cost of Capital.”


Image by Dianna Ingram / Bergman Group