Regulators should encourage more diversity in the financial system

Charles A.E. Goodhart, Wolf Wagner 12 April 2012

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The latest round of international financial regulations – known as Basel III – is making important steps towards a safer financial system. However, we believe it ignores a key aspect of systemic risk – the lack of diversity across financial institutions.

While up to a few decades ago the financial system consisted of predominantly small institutions that specialised in different businesses and had relatively few interlinkages with each other, this picture has dramatically changed. Financial institutions – in particular the very large ones – have become very similar to each other. The biggest institutions are now operating in the same global markets, undertake similar activities, and are exposed to the same funding risks. This process has made their survival very intertwined – also owing to the manifold types of connections modern financial institutions form with each other.

Potential costs

This lack of diversity is very costly for society. Similar institutions are likely to encounter problems at the same time. This makes systemic crises such as the crisis of 2007-2009 – more likely. After all, we are not concerned with isolated bank failures but only with systemic events where a large part of the financial system comes under severe strain. When many institutions are facing difficulties, the policy options are very limited as regulators cannot afford to let a large number of institutions fail.[1]

A more homogenous financial system also means that contagion effects are likely to be more pronounced. This is because a failure of one institution is then more likely to occur at times when other institutions are operating under stress. As a result, spillovers from institutional failures will be larger.

Margins for diversifying financial institutions

There are several margins at which diversity in the financial system can be improved.

  • To start with, diversity could be achieved if financial institutions were to specialise more in different activities rather than all undertaking the same type of activities.
  • Another key area where greater diversity can be improved is risk management.

There has been a convergence in the risk management systems used by institutions which now results in near-identical assessments of risks in the financial system. This causes a more homogenous behaviour of institutions and amplifies the impact of shocks in the financial system.[2] Current regulation plays a counterproductive role in this respect as it encourages the spread of “best practice” – taken to the extreme this would lead to all institutions adopting the same risk management and hence reacting to shocks in the same way. A stable financial system by contrast needs a diversity of views on risks that are competing with each other.

Related to the issue of risk management, homogenous behaviour further results from similar trading strategies. A key cause of the stock market crash of 1987, for example, was that institutional investors followed portfolio insurance strategies that stipulated the selling of assets following a fall in prices. This led to joint sell-offs following an (initially negligible) shock and a crash in the market by 30%. The quant event of 2007 was similarly caused by hedge funds followed the same strategy and holding similar portfolios.[3]

Diversity on the liability side

The liability side of financial institutions is also an important source of diversity – or lack thereof. Financial institutions nowadays have many ways through which they can raise funds to finance their activities. However, if they raise funds from similar sources (for instance, if they all become reliant on short-term wholesale financing), the financial system as a whole becomes vulnerable to disruptions in funding markets.

If a significant proportion of systemically important banks were to specialise, for example, in retail deposit funding, this would contribute to greater resilience of the financial system. Homogeneity arises also indirectly through interlinkages among institutions – be it through lending relationships, securitisation activities, or derivatives trading. Resulting counterparty risk increases the reliance of institutions on each other and reduces the chance that a single institutional failure remains an isolated event.[4]

Positive externalities from diversity and its underprovision

A lack of diversity alone does not suffice to justify regulation. We believe that regulation needs to be based on first principles. We thus have to ask ourselves whether we would expect the financial system to produce “too little” diversity from a social point of view or – equivalently -- whether there are externalities associated with diversity. The answer is very likely “yes”. There are strong reasons to believe that, in the absence of regulation, institutions will become too similar:

  • Banks have an incentive to undertake correlated activities because in the event of joint failure they are likely to be bailed out (Acharya and Yorulmazer 2007).
  • A single institution will not take into account that if it undertakes actions that makes it more similar to other institutions, systemic risk for others in the system will increase by increasing the likelihood of joint failures (Wagner 2011).
  • Herding by managers (or the traders employed by the institutions) will tend to result in institutions taking on similar exposures. Such herding may arise for psychological reasons but may also be rooted in performance evaluation as managers will not be fired if they underperform jointly with their peers (see Rajan 2005).
  • Financial institutions have a tendency to interconnect and cross-insure too much, resulting in more correlated failures. This tendency arises because cross-insurance trade-off individual failures against systemic failures and institutions will not fully internalise the costs arising from the latter (Kahn and Santos 2006).

A proposal for pro-diversity regulation

This tendency for the financial system to become excessively homogenous provides a rationale for regulation that encourages diversity. But what form should such regulation take?

We believe that imposing direct restrictions on the activities of financial institutions is not a promising avenue. As argued above, diversity arises through many and very different channels. Such regulation would thus be very complex and burdensome. An additional issue is that diversity cannot be easily quantified. For example, it would be an onerous task for regulators to measure similarities in bank funding structures – not to speak of similarities created by counterparty risks.

We instead advocate an approach where financial institutions will be subjected to capital requirements that condition on how correlated their overall activities are with the rest of the financial system. This may be in the form of a surcharge on existing capital requirements or, preferably, a redefinition of current risk weights that keep average capital requirements unchanged.[5] Such capital requirements would serve a dual purpose. They would make banks that are systemic because of high correlations less risky by forcing them to hold more capital. More importantly, they would also provide banks with proper incentives to increase diversity in order to reduce capital charges. The appeal of this approach is that it would leave it open for banks how they can achieve diversity, allowing them to choose the most cost-effective way.

A key question is how to measure these correlations. We suggest using the correlations of either bank profits or share prices with a corresponding banking sector index. Share prices correlations have the appeal that they incorporate information in a timely manner and are forward-looking. However, it is well-known that correlations tend to rise in crisis times, which would cause undesirable procyclicality if they are used as input into regulation. We hence propose to use relative correlations, which rank institutions relative to their peers. Such correlations will be more stable over the financial cycle and hence provide a reliable measure of diversity.

Conclusion

We believe that encouraging diversity is desirable and feasible for regulation. A key advantage compared to other forms of regulation is that encouraging diversity directly tackles the root of systemic risk. It also does not punish risk-taking in general. It is the primary business of the financial system to finance activities that are inherently risky. Simply raising capital requirements – such as proposed by Basel III -- thus necessarily poses a trade-off. Increasing diversity, in contrast, can be achieved without reducing the level of risky activities. Regulation that promotes diversity may also be welcomed by financial institutions as it corrects incentives that would otherwise produce a financial system that is too homogenous – and one that displays excessive shock amplification and contagion.

References

Acharya, Viral V and Tanju Yorulmazer (2007), "Too many to fail – An analysis of time-inconsistency in bank closure policies", Journal of Financial Intermediation, 16:1-31.

Acharya, Viral V (2009), "A theory of systemic risk and design of prudential bank regulation", Journal of Financial Stability, 5:224-255.

Franklin Allen, Elena Carletti (2008), “Mark-to-Market Accounting and Liquidity Pricing”, Journal of Accounting and Economics, 45:358-378.

Brunnermeier, Markus, Andrew Crockett, Charles A Goodhart, Avinash Persaud, Hyun Song Shin (2009), “The Fundamental Principles of Financial Regulation”, Geneva Reports on the World Economy, 11.

Kahn, Charles and Joao Santos (2006), “Endogenous Financial Fragility and Prudential Regulation”, Working Paper, Federal Reserve Bank of New York.

Khandani, Amir and Andrew Lo (2008), “What Happened To The Quants In August 2007?: Evidence from Factors and Transactions Data”, NBER Working Paper No. 14465.

Persaud, Avinash (2000), “Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management models”, Jacques de Larosiere Prize Essay, Institute of International Finance.

Rajan, Raguram (2005), "Has Financial Development Made the World Riskier?", NBER Working Papers 11728.

Wagner, Wolf (2008), “The Homogenization of the Financial System and Liquidity Crises”, Journal of Financial Intermediation, 17:330-356

Wagner, Wolf (2010), “Diversification at Financial Institutions and Systemic Crises”, Journal of Financial Intermediation, 19:373-386


[1] The too-many-to fail doctrine (see Acharya and Yorulmazer 2007) is the small-bank equivalent of too-big-to-fail. The point of institutions becoming systemic because of correlation and interconnections is also well spelt out in Brunnermeier et al. (2009).

[2] The potential for similar risk management systems to be destabilising has first been made in Persaud (2000).

[3] During summer 2007 liquidation by one hedge fund caused a price decline in the assets held by the other funds. This led to selling by these funds as well and resulted in dramatic price dislocations. An excellent description of this event is provided in Khandani and Lo (2008).

[4] It should be pointed out that regulation itself also contributes towards more homogeneity. For example, when an increasingly large part of the financial system is subjected to the same regulation, this will produce more homogenous behavior as institutions will then face regulatory constraints at the same time. Treating investment banks, insurance companies and institutions in the shadow financial system similar to traditional banks can thus lead to greater instability in the advent of adverse shocks. Also, if regulation of different types of institutions predominantly relies on mark-to-market accounting, this can result in greater amplification of shocks (see Allen and Carletti, 2008).

[5] Acharya (2009) and Wagner (2009) have made similar proposals in order to discourage banks from making similar investment choices.

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Topics:  Financial markets International finance

Tags:  financial regulation

Comments

Professor Goodhart, Whilst diversity may lessen the effects of future recessions we will have to return to significant growth before this can happen. In the foreword to 'Where does money come from?' you wrote of the challenge that our current system of money creation presents in this regard. Do you feel an emergency injection of money directly into Governments bank accounts via their Central Banks could fulfil this purpose? Indeed a second source of digital money in circulation could form the basis of the economy going forward. Regards, Paul Ferguson Sensible Money

Emeritus Professor in the Financial Markets Group, London School of Economics

Wolf Wagner

Professor of Economics, University of Tilburg