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Some Mechanisms to Restore Market Discipline
The Basel Committee on Bank Supervision (BCBS) serves as the forum through which central bankers coordinate bank supervisory standards…
The Basel Committee on Bank Supervision (BCBS) serves as the forum through which central bankers coordinate bank supervisory standards. When the BCBS unveiled the Basel II: Revised International Capital Framework in 2004, a key addition to the revised guidelines was market discipline. Market discipline concerns the role of bank monitoring by investors in the marketplace, in such a way as to influence the behavior of bank decision-makers. Ceteris paribus, less (more) risky bank decisions translate to higher (lower) bond and stock prices. That’s what’s supposed to happen and the BCBS approach emphasizes disclosure.
Yet complying with the BCBS guidelines embodied in U.S. bank capital adequacy standards calls for banks to report accounting data rather than to act in response to changes in the market prices of their securities. That means that even though U.S. regulations reflect Basel II principles, which attempt to foster prudent behavior by bank staff through disclosure, the regulations still do not reflect strong market discipline.
Effective alternative mechanisms include 1) double/contingent liability, 2) using contingent capital with a market trigger, or 3) implementing a minimum 15 percent market value of equity to short-term liability leverage ratio. Unlike the “top-down” Basel approach that involves having a select few decide what is prudential behavior, these approaches take a “bottom-up” approach, in which investors across the marketplace can collectively decide and act upon imprudent bank staff behavior.
Politically speaking, double liability might be least likely among the three mechanisms to come back, but it has had a successful history. To understand why, under double liability, if a bank becomes insolvent, its shareholders could not only lose their initial investment, but might have to cover additional creditor losses equal to the par value of the stock per share owned. While par value has largely lost its meaning today, the par value was a sort of minimum price stated in the corporation’s charter. Shareholders were therefore, responsible for more than just investment losses.
In a 1998 study, Harvard University Professor Benjamin Esty showed that over a century ago, non-national banks in some states were subject to double liability (or, in Colorado and California respectively, triple and unlimited liability). Similarly, Rutgers University Professor Eugene White observed in a study that national banks, first created after the National Bank Act of 1863, were all once subject to double liability, too. Prior to the establishment of the Federal Reserve, national bank failures were relatively rare. Most bank closures were voluntary liquidations because weak banks’ shareholders sought to liquidate early rather than bear the additional penalty of double liability.
It was the new Federal Reserve’s discount window lending program that undermined the effectiveness of double liability. That’s because weak banks suddenly had a reason to stay around longer, and shareholders no longer had a reason to quickly shut down the bank before being exposed to the double liability penalty. When federal deposit insurance was established in 1934, double liability was considered irrelevant and as I recently discussed, the costs of crises have been escalating ever since we’ve moved away from relying solely on double liability.
Consider another proposal, reverse convertible debentures (RCDs), put forth by former Securities and Exchange Commission chief economist Mark Flannery. RCDs can serve as capital and are effectively convertible debt, with a market trigger. In short, if a bank’s asset values drop, which causes the market value of the bank’s equity to fall below the regulatory minimum, some of the RCDs would convert to equity to bring the bank back into regulatory compliance. RCDs with a market trigger, therefore, also offer a mechanism to restore market discipline.
Concerning the third related proposal, I mentioned the idea in an earlier op ed and elaborated further in a recent public interest comment that concerned suggestions for simplifying capital requirements. In short, banks operating in the U.S. should maintain an equity capital ratio measured at market value equal to at least 15 percent of short-term liabilities.
I choose market value of equity because market values are more volatile than book values, and that volatility can instill market discipline, if instead of regulatory forbearance, everyone who cares can observe when a bank must recapitalize. I choose 15 percent because in a recent study, my co-author and I show that the benefits of increasing the book equity to book asset leverage ratio from 4 to 15 percent generally outweigh the costs. Since any positive net worth bank has assets greater than short-term liabilities, a leverage ratio measured relative to short-term liabilities is always larger than one measure relative to total assets. In that sense, this proposal would be less onerous than the approaches outlined in the Brown-Vitter Bill and the Minneapolis Fed Plan to End TBTF.
To implement the idea, we could build on the U.S. model for calculating bank required reserves. Banks currently have to determine the target amount of reserves they need to maintain and then cover that target during the so-called “reserve maintenance period”. Similarly, under this proposal, during a “capital maintenance period”, a bank’s treasury staff would have to determine the bank’s target amount of outstanding short-term liabilities, and then cover that with an average amount of equity capital equal to the market price of shares multiplied by the total number of shares of common stock outstanding. So with a 15 percent requirement, the staff of a bank with an average face value of short-term liabilities during some short-term period (e.g., a week, month, or quarter) equal to $100 billion dollars, would need to ensure that the market value of its equity equals at least $15 billion. The bank staff charged with this responsibility, together with investors, would perform a disciplining role.
Top-down solutions, even if well-intended, have created the TBTF problem. If policy-makers have as an objective to end TBTF that can be achieved using a bottom-up that emphasizes market discipline.