Defining Ideas

Real Prudential Regulatory Reform vs. Dodd-Frank

Monday, December 13, 2010
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The Dodd-Frank reforms, like the Basel Committee’s increase in minimum required equity capital, are supposed to address regulatory failings and thereby reduce the risk of crises. Which regulatory failings magnified the recent crisis? Do the reforms address them? If not, what would?

Two Key Failings of Prudential Regulation

There are two fundamental failings of the prudential regulatory system: (1) to credibly measure the riskiness of bank assets on a forward-looking basis and require a sufficient proportion of equity finance commensurate with that risk; and (2) to credibly impose losses on the stockholders and uninsured creditors of insolvent financial institutions that are sufficiently large to be able to successfully demand protection from the government in the name of avoiding "systemic risk" (the so-called "too-big-to-fail" problem, or TBTF).


The fall in housing prices brought the global financial system to its knees because exposures to subprime risk were taken by banks with insufficient equity capital (i.e., excessive leverage, given the risk). Moderate declines in housing prices made many lenders insolvent.

The government bailouts of Bear Stearns, AIG, Citibank, UBS, and others reflected the fear that allowing a large institution to default would produce chaos: the unobserved incidence of potential losses associated with such a default could make many or all large financial institutions questionable risks, producing a liquidity crisis as creditors and counterparties head for the doors together to avoid hard-to-measure default risks.

Will Dodd-Frank or Basel Reforms Solve These Problems?

There is virtually no discussion in either the Dodd-Frank bill or the Basel Committee admitting the problem of risk measurement or proposing a solution for it. Slightly higher capital requirements are being imposed and more are being discussed, but nothing is being done to fix the regulatory system’s failure to measure risk and require capital accordingly. Nothing is being done to address the incentives of banks or rating agencies to hide risk; the two methods to measure risk (asking banks and rating agencies for opinions) have proven to be unreliable, but regulation still relies on them. So long as banks can vary risk as they please, small increases in required capital will be easily undone in their effects simply by goosing up risk invisibly.

Nothing is being done to fix the regulatory system’s failure to measure risk.

With respect to TBTF, Dodd-Frank makes the problem much worse by institutionalizing a mechanism whereby the government, through the FDIC, can bail out any debt they choose. It is a profound irony that Chairman Ben Bernanke and Secretary Timothy Geithner argued for the new resolution authority as a means of imposing "haircuts" on uninsured creditors; they claimed that without a resolution authority haircuts would not be possible. But the new resolution authority permits the FDIC to impose zero haircuts, and that path of least political resistance will likely be chosen by government officials charged with implementing the new law.

What Would Work?

The good news is that reformers are finding common ground about the importance of designing credible means of measuring risk, requiring capital commensurate with risk, and constraining TBTF bailouts. And there is growing recognition that to succeed regulations must take into account the incentives of market participants and regulators. "Incentive-robust" rules are those unlikely to be undermined easily by dissembling market participants or unwilling regulatory enforcers. Here are four examples:

  • Interest rates and default risk.

    Loan interest rate spreads compensate banks for the risk of default. Two New York Fed economists, Don Morgan and Adam Ashcraft, showed in 2003 that higher loan spreads are powerful predictors of higher default risk. If only politicians and regulators had listened to them and others in 2003, the amount of capital required against subprime loans would have been much higher, which would have discouraged the over-investing in housing ex ante, and would have insulated the banking system from the losses on those loans ex post.

    Using the loan spread to measure risk is relatively immune from manipulation or lack of enforcement. Bankers won’t cut their rates to save on capital charges. Supervisors can enforce the rule easily, without supervisory or regulatory discretion.

  • The SEC should require NRSROs to report estimated probabilities of default, not letter grades, provide that number as their rating for regulatory purposes, and hold NRSROs accountable for the accuracy of estimates.

    If NRSROs were required to provide numbers, representing their estimates of the five-year probability of default on the debt, then regulators could construct (generous) confidence intervals for those estimates over significant periods of time, and penalize rating agencies for persistently and grossly underestimating the probability of default. An appropriate penalty would be a "sit out" from rating those classes of debts as an NRSRO for some period of time (say, several months) while the rating agency recalibrates its estimates. That prospective loss of fee income would provide a powerful incentive not to understate risk.

To succeed, regulations must take into account the incentives of market participants and regulators.

  • Establish a minimum uninsured debt requirement for large banks in the form of "CoCos," or contingent capital certificates.

    CoCos would convert to equity based on observable market triggers (when the ratio of the market value of equity relative to the market value of assets falls below a pre-established threshold).

    CoCos have three desirable properties: (1) Because debt holders are not bailed out, their pricing provides information to supervisors about risk (unlike spreads on protected debt). Because CoCos provide early warning of problems in a very public way, they also encourage credible supervision. (2) During a down market, if CoCos convert, debt service falls, stabilizing banks. (3) Most importantly, CoCos incentivize managers to issue equity to prevent the triggering of CoCo conversion. The key to encouraging timely voluntary issuance is making CoCo conversion sufficiently dilutive, so that bank management will reliably prefer dilution from issuing new equity. As Richard Herring and I show in recent work, if this CoCo requirement had existed in 2006, few if any of the major banks in the U.S. or Europe would have failed; they had ample opportunity and incentive to recapitalize. TBTF bailouts would have been avoided and the financial crisis would have been far less severe.

  • Limit the bailouts of creditors under Dodd-Frank.

    As noted, Dodd-Frank makes unlimited bailouts of uninsured creditors likely. A large improvement would be to amend it to limit to the protection of creditors. Even if creditors knew that only 90 percent of their principal was protected, that would provide a powerful incentive for them to be careful when selecting debts. By making that percentage generous (say, 90 percent), the rule should be credibly enforceable – no one could reasonably argue that permitting a 10 percent loss to large bank creditors could cause a chain reaction of cascading loss leading to a global meltdown.