BASEL ON THE WRONG PATH TO TACKLE SYSTEMIC RISK / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

July 6, 2011 2:32 pm

Basel on wrong path to tackle systemic risk

By Charles Goodhart

An enduring deficiency of our regulatory system has been that it has focused unduly on attempts to improve the resilience of individual banks and other systemically important financial intermediaries to shocks rather than concentrating on the stability of the financial system as a whole.


In doing so, regulation may unwittingly have actually added to procyclicality and systemic fragility, for example by encouraging all banks to behave in similar ways.


There is a danger that we may be about to reprise this same tendency in the shape of the Basel Committee on Banking Supervision and Financial Stability Board support for low-trigger contingent convertible bonds (cocos), which convert to equity once a pre-agreed measure of financial stress has been breached, and bail-inable bonds, which require bondholders to take losses should a bank collapse.

The phrase ‘low trigger’ implies that conversion does not occur until the value of the bank is really very low, i.e. near bankruptcy.


There is no question that such instruments would be extremely helpful in the context of the potential failure of any individual bank. Indeed, by helping to avoid deadweight bankruptcy costs, they could often benefit those facing the bail-in haircut.


But occasions of idiosyncratic failure of just one bank are quite easily handled by existing mechanisms. Problems arise instead when the system as a whole is facing a generalised macro shock, and a large segment of the financial system is under threat, usually causing fear and incipient panic.


When the first sizeable systemically important financial institution imposes haircuts, what will happen to the market for other banks trying to raise new money by issuing new bail-inable bonds or low-trigger cocos? Such markets would dry up completely.


By contrast, the advantage of continuing to guarantee senior bank debt, despite the greater loss then falling elsewhere (e.g. on Irish taxpayers), was that other banks not already in the throes of insolvency could continue to tap that market to meet the funding and liquidity needs that such a systemic shock generates.


Indeed, should a future systemic shock hit, and then lead, as it will, to the disappearance of markets for new low-trigger and bail-inable debt, then systemically important institutions will have to resort again to guarantees on new senior debt. We will then enter a world with both bail-inable and guaranteed debt, and the more there is of the latter, the more severe the haircut on the former, to the point that bail-inable bonds may become discredited as an asset class.


This same criticism cannot be levelled against high-trigger cocos. Here the idea, for example in the proposal put forward by academics Charles Calomiris and Richard Herring, is to induce systemically important banks to issue new equity after a systemic shock has reduced bank equity values but well before the bank approaches bankruptcy. That should also make it easier for these banks to tap debt markets as well.


Individual bank managers and existing shareholders will not much like the idea since it threatens them with dilution and falling equity prices in the face of a systemic shock, but the incentive on them to maintain a larger equity buffer is socially valuable.


But what should one do if the systemically important financial institution, having exhausted its high-trigger coco, should nonetheless continue its downward slide into bankruptcy? My own answer would be prompt corrective action, to intervene before insolvency befalls, based on a combination of market and accounting triggers.


Thus when both the market value of equity and the accounting value of equity fall, as a percentage of total assets, below preset trigger ratios (the market value being the most likely to breach its trigger first), the special resolution authority should be required to intervene, to fire the existing management and board, to wipe out existing shareholders, and to run the financial institution until a new private sector owner can be found. There could be some discretion for the authority to waive these sanctions, but only on the basis of a public explanation and with the agreement of the appropriate politician.


There are at least two, possibly many more, approaches to maintaining stability in the face of future systemic shocks. The first is to encourage much more equity, especially after the shock has hit, and to aim to intervene well before such equity becomes exhausted. The second is to allow a bit less equity (though much more than in Basel II) but to make up the leeway with low-trigger cocos and bail-inable bonds. The BCBS/FSB has been taking the second route. They would have done better to follow the first.


Charles Goodhart is professor emeritus of banking and finance at the London School of Economics and a former member of the Bank of England’s monetary policy committee
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Copyright The Financial Times Limited 2011.