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Slaughter & Rees Report - An Approaching Anniversary

July 22, 2013 --

Now a month past the summer solstice, the summer days are noticeably shorter and the fifth anniversary of the Lehman Brothers bankruptcy is not far off. In this context, it is fitting that in recent weeks financial policymakers around the globe have initiated a flurry of regulatory activity. The measures differ, but all have the same broad goal of avoiding a financial crisis like the one that seized the world in fall of 2008.

Avoiding another financial crisis is indeed a worthy goal. But regulation of capital markets is much trickier than regulation of nearly all other industries. We think all these recent regulatory moves in finance bring one piece of good news yet two pieces of cautionary news.

The good news is simply that regulators are taking steps that are in some ways strengthening financial institutions relative to the past. Here are highlights of major actions:

The U.S. actions aim to bolster the balance sheets of banks (and some other financial institutions) to withstand runs by altering the composition of liabilities on the balance sheets: more equity relative to debt, and/or more long-term debt relative to short-term debt. The European measures reflect a glaring lesson of Lehman: the conventional bankruptcy process that works well for companies that make widgets works poorly for financial companies.

Measures like these have in recent years strengthened banks and, in all likelihood, the banking system’s ability to withstand runs. As Federal Reserve Governor Dan Tarullo pointed out in recent testimony, among the 18 largest financial institutions (which hold more than 70 percent of the assets in the U.S. banking system), the level of common equity capital (the most robust form of loss-absorbing capital) doubled from the end of 2008 to the end of 2012.

So what is the not-so-good cautionary news? For one, these piecemeal reforms are not very coordinated across countries. In many areas of economic policy, differences across countries are not inherently troubling. For example, there is the classic saw from late economist Joan Robinson: “If your trading partner throws rocks into his harbor, that is no reason to throw rocks into your own.” But finance is different from trade: your poor trade policy may hurt you, but your poor financial policy can trigger a world financial crisis that hurts both you and me. Public and private leaders alike are rightly voicing concern about the lack of cross-country harmonization of financial regulation. One report last week quoted an unnamed official saying, “Things have gotten more divergent.”

The other piece of cautionary news is that many wise people think the fundamental too-big-to-fail problem remains unresolved—and that no one really knows if it has been solved until in a new regulatory regime a large bank fails without triggering a crisis. There is no law of physics that identifies for regulators the optimal blend of equity, short-term debt, and long-term debt that renders a bank no longer TBTF. And let’s remember that regulators are, like the rest of us, only human, and they too can make mistakes. An earlier banking standard (Basel I) assigned the same level of risk to mortgage-backed securities as it did to sovereign debt.  In response to a question during his Congressional testimony last week about whether TBTF had been resolved, Fed Chairman Ben Bernanke replied, “I wouldn’t be saying the truth if I said that the problem is gone.”

The approaching five-year anniversary of the Lehman bankruptcy will indeed be notable. How much safer the world is remains to be seen.

Articles © 2013 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2013 Trustees of Dartmouth College. All rights reserved.

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