Tuesday, January 26, 2010

Obama-Volcker Rule Will Not Prevent A Future Financial Crisis

If an institution has a high risk tolerance, then limiting leverage, a firm's size, and its activities will not reduce the riskiness of the firm.

As a simple example, suppose a financial institution has one asset category, residential real estate loans (mortgages) totaling $100. Suppose the bank is a prudent lender and requires a 50 percent downpayment for every mortgage (a 2 to 1 leverage ratio for the borrower). The bank's $100 of mortgages is backing $200 of homes. If the bank has $3 of equity, its leverage ratio is 33.3 to 1, $100 of loans to $3 of equity. The house price risk the bank undertook is leveraged 66.7 to 1. $200 of real estate collateral is backed by $3 of equity.

Suppose we require the bank to hold twice as much capital, $6 of equity instead of $3 for each $1 of loans. Does the bank keep it 50 percent downpayment requirement or does it reduce the downpayment?

If the bank wants the same risk, it will reduce the downpayment requirement for its mortgages to 25 percent. Now, its $100 of mortgages will back $400 of home value, and the bank's leverage ratio will look better, 100 to 6, 16.7 ratio, instead of 100 to 3, a 33.3 ratio. The risk though will be the same because $400 of real estate value is backed by $6 of equity for a ratio of 66.7. The bank has the same home value risk as before.

The value of a collateralized loan is dependent on both the expected default rate and the value of the collateral. If default rates increase, the value of the loan portfolio decreases. If the collateral value decreases, the loan portfolio value decreases. If both happen simultaneously, there is a greater loan value decrease than from either alone. If default rates correlate with collateral value, there will be further declines in portfolio value over and beyond those that occur if default rates are not correlated with asset values. During the crisis, some of the CDOs held by Bear Stearns and others lost 70 percent or more of their value, while still being current in principal and interest payments.

In real financial institutions with many categories of loans and investments, some collateralized and some not, it will be impossible for regulators to monitor or prevent the shift in to higher asset risk with a lower leverage ratio.

Accounting values will never capture all loan or bank asset risk. There is, as in the example above, hidden leverage. Additionally, there are embedded options in assets and loans that increase their riskiness over their dollar amounts. Also, there are co-movements, correlation, effects that are not easily recognizable by regulators.

The regulators will never see full interconnectedness. In one part of the country, a bank could be lending to a homebuilder while another bank is lending to the buyers of those homes. The two banks could be in different parts of the country, lending to different groups (buyers and builders), and yet the banks are interconnected in their fates. A third bank could be lending to a business that likes to open near new home developments. The third bank's fate is bound to the first two.

There is also asymmetric information risk between the regulator and the bank. Can a regulator distinguish the riskiness of different small businesses, related businesses, new ventures, similar loans to different geographical areas, different economy sectors?

Banks can always increase or decrease the risk of their assets to keep the institutions' riskiness constant as regulators change leverage ratios.

There is an unresolved aspect of the recent financial crisis that might help to determine how governing bodies should proceed.

Did the banks think their risk was lower than it actually was? In other words, did they, the markets, the regulators and others honestly believe that the real estate investments (mortgages, CDOs, MBSs, etc.) were safe investments that could be highly leveraged to realize more risk, but one that remained after increased leverage, a modest and a safe risk for the bank? Alternatively, did they have a high risk appetite, recognize the amount of risk they were taking and gamble and lose?

If the bankers, the markets, individuals and the regulators did not see the risk, then we had an unexpected earthquake in an area that never has earthquakes. Whatever we do to prevent future earthquakes will not prevent future unexpected events from happening, such as a lightning strike or a tsunami. Future financial market crises become an unpleasant fact like a rare lightning strike. Even those who say they saw a real estate bubble never expected the severity of the financial crisis, the failure of firms, and the extent of the economic downturn.

If bankers, individuals (remember they were the ones with the insatiable demand for homes and home loans) businesses, and possibly government saw the risk, gambled and lost, we have to focus on why the economy's risk tolerance rose. Without an understanding of what created higher risk tolerance, government and regulator attempts to reduce institutional risk will fail. Controlling size or allowing failures will not be enough. The institutions will find ways through regulatory arbitrage, asymmetric information, embedded, and non-observable risks to keep their riskiness at a high level. The regulator will be a cat who can never catch the mouse. Future financial crises from high risk will continue to occur despite regulatory efforts.

Part of the regulatory solution begins by recognizing that future catastrophic financial events will occur unexpectedly, despite best analysis and modifications to regulatory and institutional structure, creating huge losses to financial institutions and harming the real economy.

Governments and regulators need better plans for after the fact damage control to the economy and financial institutions whether or not it is unpreventable. We need to develop solutions to keep business and consumer lending available, and to minimize and undo all the other foreseeable negative financial and real economy effects that occur during and after a financial crisis.

While attempts to prevent financial crises is admirable, we may achieve more economic success by assuming they will occasionally occur and developing the equivalent of fire departments and the Red Cross to deal with situations after a crisis occurs.

Originally, governments and economists thought institutions like the Federal Reserve, Bank of England, etc. were enough of a fire department and aid organization. We need to rethink that philosophy and see if we need additional organizations or tools for future crises.

The above is a comment I posted on VOX blog, "Too interconnected to fail = too big to fail: What is in a leverage ratio?" by Danile Gros.

[Also see my other post: "Obama's New Bank Restrictions Increase Systemic Risk"]

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