A few proposals to mitigate financial sector pro-cyclicality

Francesco Columba, Wanda Cornacchia, Carmelo Salleo 01 July 2009

a

A

As discussed in our first column, two key determinants of pro-cyclicality are leverage and managers’ excessive appetite for risk, induced by inadequate remuneration schemes. In this column, we discuss policy options to keep them in check.1 In principle, leverage as an indicator of balance sheet soundness should be made redundant by supervisory capital ratios; managers’ incentives, in turn, should be kept under control by the proper functioning of market practices. However, the recent events have made clear that loopholes in capital regulation may let managers increase leverage undisturbed and that market forces may be unable to properly self-regulate remunerations.

We focus on policy proposals for changes to capital regulation and managers’ remuneration schemes. Some have been already been floated on an individual basis in the wake of the crisis; others have been around for a while. We argue that there is no single silver bullet that solves all problems and that the goal of taming pro-cyclicality should be achieved by an internally consistent set of proposals (see Panetta et al., 2009).

A consistent framework for capital regulation…

A framework for capital regulation that takes into account its pro-cyclical effects needs to tackle four main issues.

The first issue is how regulation links capital to risk, i.e. Basel II’s capital function. Since the inputs (probability of default, loss given default, exposure and maturity) are predominantly calculated at a point in time rather than through the cycle, smoothing them (or smoothing the output) would result in a less pro-cyclical capital ratio. A limitation of this approach is that if pushed too far it ends up disconnecting capital from risk, which is precisely the heart of modern prudential regulation.

The second issue is that risk materialises during downturns but accumulates during upturns; the capital base should reflect this already during upturns to cover loan losses that are not yet incurred but expected, possibly on the basis of the deterioration in credit quality experienced in previous downturns. We suggest introducing credit value adjustments, for supervisory purposes only, that follow this logic and would stabilise equity through the cycle. Our proposal is similar in spirit to the dynamic provisioning adopted by Spanish banks, but it has the advantage of being fully compatible with current international accounting standards.

A third issue is that Basel II is essentially a micro-economic model, while financial stability requires also a global outlook on banks and markets. Ideally, one would like to internalise the spillover effects. Brunnermeier et al. (2009) suggest computing a macro-prudential risk spillover factor on the basis of leverage, maturity mismatch, credit and asset price expansion, etc. However, the weight of each component would be difficult to estimate ex ante. Furthermore, just as with Value-at-Risk models, such a factor would use backward-looking data that in most cases tend to underestimate tail risk and so far there is no reliable way to generate forward-looking estimates. For supervisory purposes, an alternative – much rougher but simpler – indicator of systemic relevance may be preferable – size. Larger institutions are exponentially more complex, more interlinked with the financial system and more costly to bail out, therefore one might consider an additional capital charge, (more than) proportional to size (including off balance sheet obligations) and possibly to some simple, readily observable proxy for operational complexity.

The fourth issue is that these measures deal essentially with losses incurred during a normal business cycle; they are not of much use in the case of systemic crises. Therefore we need an efficient way to provide banks with capital when they need it, without having them pay (too much) for it when they don’t, i.e. most of the time. An insurance-like approach to systemic risk seems appropriate. We think that a “systemic” reverse convertible-type security may provide a viable solution – banks could issue bonds that convert into equity given a trigger event, defined by some sector-wide indicator, e.g. the industry’s aggregate capital ratio, that could be published by supervisory authorities, to avoid moral hazard (this proposal combines the reversible convertible described in Flannery, 2005, with the systemic trigger suggested in Kashyap et al., 2008). Such instruments would provide capital when needed and could be traded, lowering transaction costs and allowing price formation.

… and a suggestion for a backstop…

Finally, we should think of the unknown unknowns. The proposals described above cover most foreseeable situations, but as usual there is the danger of still being behind the curve as the financial system evolves in unpredictable directions. Risk-adjusted capital regulation might overlook some risk factor that could end up bringing down the house. For example, right before the crisis, some very large institutions that ended up being hard hit had manageable risk-adjusted capital ratios but sky-high leverage. As proposed by the Financial Stability Forum (2009), financial institutions could therefore be required to respect a ceiling on leverage, computed on the basis of non-risk-weighted assets. This ceiling, which various countries have already adopted, would be insurance against the failure of the complex models used to assess credit risk and compute capital requirements. A refinement of existing proposals might consist of letting the ceiling vary depending on the nature of a financial firm’s business model, since sustainable leverage ratios vary according to the nature and amount of risk taken by banks.

However, even if an amended framework for capital regulation manages to contain leverage, measures to contain incentives to take on risk are just as important, since otherwise managers will always be looking for ways to boost performance by eluding risk-limiting regulation.

…compounded with a balanced diet for excessive managers’ appetite for risk made of…

The awareness that high-powered compensation policies may tempt managers to take on excessive risk is generating a broad consensus on the need to avoid excessive risk-taking, through both market self-regulation and supervisory policy. So far, no simple solution for compensation reform has been proposed, but two basic principles have been emphasised: (i) the parameters for variable remuneration should be adjusted for risk; (ii) remuneration should be linked to long-term profitability, using such instruments as deferred bonuses, restricted stock grants, and claw-back clauses. Both principles are fine in theory but difficult to implement. In the remaining part of this column, we discuss their practical limitations and suggest in what direction firms should work to overcome them. We also recall briefly what is being done about managerial incentives at an institutional level.

…more risk adjustment, less short-termism …

Risk-adjustment methods are hard to apply because genuine performance is difficult to disentangle, ex ante, from simple risk remuneration (see our previous column. Risk management and internal control systems must in any case be improved, to reduce the danger that risk managers are overruled by traders and to improve estimates of extreme events. This would be a start in the direction of at least having a grip on risk.

As for remuneration being linked to future outcomes, the problem is that the mismatch between when bonuses are paid and when risks and losses materialise can be great; managers could therefore manipulate the risk profile of the bank so that large losses are unlikely during the relevant period for bonus calculation. To avoid this, remuneration packages might be linked (also) to variables that are less sensitive to risk and more related to “industrial” performance, such as cost-income ratios (net of trading profits).

Fostering models that emphasise the importance of teamwork in well-organised structures over that of individual talents would also limit the excessive bargaining power of managers (clearly one of the main drivers of high-powered compensation schemes).

… and some regulation

But market discipline has its limits. At least for systemically relevant institutions, the strong incentives to invest in risky assets and ventures at the expense of tax payers (who bear the burden of bailouts) justify an active role of regulators in a field such as remuneration, which is typically left to private contractual arrangements. Since stricter rules on managers’ remuneration schemes are prone to elusion, regulatory policies should aim mostly at improving disclosure on incentives. In this vein, the Bank of Italy has recently issued rules requiring supervised banks to disclose detailed information on their compensation policy (Bank of Italy, 2008, 2009).

Finally, supervisors are also considering options to recognise executives’ incentives to assume excessive risks as an explicit source of risk for the bank that has to be taken into account in capital requirements (FSA, 2008). The problem is that risk arising from incentives schemes may be hard to spot in advance and that managers might invest in risks not yet fully understood and monitored (e.g. the recent love affair with liquidity risk).

Conclusion

Overall, a consistent set of proposals on changes to capital regulation and limits to managers’ incentives would go a long way to reduce the pro-cyclicality of the financial sector and curb excessive risk-taking, thus improving its stability.

Disclaimer: The opinions expressed are those of the authors and do not necessarily reflect those of the Bank of Italy.

Footnotes

1 Accounting standards were also relevant in the financial turmoil; see Panetta et al. (2009) for a discussion of their role and for policy proposals.

References

Bank of Italy (2008), “Supervisory Provisions Concerning Bank’s Organization and Corporate Governance”, March 4.

Bank of Italy (2009), “Clarification Note Regarding Corporate Governance”, February 19.

Brunnermeier, M., A. Crocket, C. Goodhart, M. Hellwig, A. Persaud and H. Shin (2009), “The Fundamental Principles of Financial Regulation”, Geneva Report on the World Economy, No.11.

Flannery, M. J., (2005), “No Pain, No Gain? Effecting Market Discipline via Reverse Convertible Debentures”, Chapter 5 of Hal S. Scott, ed., Capital Adequacy beyond Basel: Banking, Securities and Insurance, Oxford: Oxford University Press.

Financial Stability Forum (2009), “Report of the Financial Stability Forum on Addressing Procyclicality in the Financial System”, April.

FSA (2008), “Remuneration policies”, Dear CEO letters, October.

Kashyap, A., R. Rajan and J. Stein (2008), “Rethinking Capital Regulation”, paper prepared for Federal Reserve Bank of Kansas City symposium on “Maintaining stability in a changing financial system”, Jackson Hole, Wyoming, August 21–23.

Panetta F., Angelini P., Albertazzi U.., Columba F., Cornacchia W., Di Cesare A., Pilati A., Salleo C. and Santini G. (2009), “Financial Sector Pro-Cyclicality: Lessons from the Crisis”, Bank of Italy Occasional Papers No. 44

a

A

Topics:  Financial markets

Tags:  financial crisis, leverage, Pro-cyclicality

Senior Economist, Western Hemisphere Department, IMF

Economist at the Research Department of the Bank of Italy

Senior Economist at the Research Department of the Bank of Italy

Events