Journal of Economic Perspectives—Volume 25, Number 1—Winter 2011—Pages 3–28
A Macroprudential Approach to
Financial Regulation
Samuel G. Hanson, Anil K Kashyap, and
Jeremy C. Stein
M
any observers have argued that the regulatory framework in place
prior to the global financial crisis was deficient because it was largely
“microprudential” in nature (Crockett, 2000; Borio, Furfine, and Lowe,
2001; Borio, 2003; Kashyap and Stein, 2004; Kashyap, Rajan, and Stein, 2008;
Brunnermeier, Crockett, Goodhart, Persaud, and Shin, 2009; Bank of England,
2009; French et al., 2010). A microprudential approach is one in which regulation
is partial equilibrium in its conception and aimed at preventing the costly failure of
individual financial institutions. By contrast, a “macroprudential” approach recognizes the importance of general equilibrium effects, and seeks to safeguard the
financial system as a whole. In the aftermath of the crisis, there seems to be agreement among both academics and policymakers that financial regulation needs to
move in a macroprudential direction. For example, according to Federal Reserve
Chairman Ben Bernanke (2008):
Samuel G. Hanson is a Ph.D. Candidate in Business Economics, Harvard University,
Cambridge, Massachusetts. From February to December 2009, Hanson was a Special Assistant
at the U.S. Department of the Treasury, Washington, D.C. Anil K Kashyap is Edward Eagle
Brown Professor of Economics and Finance and Richard N. Rosett Faculty Fellow, University of
Chicago Booth School of Business, Chicago, Illinois. Jeremy C. Stein is Moise Y. Safra Professor
of Economics, Harvard University, Cambridge, Massachusetts. From February to July 2009,
Stein was Senior Advisor to the Secretary, U.S. Department of the Treasury, and Staff Member
of the National Economic Council, both in Washington, D.C. Kashyap and Stein are both
Research Associates, National Bureau of Economic Research, Cambridge, Massachusetts.
Their e-mail addresses are ⟨shanson@fas.harvard.edu
shanson@fas.harvard.edu⟩⟩, ⟨Anil.Kashyap@chicagobooth.edu
Anil.Kashyap@chicagobooth.edu⟩⟩,
and ⟨ jeremy_stein@harvard.edu
jeremy_stein@harvard.edu⟩⟩.
■
doi=10.1257/jep.25.1.3
4
Journal of Economic Perspectives
Going forward, a critical question for regulators and supervisors is what their
appropriate “field of vision” should be. Under our current system of safetyand-soundness regulation, supervisors often focus on the financial conditions
of individual institutions in isolation. An alternative approach, which has been
called systemwide or macroprudential oversight, would broaden the mandate
of regulators and supervisors to encompass consideration of potential systemic
risks and weaknesses as well.
In this paper, we offer a detailed vision for how a macroprudential regime
might be designed. Our prescriptions follow from a specific theory of how modern
financial crises unfold and why both an unregulated financial system, as well as one
based on capital rules that only apply to traditional banks, is likely to be fragile. We
begin by identifying the key market failures at work: why individual financial firms,
acting in their own interests, deviate from what a social planner would have them
do. Next, we discuss a number of concrete steps to remedy these market failures. We
conclude the paper by comparing our proposals to recent regulatory reforms in the
United States and to proposed global banking reforms.
Theories of Financial Regulation
Microprudential Regulation
Traditional microprudential regulation of banks is based on the following
logic. Banks finance themselves with government-insured deposits. While deposit
insurance has the valuable effect of preventing runs (Diamond and Dybvig, 1983;
Bryant, 1980), it creates an incentive for bank managers to take excessive risks,
knowing that losses will be covered by the taxpayer. The goal of capital regulation
is to force banks to internalize losses, thereby protecting the deposit insurance
fund and mitigating moral hazard. Thus, if the probability of the deposit insurer
bearing losses is reduced to a low enough level, microprudential regulation is
doing its job.
To be specific, consider a bank with assets of $100 that is financed with insured
deposits and some amount of capital. Suppose that the regulator can check on the
bank once a quarter. Suppose further that the volatility of the bank’s assets is such
that with probability 99.5 percent, the assets do not decline in value by more than
6 percent during a quarter. Then if the goal of policy is to reduce the probability
of bank failure (whereby capital is wiped out and there are losses to the deposit
insurance fund) to 0.5 percent, this goal can be accomplished by requiring the bank
to have capital equal to 6 percent of its assets as a cushion against losses. Notice
that in this setting, the exact form of the capital cushion is not important. It can be
common equity, but it can equally well be preferred stock, or subordinated debt, as
long as these instruments are not explicitly or implicitly insured—that is, as long as
they will in fact bear losses in a bad state.
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
5
An important element of existing capital regulation is the presumption that
a bank will take immediate steps to restore its capital ratio in the wake of losses.
Returning to our example, suppose the bank starts out with capital of $6 but then
over the next quarter experiences losses of $2, so that its capital falls to $4. If the
volatility of its assets remains unchanged, in order for its probability of failure over
the subsequent quarter to stay at 0.5 percent, it would need to bring its capital ratio
back up to 6 percent. It could do so in one of two ways: either by going to the market
and raising $2 of fresh capital, or by leaving its capital unchanged and shrinking its
asset base to $66.67 (4/66.67 = 6 percent).
The basic critique of microprudential regulation can be understood as follows.
When a microprudentially oriented regulator pushes a troubled bank to restore
its capital ratio, the regulator does not care whether the bank adjusts via the numerator or
via the denominator—that is, by raising new capital or by shrinking assets.. Either way, the
bank’s probability of failure is brought back to a tolerable level, which is all that a
microprudential regulator cares about.
Such indifference to the method of adjustment makes sense if we are considering a single bank that is in trouble for idiosyncratic reasons. If that bank chooses
to shrink its assets—perhaps by cutting back on lending—others can pick up the
slack. Indeed, asset shrinkage in this case can be part of a healthy Darwinian process,
whereby market share is transferred from weaker troubled institutions to their
stronger peers. However, if a large fraction of the financial system is in difficulty, a
simultaneous attempt by many institutions to shrink their assets is likely to be more
damaging to the economy.
Macroprudential Regulation
In the simplest terms, one can characterize the macroprudential approach to
financial regulation as an effort to control the social costs associated with excessive balancesheet shrinkage on the part of multiple financial institutions hit with a common shock.. To
make a compelling case for macroprudential regulation, two questions must be
answered. First, what are the costs imposed on society when many financial firms
shrink their assets at the same time? Second, why do individual firms not internalize
these costs? That is, why do they not raise fresh capital rather than reduce assets
when a bad shock hits? Or alternatively, why do they not build sufficiently large
capital buffers ahead of time so that they can withstand a shock without needing
either to raise capital or to reduce assets?
Generalized asset shrinkage has two primary costs: credit-crunch and fire-sale
effects. If banks shrink their assets by cutting new lending, operating firms find
credit more expensive and reduce investment and employment, with contractionary
consequences for the economy. If a large number of banks instead shrink their
assets by all dumping the same illiquid securities (think of toxic mortgage-backed
securities) the prices of these securities can drop sharply in a “fire sale” of the sort
described by Shleifer and Vishny in this issue. Moreover, the fire-sale and creditcrunch effects are intimately connected (Diamond and Rajan, 2009; Shleifer and
6
Journal of Economic Perspectives
Vishny, 2010; Stein, 2010a). If a toxic mortgage security falls in price to the point
where it offers a (risk-adjusted) 20 percent rate of return to a prospective buyer, this
will tend to drive the rate on new loans up towards 20 percent as well—since from
the perspective of an intermediary that can choose to either make new loans or buy
distressed securities, the expected rate of return on the two must be equalized. In
other words, in market equilibrium, the real costs of fire sales manifest themselves
in the further deepening of credit crunches. Ivashina and Scharfstein (2010) offer
evidence on the extent of credit contraction during the recent crisis.
Of course, to make a case for regulatory intervention, one has to explain why
these 20 percent rates of return inside the financial sector—which are much higher
than the outside rates on, say, Treasury securities—don’t naturally draw in enough
private capital to eliminate the return differentials. One reason why capital is immobile once a crisis is underway is the “debt overhang” problem identified by Myers
(1977). Once a bank is in serious trouble and its debt is impaired in value, the
bank is reluctant to raise new equity even to fund investments that have a positive
net present value. This is because much of the value that is created is siphoned off
by the more senior creditors. Given the debt overhang problem, banks that act in
the interests of their shareholders will tend to fix their damaged capital ratios by
shrinking assets rather than by raising new capital, even when the latter is more
desirable from a social perspective.
If so, why don’t banks voluntarily build up adequate buffer stocks of excess
capital in good times, when debt overhang is not yet a concern, so they can absorb
losses in bad times without having to either shrink assets or raise new capital under
duress? After all, such a dry-powder strategy would allow them to exploit profitable
opportunities should a crisis arise. This question is addressed in Stein (2010a), who
extends the fire-sale model to consider banks’ initial choices of capital structure.
He shows that if short-term debt is a cheaper form of finance than equity, banks
will tend to take on socially excessive levels of debt: while the banks capture the
benefits of cheap debt finance, they do not internalize all of its costs.1 In particular,
when Bank A takes on more debt, it does not account for the fact that by doing
so, it degrades the collateral value of any assets it holds in common with another
Bank B—since in a crisis state of the world, A’s fire-selling of its assets lowers the
liquidation value that B can realize for these same assets.2
1
The assumption that short-term debt is a cheap form of finance represents a particular deviation from
the Modigliani–Miller (1958) capital-structure irrelevance framework. In the context of financial firms,
this deviation can arise to the extent that their short-term claims are “money-like” and carry a premium
that reflects their usefulness as a transactions medium. We discuss this point in greater detail below.
2
A subtlety is that this is a pecuniary externality—that is, it works through prices. For a pecuniary
externality to cause a misallocation of resources, one requires a departure from the standard assumptions that deliver the fundamental welfare theorems (Geanakoplos and Polemarchakis, 1986). In Stein
(2010a), this departure is in the form of a collateral constraint: banks’ ability to raise short-term debt is
constrained by the collateral value of their assets.
A Macroprudential Approach to Financial Regulation
7
In sum, a model based on fire sales and credit crunches suggests that financial
institutions have overly strong incentives 1) to shrink assets rather than recapitalize
once a crisis is underway, and 2) to operate with too thin capital buffers before a
crisis occurs, thereby raising the probability of an eventual crisis and systemwide
balance-sheet contraction. Therefore, the macroprudential approach to capital
regulation aims to counterbalance these two tendencies. With this in mind, we turn
next to some of the individual items in the macroprudential toolkit.
Before doing so, however, we should emphasize that, in contrast to the traditional view, nothing in this alternative theory relies on the existence of deposit insurance..
In other words, in a model of crises based on fire sales, there is socially excessive
balance-sheet shrinkage, and a rationale for regulation, even absent government
deposit insurance. Thus, there is a strong presumption that macroprudential regulation should apply to more than just insured deposit-takers. The broader point
(stressed by Tucker, 2010, and Kashyap, Berner, and Goodhart, forthcoming) is
that regulators need to pay attention to all the channels through which the actions
of financial institutions—both those who are insured and those who are not—can
cause damage.
Macroprudential Tools
We now discuss six sets of tools that can be helpful in implementing a macroprudential approach to financial regulation. Our goal here is not to provide a
comprehensive laundry list of reform proposals, but rather to show how a particular
conceptual framework provides a unified way of thinking about what otherwise
might seem like a hodgepodge of different fixes.
As a prelude, note that if the goal of regulation is to prevent financial firms
from shrinking their balance sheets excessively in an adverse state of the world, a
simple accounting identity imposes a lot of discipline on our thinking. In particular,
when a bank is hit with a shock that depletes its capital, there are only two ways to
prevent it from shrinking its assets: 1) it can raise new capital to replace that which
was lost; or 2) it can let its ratio of capital to assets decline. Many of the tools that we
discuss are just different mechanisms for facilitating adjustment on one of these two
margins. We start with capital proposals and then broaden the discussion to other
options that have heretofore been outside of the regulatory toolkit.
Time-Varying Capital Requirements
One intuitively appealing response to the problem of balance-sheet shrinkage
is to move to a regime of time-varying capital requirements, with banks being asked
to maintain higher ratios of capital to assets in good times than in bad times. Under
such a rule, banks can draw down their buffers when an adverse shock hits and
continue operating with less pressure to shrink assets. Kashyap and Stein (2004)
argue that time-varying capital requirements emerge as an optimal scheme in a
8
Journal of Economic Perspectives
Table 1
Capital Ratios for Top Four U.S. Banks, 2010Q1
Total risk-weighted assets
($ millions)
Tier 1 common equity to
risk-weighted assets (%)
Tier 1 capital to risk-weighted
assets (%)
Bank of
America
Citigroup
JPMorgan
Chase
Wells
Fargo
Weighted
average
1,519
1,023
1, 147
988
7.6
9.1
9.1
7.1
8.2
10.2
11.2
11.5
10.0
10.7
Sources: Data is from the websites of individual banks.
Note: This table lists the capital ratios for the four largest U.S. banks as of 2010Q1.
model where the social planner maximizes a welfare function that weights both
1) the microprudential objective of protecting the deposit insurance fund and
2) the macroprudential objective of maintaining credit creation during recessions.
A planner concerned with both objectives should be willing to tolerate a higher
probability of bank failure in bad times, when bank capital is scarce and credit
supply is tight, than in good times.
One challenge in designing such a regime is that, in bad times, the regulatory capital requirement is often not the binding constraint on banks. Rather,
as the risk of their assets rises, the market may impose a tougher test on banks
than do regulators, refusing to fund institutions that are not strongly capitalized.3
Table 1 shows that, as of the first quarter of 2010, the four largest U.S. banks had
an average ratio of Tier 1 common equity to risk-weighted assets of 8.2 percent and
an average ratio of total Tier 1 capital (including preferred stock, for example)
to risk-weighted assets of 10.7 percent. These are both well above the pre-crisis
regulatory standard, which required a ratio of total Tier 1 capital to risk-weighted
assets of 6 percent for a bank to be deemed “well capitalized.” Thus, even as the
U.S. economy was emerging from a deep financial crisis in early 2010, the regulatory constraint was nonbinding.
This pattern implies that to achieve meaningful time variation in capital ratios,
the regulatory minimum in good times must substantially exceed the market-imposed standard
in bad times.. Thus, if the market standard for equity-to-assets in bad times is 8 percent,
and we want banks to be able to absorb losses of, say, 4 percent of assets without
pressure to shrink, then the regulatory minimum for equity-to-assets in good times
3
This tendency may be amplified by the widespread use of “Value at Risk” (VaR) models by banks. As
measured volatility and hence VaR go up in bad times, such models mechanically call for banks to hold
higher ratios of capital. Thus, banks’ own internal risk management practices might compel shrinkage
even if market funding remains available.
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
9
would have to be at least 12 percent. A loss on the order of 4 percent of assets is
actually less severe than the experience of the major banks during the recent crisis;
the IMF (2010) estimates that cumulative credit losses at U.S. banks from 2007 to
2010 were on the order of 7 percent of assets. Using this figure, one could argue for
a good-times regulatory minimum ratio of equity to assets of 15 percent. Either way,
these are high values, significantly higher than obtained from a microprudential
calculation that asks only how much capital is needed to avert outright failure. (We
examine the potential costs of raising capital requirements by this much below, in
the penultimate section of the paper.)
Higher-Quality Capital
Traditionally, the capital metric given the most attention by regulators has
been the ratio of total Tier 1 capital to risk-weighted assets. In addition to common
equity, total Tier 1 capital includes, among other items, preferred stock. Thus, both
equity and preferred have “counted” in the same way towards satisfying capital
requirements. From a microprudential perspective, this makes perfect sense. If the
only concern is avoiding losses to the deposit insurer in the event of bank failure,
so long as both common and preferred holders are strictly junior in priority to the
deposit insurer, they will provide the desired loss-absorption cushion.
However, in the wake of the financial crisis, many investors and regulators
have discussed the “quality” of a bank’s capital base and how common stock is a
“higher-quality” form of capital than preferred. While this distinction is hard to
understand from a microprudential loss-absorption perspective, it flows naturally
from the macroprudential approach, which focuses less on a static failure scenario
and more on enabling troubled institutions to recapitalize dynamically and remain
viable as going concerns. Common equity is more friendly to the recapitalization
process than preferred stock because it is more junior and hence less problematic
in terms of the debt overhang problem described above.
To see this point, consider two banks, A and B. Both begin with total assets of
$100 and total capital of $6. But A’s capital is composed entirely of equity, while B
has $2 of equity and $4 of preferred. Now suppose both banks lose $3. To avoid
shrinking their assets, they would like to raise new capital. Suppose they do so by
trying to issue equity. This will be harder for Bank B—whose entire pre-existing
equity layer has been wiped out and whose preferred stock is, as a result, now trading
at a steep discount to its face value—for any new equity that B brings in will largely
serve to bail out the position of its more senior preferred investors.
This logic suggests that given the goal of promoting rapid recapitalization by
going-concern banks that run into trouble, it is entirely reasonable for regulators
to require that most of the capital requirement be satisfied with common equity.
Indeed, one can argue that essentially all of what is now the Tier 1 requirement
should be in terms of equity, or instruments that are contractually guaranteed to
convert into equity in a bad state (see below for a discussion), while more senior
securities like preferred stock should for the most part not count.
10
Journal of Economic Perspectives
Corrective Action Targeted at Dollars of Capital, Not Capital Ratios
When regulators are vigilant, banks that fall below a designated capital threshold
may be subject to a variety of sanctions (for example, restrictions on dividends)
until they repair their capital ratios. The principle of rapid regulatory intervention
is undoubtedly a good one, but the form of the intervention matters a great deal.
If a bank is put in the penalty box until it manages to fix its capital ratio,, it may well
choose to fix the ratio not by raising the numerator (capital) but by reducing the
denominator (assets).4 A better approach is to create incentives for the bank to raise
incremental dollars of new capital.
One way to implement this policy would be with a capital ratio requirement that
refers to the maximum of current and lagged assets. Imagine a bank that starts with
assets of $100 and capital of $8 at the end of year t, and suppose that the threshold for
corrective action is a capital ratio of 6 percent. Now assume that the bank has losses of
$4 over year t + 1, so it ends the year with $4 of capital. Normally regulators would push
the bank to get its ratio back to 6 percent, which it might do by shrinking its assets to
$66.67. Under our alternative, the bank would only get out of the penalty box when
its ratio of capital to the maximum of year t assets or year t + 1 assets exceeded 6 percent.
Given that year t assets were $100 and cannot be reduced retroactively, the bank would
have to raise $2 of new capital—it could not avoid sanctions by shrinking assets.
A dramatic illustration of this dollars-based corrective action principle comes
from the Supervisory Capital Assessment Program (SCAP), the “stress tests” that
the major U.S. banks underwent in spring 2009.5 The output of the SCAP was, for
each bank being tested, a dollar target for new equity capital that had to be raised,
via equity issues or asset sales. For some of the banks involved, the numbers were
very large—for example, Bank of America was required to raise $33.5 billion. The
penalty box in this case was that any bank failing to raise the capital from the private
markets would be required to accept an equity injection from the Treasury, which
would have involved strict limits on executive compensation. Remarkably, in the
few weeks following the release of the SCAP results, the banks involved were able to
raise nearly $60 billion in new common equity; by the end of 2009 this figure had
risen to over $125 billion.
Here is a case where a strong regulatory hand appears to have had highly
beneficial effects. Indeed, by being tough and giving banks no choice, regulators
probably made it easier for banks to do the capital raising. This is because absent
discretion, the adverse selection problem normally associated with equity issues
disappears. If a bank has a choice of whether to issue equity, its decision to do so
may signal that management believes it to be overvalued, and hence this issuance
may knock down the stock price (Myers and Majluf, 1984). But if it has no choice,
4
Hart and Zingales (2010) recommend forcing banks to issue equity whenever their credit risk (as
measured by spreads on credit default swaps) goes above a certain level. However, this does not address
the shrinkage problem, because a bank can also reduce its credit spreads by selling risky assets.
5
See Hirtle, Schuermann, and Stiroh (2009) for a fuller discussion of the lessons learned from the SCAP.
A Macroprudential Approach to Financial Regulation
11
there is no information content, and hence no negative price impact. We hope that
this lesson can be incorporated into regulatory policy going forward. As we note
below, it may be especially helpful in thinking about the phase-in of higher capital
requirements under Basel III.
Contingent Capital
A dollars-based corrective action policy amounts to an attempt to force banks
to recapitalize on the fly when they get into trouble. A closely related idea is to “prewire” the recapitalization with a contingent instrument that automatically increases
a bank’s equity position when some prespecified contractual provision is triggered.
Two broad types of contingent capital instruments have been proposed. The first,
sometimes called “reverse convertibles” or “contingent convertibles,” involves a bank
issuing a debt security that automatically converts into equity if a measure of either
the bank’s regulatory capital or stock market value falls below a fixed threshold
(Flannery, 2005; French et al., 2010).6 For example, in November 2009, Lloyds Bank
issued £7.5 billion in contingent convertible debt, with conversion to equity to be
triggered if Lloyds’ Tier 1 capital ratio falls below 5 percent.
A second type of contingent capital is “capital insurance,” which involves a bank
purchasing an insurance policy that pays off in a bad state of the world (Kashyap,
Rajan, and Stein, 2008). To address concerns about the insurer defaulting, the policy
would be fully collateralized—that is, the insurer would put the full amount of the
policy into a lock-box up front. For example, a bank might contract with a pension
fund to buy a capital insurance policy that pays $20 billion in the event that an economywide index of bank stock prices falls below some designated value any time in the
next five years. At initiation, the pension fund would turn the $20 billion over to a
custodian; if the bad state is not realized within five years, the $20 billion reverts back
to the pension fund, and if it is realized, the funds are transferred to the bank.
These designs share a common motivation. The premise is that banks view
equity capital as an expensive form of finance—in other words, there are one or
more violations of the Modigliani–Miller (1958) conditions that make banks reluctant to carry large precautionary buffers of equity. (We discuss the precise nature
of these violations in detail below.) In principle, regulation could simply mandate
that banks maintain very large equity buffers. However, it may be more efficient to
develop a financing arrangement that delivers more equity only in those bad states
where it is most valuable.
If these forms of contingent capital are such a good idea, why haven’t we seen
more of them? One simple answer is that they would have to be allowed to count
towards regulatory capital requirements. Consider the following approach. The
capital requirement for a bank in good times might be set at a relatively high level,
6
There are many important design issues associated with the specification of the trigger in a contingent
convertible security, with both pros and cons to using a trigger based on stock prices as opposed to
regulatory accounting numbers. See McDonald (2010) for a detailed discussion of these issues.
12
Journal of Economic Perspectives
say 20 percent. Banks would then be given a choice: they could satisfy the entire
requirement with equity, or they could satisfy up to say 10 percentage points of it
with a reverse convertible so long as it was contractually guaranteed to turn into
equity in a well-defined bad state. (As we discuss below, Swiss banking regulators
recently announced new rules of exactly this form.) The reverse convertible might
be seen as more costly than straight debt—which is why banks would not use it if it
did not count as regulatory capital—but as long as it was cheaper than equity, there
would be an efficiency gain.
Finally, it is worth noting the close connection between contingent capital and
proposals to reform executive compensation by imposing bonus holdbacks on key
employees of financial firms. For example, French et al. (2010) suggest withholding
a significant share of each senior manager’s total compensation for several years.
The withheld compensation would not take the form of stock or options, but would
instead be a fixed dollar amount. And, managers would forfeit their holdbacks if
the firm were to fail or to receive extraordinary government assistance.
Structurally, this holdback proposal is similar to the capital insurance scheme
of Kashyap, Rajan, and Stein (2008), with the key difference being that it requires
firm managers—rather than, say, a pension fund—to be the insurance provider.
The merit of this approach is that not only does the held-back compensation
create an extra, contingent capital buffer, it also helps to improve incentives
within the firm. In particular, by making insiders bear downside risk without any
additional upside potential, it aligns their fortunes with those of taxpayers and
other creditors—and in so doing, leans against the “heads I win, tails you lose”
risk-taking incentives created by more conventional forms of stock- and profitlinked compensation.
Regulation of Debt Maturity
One important lesson from the recent crisis is that the distinction between
short-term and long-term debt had been given insufficient attention by regulators. Table 2 presents a snapshot of the aggregate liability structure of the U.S.
banking system, including not only traditional commercial banks but also brokerdealer firms. Clearly, the majority of their debt is short-term: either in the form of
deposits or “wholesale” funding, which includes commercial paper and repurchase
(repo) agreements. While deposits are generally insured and hence not likely to
run at the first sign of trouble, the same is not true for wholesale funding. Indeed,
wholesale funding runs—a refusal of repo and commercial paper creditors to roll
over their loans—played a key role in the demise of Northern Rock, Bear Stearns,
and Lehman Brothers, among other high-profile failures (Shin, 2009; Gorton and
Metrick, 2010; Duffie, 2010).
The case for regulating the use of short-term debt by financial firms—above
and beyond regulating total leverage—rests on two observations. First, the ability of
short-term lenders to run leads to more fragility than in the case with an equivalent
amount of long-term debt (Diamond and Dybvig, 1983). It is hard to imagine that
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
13
Table 2
Liability Structure of U.S. Bank Holding Companies, 2009
$ trillion
Assets
% of assets
15.927
100.0%
Deposits
7.502
47.1%
Short-term wholesale funding
Repurchase agreements and federal funds purchased
Other short-term wholesale funding
Trading liabilities
Total
1.658
0.880
0.736
3.274
10.4%
5.5%
4.6%
20.6%
Long-term funding
Long-term wholesale funding
Subordinated debt and trust preferred
Total
1.718
0.416
2.134
10.8%
2.6%
13.4%
Other liabilities
1.570
9.9%
Total liabilities
14.480
90.9%
1.309
0.137
1.446
8.2%
0.9%
9.1%
Liabilities
Equity
Common stock
Preferred stock
Total equity
Sources: The table is based on data from the FR Y-9C reports that Bank Holding Companies are required
to file with the Federal Reserve.
Note: This table summarizes the liability structure of U.S. bank holding companies as of December 31,
2009.
Northern Rock, or Bear Stearns, or Lehman would have faced the same problems
had they done most of their borrowing on a long-term basis. Second, in the presence of marketwide fire sales, the choice of debt maturity creates an externality.
When an individual bank or broker-dealer opts to finance largely with short-term
debt, it fails to internalize that in a crisis, an inability to roll over short-term debt
will force it to liquidate assets, thereby imposing a fire-sale cost on others who
hold the same assets and who see the value of their own collateral diminished. The
result is a level of short-term financing that is socially excessive—hence the role for
regulation (Stein, 2010a).
Regulating the Shadow Banking System
The fire-sale risk associated with excessive short-term funding comes from not
just insured depositories, but rather, any financial intermediary whose combination of asset choice and financing structure may exacerbate a systemic fire-sale
problem. A narrow interpretation of this principle would say that regulation should
cover large, systemically significant nonbank institutions such as Bear Stearns and
14
Journal of Economic Perspectives
Figure 1
Quarterly Issuance of Asset-Backed Securities, 2000–2010Q2
350
Traditional (auto, credit cards, student loans)
Nontraditional (subprime, CDOs, CLOs)
300
$ billion
250
200
150
100
50
0
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8
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ar
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M
3
.0
ar
M
2
.0
ar
M
1
.0
ar
M
0
.0
ar
M
Source: The data underlying this figure come from Thompson SDC.
Notes: The figure plots the quarterly issuance of traditional versus nontraditional asset-backed securities
(ABS). Traditional ABS includes securitizations backed by auto loans, credit card receivables, and
student loans. Nontraditional issuance includes ABS backed by subprime mortgages, collateralized debt
obligations (CDOs), and collateralized loan obligations (CLOs). While the nontraditional category
includes securitizations backed by subprime mortgages, it does not include securitizations backed by
prime mortgages, such as mortgage-backed securities guaranteed by Fannie Mae or Freddie Mac.
Lehman Brothers, who did not finance themselves with insured deposits but who
were nevertheless subject to wholesale financing runs. While this specific point is
now well appreciated, the principle has broader application. From the perspective
of credit creation and macroeconomic impact, some of the most damaging aspects
of the crisis arose not just from the problems of individual large firms, but also from
the collapse of an entire market—namely
—namely the market for asset-backed securities.
Figure 1 illustrates this collapse.7 The market for “traditional” asset-backed securities, those based on credit-card, auto, and student loans, averaged between $50 and
$70 billion of new issues per quarter in the years prior to the crisis (total issuance for
2007 was $238 billion). However, in the last quarter of 2008, following the demise
of Lehman, issues in this category fell to just over $2 billion. The disappearance of
this market represented a major contraction in the supply of credit to consumers.
The investors who buy tranches of asset-backed securities frequently do so
by relying on short-term borrowing. Entities known as “structured investment
vehicles” or “conduits,” which in the past tended to be affiliated with sponsoring
7
The discussion in the remainder of this section is a much-abridged version of material in Stein (2010b).
A Macroprudential Approach to Financial Regulation
15
commercial banks, hold tranches of asset-backed securities and finance them with
commercial paper, which typically has a maturity of only days or weeks. Hedge
funds and broker-dealer firms may finance their holdings of asset-backed securities
with repurchase agreements, a form of overnight collateralized borrowing. Collectively, these various investors who acquire asset-backed securities and finance them
with short-term debt are often referred to as the shadow banking system.. Moreover,
as emphasized by Gorton (2010), Gorton and Metrick (2010), and Covitz, Liang,
and Suarez (2009), the collapse of the asset-backed securities market featured the
essential elements of a classic bank run—namely an inability of investors in assetbacked securities to roll over short-term financing.
One manifestation of the withdrawal of short-term lending to the asset-backed
securities market comes from the behavior of “haircuts” in repurchase agreements.
When an investor borrows in the repo market, the investor is required to post a
margin, or down payment, known as the “haircut.” Haircuts on most highly rated
asset-backed securities were very low prior to the crisis, on the order of 2 percent.
Thus, if a hedge fund wanted to buy $1 billion of AAA-rated, auto-linked assetbacked securities, it only needed to put up $20 million of its own capital. The other
$980 million could be borrowed on an overnight basis in the repo market; in many
cases the ultimate lenders were money-market mutual funds.8
In the midst of the crisis, haircuts skyrocketed. Even haircuts on consumer
asset-backed securities—which were not linked to subprime problems—rose to over
50 percent. From the perspective of the hedge fund holding $1 billion of such
securities, all of a sudden it could only borrow $500 million, and instead of having to
post a $20 million down payment, had to put up $500 million. If it did not have the
cash to do so, it would be forced to liquidate its holdings. These liquidations, and
the effect they had on the level and volatility of prices, in turn justified the increased
skittishness of the lenders in the repo market, since their protection depends on
the collateral value of the assets they lend against. In other words, the disruption to
the asset-backed securities market may have been what Brunnermeier and Pedersen
(2009) call a “margin spiral.”
From a macroprudential perspective, it would be a mistake to focus too
narrowly on the largest financial institutions while paying insufficient attention
to potential vulnerabilities in the rest of the system.9 What concrete steps might
be taken in this regard? A useful first principle is that an effort should be made to
impose similar capital standards on a given type of credit exposure irrespective of
8
This is not to say that the hedge fund’s overall leverage would be 50 to 1, as in this example—only that
it could borrow aggressively against certain highly rated assets that were seen as low risk and hence as
very good collateral.
9
Some have advocated a “narrow banking” model, whereby tightly regulated banks are restricted to
core deposit-taking and lending activities, and a substantial chunk of their other business is pushed out
to a more lightly regulated periphery. While such an approach may keep certain functions (such as the
payments system) safe, the risk is that the overall process of credit creation may be made more vulnerable, not less, to shutdown in the event of a crisis.
16
Journal of Economic Perspectives
who winds up ultimately holding the exposure—be it a bank, broker-dealer, hedge
fund, or special purpose vehicle. This task is not easy, but one tool that would help
is broad-based regulation of haircuts on asset-backed securities.10
Consider the case where the exposure is a consumer loan. If this loan is made
by a bank, it will be subject to a capital requirement. Now suppose instead that
the loan is securitized by the bank and becomes part of a consumer asset-backed
security whose tranches are distributed to investors. The regulation we have in mind
would stipulate that whoever holds a tranche of the asset-backed security would
be required to post and maintain a minimum haircut against that tranche—with
the value of the haircut depending on the seniority of the tranche, the quality of
the underlying collateral, and so forth. Such a requirement is nothing conceptually
new and should not be difficult to enforce; indeed, it is closely analogous to the
initial and maintenance margin requirements that are currently applicable to investors in common stocks. For models that suggest a role for haircut regulation, see
Geanakoplos (2010) and Stein (2010a).
If these requirements are well-structured, they would have two benefits. First,
they could help to harmonize regulation across organizational forms, thereby
reducing the incentive for lending activity to migrate into the shadow banking
sector. Second, for those assets that do end up in the shadow banking system,
haircut regulation can dampen the destabilizing dynamics described above. If haircuts start out at 2 percent and then jump to 50 percent in a crisis, this creates a
powerful forced-selling pressure on owners of asset-backed securities. If haircuts are
set instead at a higher value before the crisis, this forced-selling mechanism and the
vicious spiral it unleashes might be attenuated. Note that central banks, through
their discount window and emergency-lending facilities, have already developed
significant expertise in determining prudent values of haircuts on various kinds of
asset-backed securities.
While we have focused on regulations that address fire-sale externalities, the
problems of the asset-backed securities market arguably go beyond fire sales. Hanson
and Sunderam (2010) show that the “tranching” process, by which large fractions
of underlying collateral pools are turned into AAA-rated securities, can blunt the
incentives of investors to become informed about what they are buying—because
AAA-rated securities are ostensibly so low risk that the returns to becoming informed
are minimal. A lack of informed investors can in turn make securitization markets
more fragile when times turn bad and the need to analyze securitization cash flows
rises. This implies that regulators should worry about the structure of securitizations—particularly the amount of AAA-rated securities being manufactured from
any given collateral pool.
10
A more general version of this observation is that a regulatory toolkit with only a capital ratio and a
single liquidity ratio will be inadequate for controlling instability arising from deposit defaults, fire sales,
and credit crunches (Kashyap, Berner, and Goodhart, forthcoming).
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
17
What Are the Costs of Higher Capital Requirements?
We have argued that a macroprudential approach involves imposing substantially higher capital requirements on financial firms, particularly in good times.
But will these higher capital requirements lead to increased costs for borrowers? In
what follows, we focus on the long-run steady-state consequences of higher capital
requirements, setting aside the transitional issues associated with phase-in of a new
regime.11 To preview, our reading of the theory and relevant empirical evidence
suggests that while increased capital requirements might be expected to have some
long-run impact on the cost of loans, this effect is likely to be quite small.
A Modigliani–Miller Perspective
Modigliani and Miller (1958) famously showed that under certain conditions, a
firm’s capital structure is irrelevant for its operating decisions. In the banking context,
this would imply that the rate that a firm charges on its loans should be independent
of its capital ratio. The Modigliani and Miller conditions are stringent, including
no taxes, symmetric information, rational risk-based pricing, and cashflows that are
independent of financial policy. Thus, they are not meant as an accurate depiction
of reality. Rather, the value of the Modigliani and Miller framework is that it forces
one to be precise about which of the conditions is violated, and this allows for a more
disciplined analysis of the effects associated with changes in capital structure.
In particular, the Modigliani and Miller paradigm exposes the flaw in the
following reasoning: “Equity is more expensive than debt because it is riskier. Thus,
if a bank is forced to rely more on equity, its overall cost of finance will go up, and
it will have to charge more for its loans.” The fallacy here is that the risk of equity,
and hence its required return, is not a constant, but rather declines as leverage
falls.12 Indeed, when all the Modigliani and Miller conditions hold, this effect is just
enough to offset the increased weight of the more-expensive equity in the capital
structure so that the overall cost of capital stays fixed as bank leverage varies.
With this caveat in mind, we discuss two deviations from Modigliani and
Miller’s idealized conditions that are likely to be relevant in the present context.
First, interest payments on corporate debt are tax deductible while dividend
payments on equity are not. This effect lends itself to easy measurement. Suppose
that new equity capital displaces long-term debt in a bank’s capital structure and
that the only effect on the bank’s weighted average cost of capital comes from the
lost tax shields on the debt. If the coupon on the debt is 7 percent, and given a
corporate tax rate of 35 percent, each percentage point of increased equity raises
11
This section draws on material from our unpublished working paper, Kashyap, Stein, and Hanson
(2010).
12
In Kashyap, Stein, and Hanson (2010), we show that this holds empirically in the banking sector: in a
panel of large banks, those with less leverage have significantly lower values of both beta and stock-return
volatility.
18
Journal of Economic Perspectives
the weighted average cost of capital by .07 × .35 = .0245 percent, or 2.45 basis
points. Thus, even a 10 percentage-point increase in the capital requirement only
boosts the weighted average cost of capital—and hence loan rates—by 25 basis
points, which is a small effect.
To generate a higher figure, consider a case where equity displaces shortterm debt; this can be interpreted as capturing the joint effects of an increase
in both capital and liquidity requirements. Moreover, following Gorton (2010),
Gorton and Metrick (2010), and Stein (2010a), assume that—in violation of the
Modigliani and Miller conditions—there is a non-risk-based “money” premium
on wholesale short-term bank debt that reflects its usefulness as a transactions
medium. (Commercial paper and repo are often held by money-market mutual
funds, who in turn issue checkable deposits.) An upper-bound estimate of this
money premium might be on the order of 100 basis points.13 Now, a 10 percentagepoint increase in capital requirements raises the weighted average cost of capital
by an added 10 basis points relative to the previous taxes-only case, and we are up
to 35 basis points. This number is still quite modest.
Time Variation in Bank Capital Ratios and Lending Rates
Our calibrations based on the Modigliani–Miller paradigm suggest that the
long-run effects of higher capital requirements on loan rates should be small. A
complementary approach is to examine the historical record. Figure 2A, which is
adapted from Berger, Herring, and Szego (1995), shows the ratio of book equity to
book assets for U.S. commercial banks from 1840 to 2009. Capital ratios exceeded
50 percent in the 1840s and fell steadily for the next 100 years, reaching 6 percent
by the 1940s. Have these large fluctuations in capital ratios translated into big differences in the cost of bank credit? To address this question, we have examined the
behavior of various proxies for the markup that banks charge on loans. In a variety
of regression specifications (not shown here), we found no reliable time-series
correlation between these markup variables and bank capital ratios. The historical
data is simply too noisy, and our proxies for loan spreads too crude, for us to draw
any confident conclusions about whether a correlation between equity ratios and
loan rates even exists..
To illustrate the loose ties between loan costs and capital ratios, Figure 2B
plots capital ratios for the period 1920–2009 against two markup proxies: 1) the
net interest margin (net interest income over earning assets); and 2) the yield on
loans (interest income on loans over gross loans) minus the rate paid on deposits
(interest expense on deposits over deposits). As can be seen, there is no apparent
correlation between capital ratios and either measure of markups.
13
As a benchmark, Krishnamurthy and Vissing-Jorgensen (2010) estimate that Treasury securities
impound a money-like convenience premium of approximately 72 basis points, on top of what would be
expected in a standard risk-vs.-return asset-pricing setting.
A Macroprudential Approach to Financial Regulation
19
Figure 2
U.S. Bank Capital Ratios and Loan Spreads
A: Book Equity to Assets for U.S. Banks, 1840–2009
60%
Equity to assets
50%
40%
30%
20%
10%
0%
00
10
20
20
90
80
19
19
70
60
19
19
50
40
19
19
30
19
20
10
19
19
00
90
19
18
80
70
18
18
60
50
18
18
40
18
B: Relationship between Loan Spreads and Bank Equity/Assets, 1920–2009
16%
7%
14%
6%
12%
5%
10%
4%
8%
3%
6%
2%
4%
1%
10
20
00
20
90
19
80
19
70
19
60
19
50
19
40
19
30
19
20
19
Bank equity/assets (left scale)
Bank net interest margins (right scale)
Bank loan yield - Deposit rate (right scale)
Sources: Data from 1840 to 1896 is based on Berger, Herring, and Szego (1995) who use data from the
Statistical Abstracts of the United States. Data from 1896 to 1919 is based on data for “All Banks” from the All
Bank Statistics, 1896–1955 (Board of Governors of the Federal Reserve, 1959). Data from 1919 to 1933 is
based on Federal Reserve member banks and is from Banking and Monetary Statistics, 1919–1941 (Board
of Governors of the Federal Reserve, 1943). Data from 1934 to 2010 is for all insured commercial banks
and is from the FDIC’s Historical Statistics on Banking.
Notes: Figure 2A plots the ratio of book equity to book assets for U.S. commercial banks from 1840 to
2009. Figure 2B plots two measures of bank loan spreads versus equity/assets from 1920 to 2009. We
measure loan spreads using either the net interest margin (net interest income over earning assets)
or the yield on loans minus the rate paid on deposits (interest income on loans over gross loans minus
interest expense on deposits over deposits).
20
Journal of Economic Perspectives
But Then Why Are Banks So Determined to Operate with High Leverage?
These conclusions may appear surprising, even paradoxical. If significant
increases in capital ratios have only small consequences for the rates that banks
charge their customers, why do banks generally feel compelled to operate in
such a highly leveraged fashion in spite of the risks this poses? And why do they
deploy armies of lobbyists to fight increases in their capital requirements? After
all, nonfinancial firms tend to operate with much less leverage and indeed appear
willing in many cases to forego the tax (or other) benefits of debt finance altogether.
In Kashyap, Stein, and Hanson (2010), we argue that the resolution of this
puzzle has to do with the nature of competition in financial services. The most
important competitive edge that banks bring to bear for many types of transactions
is the ability to fund themselves cheaply. Thus, if Bank A is forced to adopt a capital
structure that raises its cost of funding relative to other intermediaries by 20 basis
points, it may lose most of its business, (or become much less profitable, since the
return on assets in banking is on the order of 125 basis points). Contrast this with,
say, the auto industry, where cheap financing is only one of many possible sources
of advantage: a strong brand, quality engineering and customer service, and control
over labor costs may all be vastly more important than a 20 basis-point difference in
the cost of capital.
One suggestive piece of evidence for this competition hypothesis comes from
the distribution of capital ratios by bank size, as illustrated in Figure 3, which covers
the period 1976–2009. There is a strong inverse relationship between bank size
and capital ratios, with the smallest banks (with assets under $100 million) having
Tier 1 risk-based capital ratios more than double those of the largest banks (with
assets over $100 billion) for most of the sample period. Whatever their root cause,
these large differences in capital ratios hint at a couple of important points. First,
they suggest that several percentage points of additional capital need not imply
prohibitively large effects on lending rates—for if they did, it would be hard to
understand how the smaller community banks have managed to stay in business.
Second, the ability of small banks to survive at higher capital levels probably reflects
something about the softer degree of competition in their core line of business. A
large literature argues that small banks tend to focus on informationally intensive
“relationship lending” and that the embedded soft information in these relationships creates a degree of specificity between firms and their lenders (Rajan, 1992;
Petersen and Rajan, 1994, 1995; Berger, Miller, Petersen, Rajan, and Stein, 2005).
To the extent that larger banks deal with larger customers where competition from
other providers of finance is more intense, even small cost-of-capital disadvantages
are likely to prove unsustainable.
Testing the Competition Hypothesis
To further investigate the competition hypothesis, we examine the effects of
changes in state branching regulations. We test two basic predictions. First, we expect
that a regulatory shock that increases the degree of competition in a state should
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
21
Figure 3
U.S. Bank Capital Ratios by Bank Size, 1976–2009
A: Book Equity to Book Assets
14%
12%
10%
8%
6%
4%
2%
08
20
08
20
06
20
07
20
04
02
20
00
20
98
20
19
96
19
94
92
19
90
19
19
88
19
86
19
84
19
82
19
80
78
19
76
19
19
B: Tier 1 Risk-Based Capital Ratios
20%
18%
16%
14%
12%
10%
8%
6%
09
20
06
20
$100m < Assets < $1B
05
20
04
20
03
20
02
20
01
20
$10B < Assets < $100B
00
20
99
19
98
19
97
19
96
19
Assets < $100m
$1B < Assets < $10B
Assets > $100B
Source: The figure is based on data from bank Call Reports.
Notes: This figure plots capital ratios by bank size from 1976–2009. Banks are placed into size groups
based on assets in 2008Q4 dollars. Figure 3A plots book equity to book assets. Figure 3B plots Tier
1 capital ratios (Tier 1 regulatory capital over risk-weighted assets). All banks owned by a given bank
holding company are combined into a single organization for the purposes of this size classification.
22
Journal of Economic Perspectives
lead the average capital ratio of banks in that state to decline. Second, we expect a
compression effect:: the decline in capital ratios should be largest for those banks in the
state that, prior to the shock, were operating with the highest capital ratios. Or said
differently, we expect the regulatory shock to reduce the cross-sectional dispersion
of capital ratios of banks in the given state.
To implement our tests, we take data on the year that various state banking
regulations were relaxed from Stiroh and Strahan (2003). We examine two types
of deregulation: the easing of intrastate branching restrictions and the advent of
interstate banking. Prior to 1970, two-thirds of states had restrictions on intrastate
branching which were relaxed from 1975 to 1992. Between 1982 and 1993, 48 states
entered into regional or national agreements permitting interstate banking—i.e.,
allowing out-of-state bank holding companies to own banks in their state. Given the
timing of deregulation, we focus on bank data (from bank Call Reports) over the
period from 1976 to 1994. Since our source of variation is at the state-year level, we
work with state-year aggregates. We estimate reduced-form regressions of the statelevel equity-to-asset ratio on dummies that switch on in the year that a state relaxes
its regulations, along with state and year fixed effects. We have two deregulatory
dummies: INTRASTATE is based on the year that a state allows intrastate branching
by mergers, while INTERSTATE is based on the year that a state enters a regional or
national interstate banking agreement.
Table 3 displays the results of these regressions where the dependent variable in the first column is the mean equity-to-asset ratio in state s in year t ; in the
second column is the cross-sectional standard deviation of equity-to-assets; and in
the remaining columns are the cross-sectional quantiles of the equity–asset ratio.
The results in the first column imply that equity-to-assets falls by about 0.3 percentage
points following intrastate branching and another 0.2 percentage points following
interstate banking. Thus, equity-to-assets falls by roughly 0.5 percentage points for
the average state relaxing both restrictions. This decline can be compared to the
typical cross-sectional standard deviation of 1.08 percentage points and is economically meaningful considering that the average equity-to-assets ratio in our sample is
just over 7 percent.
The remaining columns in Table 3 show that, consistent with the notion of
a compression effect, the dispersion of capital ratios within a state falls following
deregulation, and capital ratios fall the most for those banks that were previously
in the upper tail of the distribution. This appears to have been particularly true
following the advent of intrastate banking: the capital ratios of banks in the 75th and
90th percentiles of the distribution fall by 60 and 70 basis points, respectively, versus
only a 10 basis point change at the 10th and 25th percentiles.
In sum, the data support the hypothesis that when banks are faced with more
intense competition, they gravitate towards both higher and more uniform levels
of leverage. Such competitive effects combined with our earlier Modigliani–Millerbased calibration results suggest one reason why tougher capital regulation of
financial firms is appealing: it would seem to have the potential to reduce competition
A Macroprudential Approach to Financial Regulation
23
Table 3
Impact of Deregulation on Distribution of Equity-to-Assets within States
Dependent variable
Mean
Standard
deviation
10th
%tile
25th
%tile
50th
%tile
75th
%tile
90th
%tile
Regression 1:
INTRASTATE
–0.288
[–2.10]
–0.274
[–2.75]
–0.099
[–0.70]
–0.106
[–0.81]
–0.193
[–1.49]
–0.626
[–2.47]
–0.682
[–2.40]
Regression 2:
INTERSTATE
–0.217
[–2.25]
–0.133
[–0.68]
0.037
[0.31]
–0.182
[–1.46]
–0.278
[–2.68]
–0.290
[–1.96]
–0.349
[–1.73]
Regression 3:
INTRASTATE
–0.281
[–2.05]
–0.270
[–2.68]
–0.100
[–0.71]
–0.100
[–0.78]
–0.183
[–1.41]
–0.617
[–2.44]
–0.671
[–2.33]
INTERSTATE
–0.203
[–2.05]
–0.120
[–0.62]
0.042
[0.34]
–0.177
[–1.43]
–0.269
[–2.62]
–0.261
[–1.69]
–0.317
[–1.47]
Sources: Based on an annual state-level panel from 1976–1994 assembled from bank Call Reports. The
deregulation dummies are based on the data in Table 1 of Stiroh and Strahan (2003).
Notes: The table shows regressions of equity-to-assets on dummies for deregulation. The INTRASTATE
dummies switch on beginning in the year when the state first permitted intrastate branching via mergers.
The INTERSTATE dummies switch on beginning in the year when the state entered a regional or national
interstate banking agreement. The dependent variables are alternately the asset-weighted average, standard
deviation, and quantiles of the equity-to-assets ratio within each state-year. The table reports coefficients
from 21 separate regressions (7 dependent variables each with 3 specifications). All regressions include a
full set of state and year effects and have 969 observations (51 states × 19 years). t-statistics, in brackets, are
based on standard errors that are robust to clustering (i.e., serial correlation of residuals) at the state level.
on a dimension that creates negative externalities and systemic risk, while at the
same time not raising loan rates by much. However, the complication is that these
same competitive pressures also create powerful incentives to evade either the letter
or the spirit of the rules. Thus, the most worrisome long-run byproduct of higher
capital requirements will likely not be its effect on the cost of credit to borrowers, but
the pressure it creates for activity to migrate outside of the regulated banking sector.
A Financial Reform Report Card
To conclude the paper, we briefly compare our proposals to policy reforms that
emerged in the second half of 2010. Our focus is primarily on the recommendations
made by the Basel Committee on Banking Supervision in September 2010 as part
of the so-called “Basel III” process (see Basel Committee on Banking Supervision,
2010, for a summary). We will say less about the Wall Street Reform and Consumer
Protection Act—often called the Dodd–Frank legislation—that was signed into law
in July 2010. This is because our analysis has been centered on capital regulation
and closely related issues, the implementation of which has been taken up in more
specific numerical detail in Basel III; conversely, we have not attempted in this paper
24
Journal of Economic Perspectives
to speak to a number of the other central elements in Dodd–Frank, such as consumer
protection, regulation of over-the-counter derivatives, and resolution authority.
We have stressed the importance of requiring that financial firms have both
more capital, and, crucially, higher-quality capital. On this score, the Basel III
recommendations look quite good. They would raise the minimum common equity
requirement from 2 percent of risk-weighted assets to 7 percent (this is inclusive of
a “capital conservation buffer”). While we have argued for a higher number, this is a
significant step in the right direction. Moreover, systemically important institutions
will be required to have an additional, as-yet-undetermined increment in terms of
equity capital, which, if it turns out to be material, would be further good news.
The major shortcoming on the equity capital front is its very slow phase-in; the
new requirements do not become fully effective until January 2019. The motivation
for this slow phase-in is the concern that if banks are asked to comply with the higher
ratios in a more compressed timeframe, they will do so by shrinking their balance
sheets rather than by raising new external equity capital, thereby causing a further
credit crunch. While we agree that this worry might be legitimate if the phase-in is
truncated and no other offsetting steps are taken, our above analysis suggests an
obvious alternative: during the phase-in period, regulators should push those banks
that are shy of the new capital standards to raise new dollars of equity,, rather than giving
them the option to adjust via asset shrinkage. The U.S. stress tests conducted in 2009
showed that this approach can work, and if it were applied again, the phase-in period
could be made much shorter with little adverse impact on credit supply.
We also discussed the usefulness of time-varying capital requirements. Here the
Basel Committee proposes an additional countercyclical buffer that will range between
0 and 2.5 percent, to be implemented on a country-by-country basis. As the report
states: “The purpose of the countercyclical buffer is to achieve the broader macro
prudential goal of protecting the banking sector in periods of excess aggregate
credit growth. For any given country, this buffer will only be in effect when there is
excess credit growth that is resulting in a system wide build up of risk.” This too is a
step in the right direction, though we worry that the wording would seem to require
an affirmative finding of “excess credit growth” for the requirement to kick in; one
can imagine that it will be politically challenging for regulators to make this case
when they ought to.
Other elements of the reform package remain less well developed. For example,
on the topic of debt maturity, the Basel Committee introduces the concept of a
“net stable funding ratio” test—a requirement that financial firms’ capital structures
have a certain amount of long-term funding, which would encompass both equity
and debt with a maturity of greater than one year. However, the details regarding
the design and calibration of this rule remain to be worked out, with an “observation period” to begin in 2012 and the introduction of the standard itself put off
until 2018.
Similarly, while the Basel Committee continues to study various forms of contingent capital, it has not yet reached any final conclusions; a review is scheduled to
Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein
25
be completed in mid 2011. Interestingly, however, Swiss banking regulators have
chosen to move forward on their own on this front. The Final Report of the Swiss
Commission of Experts proposed that the two big Swiss banks—UBS and Credit
Suisse—be required to have 19 percent total capital by 2019. Of this, 10 percent
would have to be in common equity (a higher standard than the 7 percent under
Basel III) while the remaining 9 percent could, at the bank’s discretion, take the
form of contingent convertibles that would convert when the ratio of equity to assets
hit a predetermined trigger value (Morgan Stanley Research, 2010). This “opting”
approach to contingent capital is, both qualitatively and quantitatively, closely in
line with what we described above.
Finally, perhaps the most glaring weak spot in financial reform thus far—one
that cuts across both the Dodd–Frank legislation and the Basel III process—is the
failure to fully come to grips with the shadow banking system. As we have emphasized,
if one takes a macroprudential view, the overarching goal of financial regulation
must go beyond protecting insured depositories and even beyond dealing with the
problems created by “too-big-to-fail” nonbank intermediaries. Instead, the task is to
mitigate the fire-sales and credit-crunch effects that can arise as a consequence of
excessive short-term debt anywhere in the financial system..
While higher capital and liquidity requirements on banks will no doubt help to
insulate banks from the consequences of large shocks, the danger is that, given the
intensity of competition in financial services, they will also drive a larger share of
intermediation into the shadow banking realm. For example, perhaps an increasing
fraction of corporate and consumer loans will be securitized and in their securitized
form will end up being held by a variety of highly leveraged investors (say hedge
funds) who are not subject to the usual bank-oriented capital regulation. If so,
the individual regulated banks may be safer than they were before, but the overall
system of credit creation may not.
To safeguard the system as a whole, attention must be paid to not tilting the
playing field in a way that generates damaging unintended consequences. Admittedly, regulating the shadow banking sector and the other parts of the financial
system consistently is a complex task, and one that will require a variety of specific
tools. As one concrete first step, we reiterate that it would be a good idea to establish
regulatory minimum haircut requirements on asset-backed securities, so that no
investor who takes a position in credit assets is able to evade constraints on shortterm leverage.
This discussion raises a final question about how such regulation might be
implemented. In the United States and in Europe, macroprudential oversight has
been delegated to large councils: the Financial Stability Oversight Committee and
the European System Risk Board, respectively. Membership of both groups consists
of the heads of many regulatory organizations. Whether either council can function
effectively and avoid turf wars is an open question. But these committees will be
pivotal in determining whether existing weaknesses in the regulatory system—such
as those having to do with the shadow banking sector—can be addressed sensibly.
26
Journal of Economic Perspectives
■ We are grateful for helpful comments from Charles Goodhart, Arvind Krishnamurthy, Andrew
Metrick, Victoria Saporta, Hyun Shin, Andrei Shleifer, René Stulz, Lawrence Summers, Paul
Tucker, seminar participants at numerous institutions, and JEP editors David Autor, Chad
Jones, and Timothy Taylor. Kashyap thanks the Initiative on Global Markets and the Center
for Research on Securities Prices for research support on this project.
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