10/16/2013 11:26 am ET Updated Nov 11, 2014

Is the "Too Big to Fail" Problem Too Big to Solve? Part II

My previous article argued that existing public policy toward the "too big to fail" problem was based on an unrealistic premise: that capital requirements can be used to eliminate the risk of failure by systemically important (SI) firms -- those whose failure would threaten the stability of the world financial system. This article explains why that premise is wrong.

The Intuitive Appeal of Capital Requirements

The capital of a firm is the value of its assets less the value of its liabilities. Insolvency occurs when asset values decline to the point where they are smaller than liabilities, meaning that capital is negative.

The larger a firm's capital is at any time, the larger the shrinkage in asset values it can suffer before becoming insolvent. It seems intuitively obvious, therefore, that the way to make an SI firm completely safe is to raise its capital requirements to the point where the firm can withstand any shock to the value of its assets. But this view fails to account for the reactions of the firm to higher requirements.

The Incentive to Evade Capital Requirements

Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario, such as the financial crisis in 2007-2008. For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it.. In a study of international banking crises, Richard Herring and I called this "disaster myopia."

Disaster myopia is reinforced by "herding." Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy, and opening itself to a possible takeover.

Even when decision makers are prescient enough to know that a severe shock that will generate large losses is coming, it is not in their interest to hold the capital needed to meet those losses. Because they don't know when the shock will occur, preparing for it would mean reduced earnings for the firm and reduced personal income for them for what could be a very long period. Better to realize the higher income as long as possible, because if they stay within the law, it won't be taken away from them if the firm later becomes insolvent.

Gaming Capital Requirements and Out- Smarting Regulators

A capital requirement of, say, 6 percent, means that a firm will remain solvent in the face of a shock that reduces the value of its assets by 5.99 percent. How safe that is depends on the size of potential shocks that reduce the value of assets, which in turn depends on the riskiness of the assets the firm holds. SI firms can game the system by shifting into higher-yielding but riskier assets that are subject to larger potential shocks.

Risk-Adjusted Capital Requirements Don't Help Much

Regulators have tried to shut down this obvious escape valve by adopting risk-adjusted capital ratios, where required capital varies with the type of asset. SI firms must hold more capital against commercial loans, for example, than against home loans that are viewed as less risky. However, this does not prevent the firm from making adjustments within a given asset category. For example, during the years prior to the financial crisis, some mortgage lenders shifted into sub-prime home mortgage loans, which were subject to the same capital requirements as prime loans.

Market Bubbles Can Also Undermine Capital Requirements

A given set of capital requirements may make SI firms safe in one economic environment, but not in another. In particular, if a bubble emerges in a major segment of the economy, as it did in the home mortgage market during 2003-2007, a massive shock to asset values will occur when the bubble bursts.

Regulatory Corrections Are Unlikely

In principle, regulators can offset a shift toward riskier assets within given asset categories by breaking the categories down into even smaller sub-categories subject to different capital requirements. And they can adjust to emerging bubbles by raising requirements for the sector being impacted by the bubble. But such actions require a degree of intelligence, foresight, and political courage on the part of regulators that history suggests we have no reason to expect.

Banks and other depositories have been subject to capital requirements since the 1980s. During the housing bubble, regulators did not set higher capital requirements for sub-prime mortgages, nor did they increase the ratios overall.

The need is for a regulatory system that can't be gamed by SI firms; that does not require regulators to be smarter, or more strongly motivated than the firms they regulate; and that in the event that an SI firm nonetheless fails and needs to be bailed out, the cost of bail-out will be imposed on all SI firms rather than taxpayers.

A system with these features is described next week.

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