Keeping the financial system safe

Last week I discussed why capital requirements — requiring firms to have capital equal to some percentage of their assets — cannot prevent financial crises. Among other evasions, regulated firms can shift to riskier assets (such as subprime mortgages) within the asset categories defined by the regulations. Discretionary actions by regulators to offset such shifts during a bubble period would be extremely disruptive, requiring more foresight and political courage than we have any reason to expect from public servants.

Proposals have emerged to rectify these weaknesses of capital requirements by automating the adjustment process. This would require identifying one or more statistical measures to which capital requirements would be tied. When the measures indicated that a bubble was under way, capital requirements would increase automatically, and when the measures indicated that markets were contracting, requirements would decline.

While there are many good indicators of a contracting system that follows a bubble, there are no universal indicators of bubbles themselves. Bubbles can arise anywhere, and they can involve newly fashioned financial instruments that did not exist before. Because of this, automating capital requirements would not work.

The Alternative to Capital Requirements

A good alternative to capital requirements is transaction-based reserving (TBS). Under TBS, financial firms are regulated as if they were insurance companies that are obliged to contribute to a reserve account in connection with every asset they acquire. The portion of the cash inflows generated by the asset that is allocated to the reserve account depends on the potential future outflows associated with the asset. For example, a life insurance company that sells a policy to a 70-year-old will allocate a larger portion of the premiums it receives to a reserve account than the same policy sold to a 30-year-old.

As applied to a depository, the required allocation to a contingency reserve would be, say, 50 percent of the portion of any charge that is risk-based. If a prime mortgage were priced at 6 percent and zero points, for example, the reserve allocation for a 7 percent, 2 point mortgage might be ½ percent plus 1 point.

Contingency reserves can’t be touched for a long period, perhaps 15 years, except in an emergency. Of course, income allocated to reserves would not be taxable until it was withdrawn 15 years later.

The Great Advantage

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. A shift to riskier loans during periods of euphoria automatically generates larger reserve allocations because riskier loans carry higher risk premiums.

Another advantage of TBR is that it applies to every transaction with a risk component, whether it is shown on the firm’s balance sheet or not. The principal responsibility of the regulator is to establish the risk component of every type of transaction. When credit default swaps appeared, for example, the TBR regulator would immediately have realized that the premium was 100 percent risk-based, and sellers would have been obliged to reserve 50 percent of their premium income.

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