10/29/2013 05:07 pm ET Updated Nov 11, 2014

Is the 'Too Big to Fail' Problem Too Big to Solve? (Last of Three)

Previous articles in this series have described the major sources of public policy paralysis in dealing with the "too big to fail" problem. One source of paralysis is the operating premise that government regulation of systemically important (SI) firms can eliminate the risk that any of them will fail. Not so. If SI firms remain viable competitors, they will remain vulnerable to failure, and bail-outs might still be needed.

The second source of paralysis is the premise that capital requirements are the best way to prevent the failure of SI firms. Not so. SI firms can offset the effect of capital requirements on their risk exposure by adjusting the risk features of their assets, as well as thru off-balance sheet activities. To prevent this, regulators would have to be smarter and more strongly motivated than the firms they regulate, which is not the case.

What is needed is a regulatory system that is more effective in controlling the risk exposure of SI firms than capital requirements; and that shifts the costs of a bail-out, should one prove necessary, onto those firms. This would constitute a tax for being "too big to fail," making the bail-out politically palatable. Such a system is described here.

An Alternative to Capital Requirements: Transaction-Based Reserving

Under transaction-based reserving (TBR), 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.

If the asset is a loan or security, the required allocation to a contingency reserve would be, say, 50 percent of the portion of the income generated by the asset that is risk-based. If a prime mortgage was priced at 4 percent and zero points, for example, the reserve allocation for a 6 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. Inflows allocated to reserves would not be taxable until they were withdrawn.

Advantages of TBR

The major 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. It is akin to a capital requirement that is applied to every individual asset and risk-generating activity. The firm cannot game the system by shifting to riskier assets within the asset groups specified by the regulator, or by incurring new types of obligations that are not shown on the balance sheet, as they can with capital requirements.

Another advantage of TBR is that regulators need not make judgments about the riskiness of different assets - judgments they are not well-equipped to make. Such judgments are made by the firm itself in its pricing.

To some degree, TBR automatically dampens 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. To the degree that a euphoric SI firm underprices risk during such episodes, however, failure is possible, and with it the possible need for a bail-out.

This points up another critical advantage of TBR, which is that it provides a mechanism for shifting the cost of a bailout to the SI firms. Part of the reserve allocation of SI firms (but not other firms) would accrue not to their reserve account, but to that of the FDIC. It would be held by FDIC to cover any losses associated with the bail-out of an SI firm, should that prove necessary.

Experience of Private Mortgage Insurance Companies Is Relevant

Private mortgage insurance companies (PMIs) have been subject to TBR since their inception in the 1950s. They must allocate 50 percent of their premium income to a contingency reserve for 10 years. The system was not rigorously tested until the recent financial crisis, which devastated the industry and battered their shareholders. Yet the PMIs have been able to meet all their obligations in connection with the extraordinary losses suffered by lenders during the crisis. TBR allowed the PMIs to do exactly what they were chartered to do: cover losses out of their reserves. There were no bail-outs of PMIs.

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