Editor’s note: This is Part 4 of a multipart series.
In last week’s article, I made the point that we should expect that TBTF firms (those "too big to fail") will remain a permanent part of our financial system. The only way to avoid having to rescue them with taxpayer funds when they get into trouble is to prevent them from getting into trouble. This requires a substantially improved regulatory system.
But most of the recent proposals designed to strengthen the regulatory system are reminiscent of the old adage concerning generals preparing to fight the last war.
A core problem is that we don’t know where the next shock to financial stability will come from, and what financial instruments will be used to make the big bets that ultimately turn sour. The next time, the malefactors may very well be firms that are not on anybody’s radar screen today, using financial instruments that do not now exist.
We should have learned this from the unexpected features of the most recent crisis. Who would have guessed that the largest of the recklessly risky bets, requiring the largest government rescue, were laid by AIG, a holding company that mainly owned insurance companies and was essentially unregulated.
Because it also owned a thrift, AIG was legally subject to regulation by the Office of Thrift Supervision, but that agency did not have the knowledge or resources to deal with an insurance company with affiliates in 130 countries, and evidently did not make a huge effort. Further, the credit default swaps that AIG used to make its bets was a relatively new instrument.
One of the few useful proposals that have emerged from the post-crisis postmortems has been to create a systemic-risk regulator whose jurisdiction is not limited to conventional industry boundaries. It is essential that the regulatory net be made wide enough to cover all the firms that might become important players in the next emerging bubble leading to a crisis.
It is also essential that the systemic-risk regulator have the proper tools. Capital requirements, which regulators now depend on to ensure safety and soundness, don’t do the job, for reasons noted last week. The regulator must be able to remove some of the profit from taking excessive risk during a bubble period, while requiring that firms taking on these risks increase their capacity to bear loss.
The needed tool is transaction-based reserving, or TBR. Under TBR, financial firms are obliged to contribute a part of risk-based income to a contingency reserve account that is not accessible for 10 years except in an emergency. Income allocated to reserves would not be taxable until it was withdrawn 10 years later.
Here is an oversimplified example: The lender makes a prime home mortgage loan at 5 percent; the risk component of the rate is 1 percent; and the TBR is half of that, or 0.5 percent. The lender shifts to a subprime loan at 7 percent; the risk component is now 3 percent; and the TBR is 1.5 percent. The capital requirement doesn’t change, but the TBR reduces the profitability of the shift, and if the lender does it anyway, the required allocation to the contingency reserve becomes three times as large. …CONTINUED