Will the US financial system collapse today, or maybe over the next few days?” asked Paul Krugman exactly 10 years ago. The next day, Lehman Brothers filed for bankruptcy, marking the beginning of the global financial crisis. Was the crisis inevitable? What were the factors that contributed to it? What measures could have prevented, or at least ameliorated, the impact of the crisis? The 10th anniversary of the Lehman collapse is an appropriate occasion to revisit such questions.
In retrospect, one is struck by the vast gulf between academic discourse on the financial regulation and actual practice. Contrary to conventional wisdom, economic theory has plenty of interesting things to say about the crisis. In a prescient analysis, Bengt Holmstrom and Jean Tirole showed that given imperfect pledgeability of future cash flows, liquidity shocks may force costly and socially inefficient bankruptcies.
While the academic discussion was focused on asymmetric information, incomplete contracts and related market imperfections, banking regulation did not pay attention to these lessons. Ultimately, the regulatory architecture for depository institutions proved ineffective. While the crisis originated in non-deposit taking financial institutions, it spread to regulated deposit accepting entities with remarkable agility.
Basel-II, the international accord for banking regulation that was formalized just before the onset of the crisis, was an important improvement over its earlier version in many ways. Nevertheless, it gave excessive discretion to financial institutions for computing crucial parameters like risk weights. As these parameters are important inputs in the computation of risk weighted assets (RWAs), which in turn determined the level of required capital buffers, banks had a skewed incentive to underestimate their risk weights by using complex models. UK bank Northern Rock is a typical example. In 2007, it had assets worth £113 billion, but its RWAs under Basel-II were a mere £19 billion.
Additionally, divergent methodologies used to compute risk weights meant that there was enormous variability in reported numbers, making any meaningful comparison across banks virtually impossible. As if these problems were not enough, the risk weight for mortgage, the very instrument that precipitated the crisis, was reduced. In the light of later taxpayer-financed bailouts, these regulatory actions seem clearly misguided.
Basel-III has plugged these loopholes in three different ways. First, it has mandated a higher capital adequacy ratio to absorb potential losses originating in both trading and banking books, including additional capital conservation buffers. The idea is that once this buffer is depleted, regulators should be worried. The financial institution must build its reserves before it is allowed to distribute its profits by way of dividends, share buybacks and employee bonuses.
Second, it has taken steps to reduce the variability of the risk weighted assets by constraining the discretion of banks. For many asset classes, use of more sophisticated and complex models (so-called “advanced approach”) is disallowed. Moreover, many crucial parameters used to calculate risk weights are now subject to minimum “floor” values .
Third, the realization that financial institutions can build leverage while apparently complying with capital adequacy norms has led to the adoption of new risk metrics such as leverage ratio which are insensitive to precise risk weights. As a Basel-III document notes: “In many cases, banks built up excessive leverage while apparently maintaining strong risk-based capital ratios. At the height of the crisis, financial markets forced the banking sector to reduce its leverage in a manner that amplified downward pressures on asset prices. This deleveraging process exacerbated the feedback loop between losses, falling bank capital and shrinking credit availability.”
The unravelling of Northern Rock led to the realization that business models that relied excessively on wholesale funding are vulnerable to liquidity crunch. New reporting ratios such as liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) are mandated to account for the high-quality short-term assets and stable funding sources, respectively.
Finally, as the operational risk arising out of illegal actions such as fraud is more likely to occur when business conditions are tough, the need for an integrated and enterprise-level risk management approach is emphasized. Besides the capital requirement and new liquidity/ leverage ratios, Basel-III envisages forward-looking supervisory control that includes periodic stress testing. It is hoped that these measures, together with mandatory disclosure requirements and associated market discipline, will reduce the frequency and severity of financial crises.
Banking regulation is a typical multi-stage game: Financial institutions have a second-mover advantage over the regulator. Regulator lays down certain restrictions; participants observe the rules and, over time, learn to exploit loopholes. It would be too early to claim that the final word on banking regulation has been written. Still, Basel-III has plugged many loopholes and reduced the likelihood of such cataclysmic events taking place in future. Given the constraints, this may be the best we can hope for.
Avinash M. Tripathi is an associate research fellow (economics) at Takshashila Institution.
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