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

We have extensive experience with TBR in connection with private mortgage insurance companies (PMIs), which have been subjected to it since the industry began in 1956. PMIs have allocated 50 percent of their premium income to a contingency reserve for 10 years.

These reserves have allowed the PMIs to meet all their obligations in connection with the extraordinary losses suffered by lenders during the current crisis. They may or may not make it, depending on how long the crush of foreclosures lasts, but if not for TBR, they would have received government support or disappeared a long time ago.

A systemic-risk regulator armed with TBR could cope with the next threat to financial stability, whatever that turned out to be. Because TBR is transaction-based rather than institution-based, the regulator’s jurisdiction would extend to any institutions involved in transactions that it viewed as a threat to systemic stability.

Of course, the rules could vary by type of institution, and lots of details need to be worked out, such as the rules for determining the risk component of various kinds of transactions, and for investing and safeguarding reserves. Rules must also be developed for firms that originate risky transactions and then sell all or part of their interest.

In such cases, the required reserve allocation might be divided among all those in the chain of ownership, which would be a way to assure that they all had some "skin in the game."

Alternatively, the entire allocation might be imposed on the last actor in the chain, who would transmit the burden back through the chain in the price paid.

A great advantage of TBR, relative to capital requirements, is that TBR does not depend on discretionary actions by the regulator to offset the excessive optimism that feeds bubbles. Once the TBR rules are established, a shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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