A party pooper’s guide to financial stability - FT.com

Summary:
Charles Goodhart (LSE) and Avinash Persaud proposing two devices to help regulators and supervisors play a useful counter-cyclical role: 1) amending supervisors' pay (rather than bankers directly); and a "simple framework" building on Basel II by raising capital adequacy requirements by a ratio linked to the growth of the value of bank assets, bank by bank. Should moderate excessive lending and build up reserves during booms. (Published: 04/06/08)


Notes:

• Almost 12 months on from the start of the credit crunch and eight months since the run on the Northern Rock bank
• developing consensus on what is to be done to make the financial system less vulnerable to crisis:
• more disclosure, more regulation and reform of bankers’ compensation
• largely the same consensus we reach after every crisis, ultimately to little effect
• where there is a will there's a way?
• financial supervisors had the wherewithal to do something about the party in the financial sector that was played out in full view of everyone between 2003 and 2006
• they did not have the will to do it
• William McChesney Martin (former chairman of fed): authorities should “re­move the punch bowl before the party gets going”
• but: parties are fun
• difficult for underpaid supervisors to squeeze past and take away the bowl of punch when there are:
• powerful and rich lenders, borrowers with seemingly worthy projects and politicians taking credit for the good times
• some argue it is not regulators and supervisors but monetary policy committees that should perform the role of official party pooper
• but: interest rates changes alone cannot deliver both price and financial stability:
• asset bubbles often follow periods of price stability (US 1929; Japan 1990s; Asia 1997-98; subprime mortgages 2007-08).
  
• moreover, the level of interest rates required to prick a bubble might eviscerate the rest of the economy
• proposing two devices to strengthen the backbones of regulators and supervisors
1. amend supervisors’ pay
• easier than aligning bankers’ bonuses to longer-term outcomes
• large annual bonuses for supervisors that are withheld for five years and paid conditionally on successful supervision during this period
• will be more willing to remove the punch in time – thereby limiting bankers’ bonuses in the first place
• need independent assessment of supervisory success to avoid excessive regulatory zeal
  
2. raise Basel II capital adequacy requirements by a ratio linked to the growth of the value of bank assets
• focusing on value will help lessen the pro-cyclicality of fair value, mark-to-market accounting and value-at-risk models.
• each bank would have a basic allowance of asset growth
• would be linked to
  
• the inflation target
• the long-run economic growth rate, and
  
• some margin for structural changes in the bank lending/gross domestic product ratio
• this formulation enables regulators’ financial stability committees better to link micro to macro stability
• allowances would be different for small operations
• growth in the value of bank assets would be measured as a weighted average of annual growth
• to emphasise more recent activity, exponential weights can be used
• growth above the basic allowance over the past 12 months would have a 50 per cent weight, growth over the preceding year would have a 25 per cent weight and so forth until 100 per cent is approximated.
  
• regulatory capital adequacy requirements would be raised by 0.33 per cent for each 1 per cent excess growth in bank asset values.
  
• If a bank grew its assets at a rate of 21 per cent above its allowance, its minimum capital requirement would rise from, say, 8 per cent to 15 per cent.
• purpose is to moderate excessive lending and build up reserves during booms
• should help supervisors act as a countervailing force to powerful procyclical forces
• proposal is evolutionary, since it builds on Basel II and it provides a simple, transparent rule for supervisors to play a useful counter-cyclical role
• but: they must be given better incentives to do so
• have already seen the deleterious but powerful effects of banking bonuses
• Why not use financial incentives for more socially useful behaviour