Macroprudence is the new policy buzzword of 2009 that (in my opinion) captures well the need for a “systemic risk regulator” as opposed to an individual bank regulator. The fact remains that systems in the aggregate have emergent characteristics that do not matter when analyzing individual components under “ceteris paribus” assumptions (one form of this is the infamous “Paradox of Thrift” in Economics) The article below gives a great, simple banking example. Franklin Allen at Wharton is wholly bearish on the ability of bank regulators to stay ahead of the banks, but I believe his view is much too long-term. In the near term, regulators have a lot of power at their disposal to slow down credit extension in the conventionally recognized financial institutions, so long as they remember that they HAVE to take away the punch bowl just as the party gets going.
Felix Salmon
Article by Felix Salmon at Thomson Reuters.
Patrick Jenkins gives a good example of why insurance is not a sensible wayto think about or regulate financial products:
Investment banks, including Goldman Sachs and Barclays Capital, are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets…
The schemes, which Goldman insiders refer to as “insurance” and BarCap calls “smart securitisation”, use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases…
Under Goldman’s idea, it would sell an insurance product to a bank with a toxic portfolio, effectively shifting the risk of the underlying assets off the balance sheet. The insurance would require far less capital to be carried against it than the original assets.
The insight here (I believe Goldman considers it “financial innovation”) is that insurance is fundamentally more leveraged than finance. Rolfe Winkler is wrong when he says that regulating financial products as insurance would force banks to reduce leverage — quite the opposite.
Think about a pair of banks, A and B. Each has $1 billion in loans on its books, and needs $80 million in capital to be held against those loans. But then B insures A against any losses on its loan book, while A insures B against any losses on its loan book. Presto, each bank is now fully insured against loss, and needs much less capital. Each bank also, of course, has a large contingent liability should the other bank’s loans go bad. But the amount of capital that an insurer needs to hold against such contingent losses is much smaller than the amount of capital that a bank needs to hold against its own loans.
The fact that it’s Goldman (GS) coming up with this bright idea is particularly ironic since it was Goldman which revealed the way in which banks could use securitization to reduce their capital requirements. The bank even proposed a very sensible new principle:
Securitized loans should, in aggregate, face the same capital requirements as the underlying loans would if they were held on bank balance sheets.
I wonder whether Goldman’s financial innovators got the memo.
insuring each other is a great way of sharing capital for risky assets that normally would have low default correlation. one fails, or the other, but likely not both. problem occurs because default correlations don’t always hold true in systemic failure.