G20 leaders will meet 26 to 27 June to discuss options for a common path to address systemic risk and to rein in the social and economic cost of financial fragility. Results from the recent preparatory meeting of G20 finance ministers and progress on US reform (Beck 2010) suggest that chances are slim for real progress, namely an agreement that makes the financial system safer while ensuring a level playing field.
Different views about the required intensity and scope of regulation as well as on the preferred instruments abound. There is high risk that member countries will end up paying lip service to the need for international harmonisation and more robust safeguards against moral hazard.
Disagreement is particularly pronounced when it comes to three crucial areas.
- Taxes: It is not clear whether, and in what way, the financial system should be taxed or made subject to a levy. Some countries intend to establish a financial transaction tax, others prefer a financial market activity tax (i.e. a tax on profits and bonuses), and others favour a financial institutions tax. A final group would like to refrain from such measures completely, with the argument that they have been hardly affected by the crisis and were not forced to support banks with taxpayers’ money.
- Too big to fail: There is as yet no convergence of views as to how to address the externality that results from the behaviour of large complex financial organisations.
- Institutions: Work on institutional frameworks to make internationally active financial institutions subject to strict resolution procedures has stalled. Meaningful reforms are needed to regulate large, cross-border financial institutions. As a result, only a transfer of responsibilities to the supra-national level will yield satisfactory results. But while such a transfer is urgently needed, it is currently nowhere on the map.
There is still hope
But it is not too late for an internationally harmonised solution to these problems. It may not cover all, but it will be relevant for the most important countries. To understand why, one has to recognise that the two biggest economic areas represented in the G20 have similar views on the issue of taxing financial institutions.
The Obama administration has proposed a tax for financial institutions (“Financial Crisis Responsibility Fee”) that contains some of the crucial elements (see Acharya and Richardson 2010). Germany also favours a levy on financial institutions, and EU foreign ministers have recently agreed that they are willing to push for such a solution (see Reuters 2010).
According to BIS data, the two regions together cover 80% of the cross-border exposures of the relevant banking systems. The absolute size of the cross-border exposures is also interesting. For instance Canadian banks have about $700 billion in the cross-border exposures, Indian banks about $40 billion, European banks about $20 trillion (yes with a t not a b). (BIS, 2010). No wonder the Canadians and some emerging countries do not think this is a big problem. And it shows that Europeans are right to push ahead with a bank tax and with resolution funds even if not all of the G20 follows.
Finding common ground among the US and Europe would not only allow the implementation of a tax. This one “stone” would kill two more birds. From the US and German levy, one would be only a few steps away from the financial stability contribution proposed by the IMF (2010). In our view, such a levy would be the best way to internalise systemic externalities (see below), so the second area of disagreement could be resolved. Also, the proceeds of such a levy could and should be used to set up resolution funds for financial institutions (see Doluca et al. 2010). Such a fund could then form the nucleus of a meaningful framework for a consistent resolution regime. In the case of Europe, they would also provide a starting point to discuss the future of burden sharing.
A systemic risk levy is better than a systemic risk charge
Financial institutions have a strong incentive to become systemically relevant. The larger the financial institution and the stronger the propagation effects in case of a problem, the higher is the probability that it will be bailed out in case of financial distress. This ensures that uninsured depositors and senior creditors experience no losses. Hence, the higher the systemic relevance of a financial institution, the lower is the risk premium that an investor requires to put his money at stake. As a consequence, the cost for funding is directly related to the systemic relevance of the financial institution. This is not least reflected in rating reports that explicitly distinguish between “stand alone” ratings and ratings taking into account implicit public guarantees. For the decision-maker of an individual financial institution, being systemically relevant confers an important advantage. Return on equity can be increased by increasing the negative impact of one’s own failure on the rest of the system and the leverage under which one’s institution operates. The systemic risk that results from such behaviour, however, is a negative externality.
In principle, these externalities could be internalised either through a Pigouvian tax or through a surcharge on capital. In fact, under certain assumptions, surcharges on capital and levies can be shown to be equivalent with respect to their effect on incentives and on those features of a financial institution that determine systemic relevance.[i] For instance a levy of 50 basis points (on liabilities excluding insured deposits) can be shown to be equivalent to an increase in the leverage ratio (equity/unweighted assets) of 2 percentage points. The same behavioural change could be achieved with both instruments (see Doluca et al. 2010).
An important difference between the instruments is then that levies take off the funds from an institution’s balance sheet, while surcharges leave the funds under the control of the bank. This is one reason supervisors as well as banks prefer the surcharge. Another reason for supervisors' revealed preference for an add-on to capital adequacy regulation is that they are committed to the Basel process. They have a process in place and 20 years of experience with this process of negotiating Basel II. Banks may prefer this path for similar reasons: they are also experienced with the process of Basel II and have successfully influenced this process in the past. The advantage of the levy is that it can be used to finance a resolution fund. Such a fund would increase the possibility and thus the credibility of the public sector in implementing a policy of bail-in rather than bail-out of the financial sector.
The main problem with systemic risk capital charges is that related requirements are already used for multiple goals: they are supposed to act as a buffer against unexpected loss as well as limit risk taking. These two goals are not necessarily compatible. In addition there are proposals to use capital requirements to control liquidity risks and to introduce adjustments that reduce pro-cyclicality. The result is a system with three to four goals and only one instrument. This will inevitably involve trade-offs, leading to a system of capital requirements which is highly complex, far from transparent, and prone to manipulation, constant re-interpretation, and capture. Therefore it seems advisable to use another instrument to control systemic risk.
Another problem with using capital adequacy regulation to make systemic relevance costly is that it could lead to risk migration, a further surge of the less regulated parts of the system, sometimes called the shadow banking system. The aim of surcharges on capital would be to internalise the negative externality of being too important to fail, but capital remains on balance sheet, and the control over funds remain largely within the banks. Banks with plenty of capital on their books will try to lever it up through loopholes in the system. Not only do financial institutions have strong incentives to find loopholes in regulatory capital requirements to take a highly leveraged, one-way bet on the economy, they also create loopholes by creating financial innovations.
A final and related problem of systemic risk capital surcharges is that non-bank systemic financial institutions would be difficult to incorporate in such a regime. Prudential minimum capital requirements are and should be confined to certain institutions, not least because the presence of entities that operate without strict requirements can be beneficial for financial stability: regulatory constraints on minimum capital can lead to negative feedback loops, and financial institutions operating without them can act as buyers of last resort whenever capital restrictions cause fire sales. This does not imply, however, that some of these institutions pose systemic risks that should be internalised. Thus, a sensible approach should in principle enable the public to impose costs on non-banks, including insurance companies and hedge funds. Docking on to Basel II would make this nearly impossible.
A more effective way of enforcing the responsibility of financial institutions is to internalise the negative externalities by taxing systemic relevance directly, through a Pigouvian “tax” or levy. Implemented optimally, the tax rate should be set at such a level as to eliminate the implicit funding cost advantage of systemic institutions. It could be used to finance a resolution fund, which would serve as an at least partially pre-funded (cross-border) resolution tool. Both the rate and the perimeter of the levy would have to be reassessed at regular intervals to capture emerging systemic risk. Such a levy would be an effective macroprudential instrument. Actually, right now it is the only effective macroprudential instrument in sight.
Acharya, Viral and Matthew Richardson (2010), “Making Sense of Obama’s Bank Reform Plans”, VoxEU.org, 24 January.
BIS (2010), “Locational Banking Statistics”, Bank for International Settlements.
Doluca, Hasan, Ulrich Klueh, Marco Wagner, and Beatrice Weder di Mauro (2010), “Reducing Systemic Relevance: A Proposal”, The German Council of Economic Experts, Working Paper 04/2010.
IMF (2010), “A Fair and Substantial Contribution by the Financial Sector”, Interim Report for the G20, International Monetary Fund.
Reuters (2010), “Entwurf: EU-Staaten wollen Bankenabgabe in Europa”.
[i] Consider, for example, a situation in which the size of the externality is purely related to the size of the balance sheet. Any sensible regulation would need to reduce size to be effective. Assuming that an institution is currently operating at or close to minimum capital requirements, and that the actual return on equity (ROE) is equal to the required rate, the introduction of a surcharge would work as follows. The institution would first look at the effects of just swapping existing debt for the needed amount of additional capital. It would observe that this would lead to a ROE lower than that required from investors. The latter would demand a reduction in balance sheet size, which would eliminate or lower the surcharge. The reduction would go hand in hand with a reduction in liabilities. Taking into account that this reduction in systemic relevance would increase the cost of external funds (as part of the implicit subsidy or bail-out guarantee is taken away), the surcharge has to be defined such that this effect is in fact achieved. It has to be high enough to ensure that equity-holders are willing to reduce balance sheet size, even though this goes hand in hand with higher funding costs. The same mechanism is at work with a levy: Introducing the latter would directly lower the ROE, forcing the institution to shrink. Again, the levy has to be just high enough to force equity-holders to accept the higher funding costs associated with this shrinking.