What’s Bad for Bankers Might Really Be Bad

(Originally published here.)

Let’s step back for a moment and make an observation that shouldn’t be seen as outrageous: Sometimes, when bankers hate a new regulation designed to make the financial industry safer, they have a good case.

The liquidity-coverage ratio, which was part of the package of new banking regulations agreed to after the crisis, might be such a rule. The idea is that banks should hold some safe assets that they can sell easily in a crunch. That sounds reasonable, but U.S. bankers object, according to Bloomberg News. They do have a point: the rules will make it tougher to do business and threaten to distort the flow of credit.

Here’s an alternative: Ditch the rules governing what banks should own in exchange for tighter rules on what they’re allowed to sell.

Banks have two distinct lines of business. The asset side is all about taking risks — lending and making markets in securities. The liability side is about offloading those risks — creating and selling debts to creditors who perceive them to be “safe“. (Whether these debts are actually safe is a different question. I’m just reporting what the finance academics say.) Both have the potential to cause banks to blow up.

In practice, holders of bank debt get spooked by the prospect that the risk-takers incurred large losses. Bank creditors are supposed to be protected by the capital put up by shareholders. But when things really go south there may not be enough equity to guarantee that every creditor gets back 100 cents on the dollar. Once they suspect this, creditors do the rational thing and sell as fast as possible. Since most bank debt is relatively short-term it has to be continuously rolled over, creditor demand for immediate repayment can cause what might have appeared to be a stable institution to collapse in a matter of days. (See Lehman Brothers Holdings Inc.)

Preventing these “runs” should be the regulatory priority. The obvious solution is to restrict how much short-term debt banks and other businesses can issue, either by banning it, taxing it, or crowding it outthrough the issuance of additional government debt. Much higher equity capital requirements would also help. Focus on how banks offload their risks, not the investments they make.

Instead, we got the liquidity-coverage ratio. It’s supposed to ensure that banks can raise funds by selling their safe assets even when they can’t roll over their debt. Two problems are obvious:

  • There may not be enough safe short-term assets for banks to buy. This could get worse as the budget deficit shrinks and if the Federal Reserve ever starts withdrawing the trillions of dollars of reserves it created in its efforts to boost the economy.
  • Banks aren’t supposed to be in the business of owning safe assets. They are supposed to take risks and lend to private borrowers. If anything, they should fund themselves by selling safe investments to other people.

Good regulations can help prevent the financial system from imploding again, even if we can’t prevent recessions. The bankers are right, however, that the liquidity-coverage ratio is the wrong way to go about it.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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