macroprudential approach to financial regulation hanson

7/31/2019 Macroprudential Approach to Financial Regulation Hanson

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Journal o Economic PerspectivesVolume 25, Number 1Winter 2011Pages 328

Many observers have argued that the regulatory ramework in place

prior to the global fnancial crisis was defcient because it was largely

microprudential in nature (Crockett, 2000; Borio, Furfne, and Lowe,

2001; Borio, 2003; Kashyap and Stein, 2004; Kashyap, Rajan, and Stein, 2008;

Brunnermeier, Crockett, Goodhart, Persaud, and Shin, 2009; Bank o England,

2009; French et al., 2010). A microprudential approach is one in which regulation

is partial equilibrium in its conception and aimed at preventing the costly ailure o

individual fnancial institutions. By contrast, a macroprudential approach recog-

nizes the importance o general equilibrium eects, and seeks to saeguard the

fnancial system as a whole. In the atermath o the crisis, there seems to be agree-

ment among both academics and policymakers that fnancial regulation needs to

move in a macroprudential direction. For example, according to Federal Reserve

Chairman Ben Bernanke (2008):

A Macroprudential Approach toFinancial Regulation

Samuel G. Hanson is a Ph.D. Candidate in Business Economics, Harvard University,

Cambridge, Massachusetts. From February to December 2009, Hanson was a Special Assistantat the U.S. Department o the Treasury, Washington, D.C. Anil K Kashyap is Edward Eagle

Brown Proessor o Economics and Finance and Richard N. Rosett Faculty Fellow, University o

Chicago Booth School o Business, Chicago, Illinois. Jeremy C. Stein is Moise Y. Sara Proessor

o Economics, Harvard University, Cambridge, Massachusetts. From February to July 2009,

Stein was Senior Advisor to the Secretary, U.S. Department o the Treasury, and Sta Member

o the National Economic Council, both in Washington, D.C. Kashyap and Stein are both

Research Associates, National Bureau o Economic Research, Cambridge, Massachusetts.

Their e-mail addresses are [email protected], [email protected],

[email protected].

doi=10.1257/jep.25.1.3

Samuel G. Hanson, Anil K Kashyap, andJeremy C. Stein


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4 Journal o Economic Perspectives

Going orward, a critical question or regulators and supervisors is what their

appropriate feld o vision should be. Under our current system o saety-

and-soundness regulation, supervisors oten ocus on the fnancial conditions

o individual institutions in isolation. An alternative approach, which has beencalled systemwide or macroprudential oversight, would broaden the mandate

o regulators and supervisors to encompass consideration o potential systemic

risks and weaknesses as well.

In this paper, we oer a detailed vision or how a macroprudential regime

might be designed. Our prescriptions ollow rom a specifc theory o how modern

fnancial crises unold and why both an unregulated fnancial system, as well as one

based on capital rules that only apply to traditional banks, is likely to be ragile. We

begin by identiying the key market ailures at work: why individual fnancial frms,

acting in their own interests, deviate rom what a social planner would have them

do. Next, we discuss a number o concrete steps to remedy these market ailures. We

conclude the paper by comparing our proposals to recent regulatory reorms in the

United States and to proposed global banking reorms.

Theories o Financial Regulation

Microprudential Regulation

Traditional microprudential regulation o banks is based on the ollowinglogic. Banks fnance themselves with government-insured deposits. While deposit

insurance has the valuable eect o preventing runs (Diamond and Dybvig, 1983;

Bryant, 1980), it creates an incentive or bank managers to take excessive risks,

knowing that losses will be covered by the taxpayer. The goal o capital regulation

is to orce banks to internalize losses, thereby protecting the deposit insurance

und and mitigating moral hazard. Thus, i the probability o the deposit insurer

bearing losses is reduced to a low enough level, microprudential regulation is

doing its job.

To be specifc, consider a bank with assets o $100 that is fnanced with insured

deposits and some amount o capital. Suppose that the regulator can check on thebank once a quarter. Suppose urther that the volatility o the banks assets is such

that with probability 99.5 percent, the assets do not decline in value by more than

6 percent during a quarter. Then i the goal o policy is to reduce the probability

o bank ailure (whereby capital is wiped out and there are losses to the deposit

insurance und) to 0.5 percent, this goal can be accomplished by requiring the bank

to have capital equal to 6 percent o its assets as a cushion against losses. Notice

that in this setting, the exact orm o the capital cushion is not important. It can be

common equity, but it can equally well be preerred stock, or subordinated debt, as

long as these instruments are not explicitly or implicitly insuredthat is, as long as

they will in act bear losses in a bad state.


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Samuel G. Hanson, Anil K Kashyap, and Jeremy C. Stein 5

An important element o existing capital regulation is the presumption that

a bank will take immediate steps to restore its capital ratio in the wake o losses.

Returning to our example, suppose the bank starts out with capital o $6 but then

over the next quarter experiences losses o $2, so that its capital alls to $4. I thevolatility o its assets remains unchanged, in order or its probability o ailure over

the subsequent quarter to stay at 0.5 percent, it would need to bring its capital ratio

back up to 6 percent. It could do so in one o two ways: either by going to the market

and raising $2 o resh capital, or by leaving its capital unchanged and shrinking its

asset base to $66.67 (4/66.67 = 6 percent).

The basic critique o microprudential regulation can be understood as ollows.

When a microprudentially oriented regulator pushes a troubled bank to restore

its capital ratio, the regulator does not care whether the bank adjusts via the numerator or

via the denominatorthat is, by raising new capital or by shrinking assets. Either way, the

banks probability o ailure is brought back to a tolerable level, which is all that a

microprudential regulator cares about.

Such indierence to the method o adjustment makes sense i we are consid-

ering a single bank that is in trouble or idiosyncratic reasons. I that bank chooses

to shrink its assetsperhaps by cutting back on lendingothers can pick up the

slack. Indeed, asset shrinkage in this case can be part o a healthy Darwinian process,

whereby market share is transerred rom weaker troubled institutions to their

stronger peers. However, i a large raction o the fnancial system is in difculty, a

simultaneous attempt by many institutions to shrink their assets is likely to be more

damaging to the economy.

Macroprudential Regulation

In the simplest terms, one can characterize the macroprudential approach to

fnancial regulation as an eort to control the social costs associated with excessive balance-

sheet shrinkage on the part o multiple fnancial institutions hit with a common shock. To

make a compelling case or macroprudential regulation, two questions must be

answered. First, what are the costs imposed on society when many fnancial frms

shrink their assets at the same time? Second, why do individual frms not internalize

these costs? That is, why do they not raise resh capital rather than reduce assets

when a bad shock hits? Or alternatively, why do they not build sufciently largecapital buers ahead o time so that they can withstand a shock without needing

either to raise capital or to reduce assets?

Generalized asset shrinkage has two primary costs: credit-crunch and fre-sale

eects. I banks shrink their assets by cutting new lending, operating frms fnd

credit more expensive and reduce investment and employment, with contractionary

consequences or the economy. I a large number o banks instead shrink their

assets by all dumping the same illiquid securities (think o toxic mortgage-backed

securities) the prices o these securities can drop sharply in a fre sale o the sort

described by Shleier and Vishny in this issue. Moreover, the fre-sale and credit-

crunch eects are intimately connected (Diamond and Rajan, 2009; Shleier and


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Vishny, 2010; Stein, 2010a). I a toxic mortgage security alls in price to the point

where it oers a (risk-adjusted) 20 percent rate o return to a prospective buyer, this

will tend to drive the rate on new loans up towards 20 percent as wellsince rom

the perspective o an intermediary that can choose to either make new loans or buydistressed securities, the expected rate o return on the two must be equalized. In

other words, in market equilibrium, the real costs o fre sales maniest themselves

in the urther deepening o credit crunches. Ivashina and Scharstein (2010) oer

evidence on the extent o credit contraction during the recent crisis.

O course, to make a case or regulatory intervention, one has to explain why

these 20 percent rates o return inside the fnancial sectorwhich are much higher

than the outside rates on, say, Treasury securitiesdont naturally draw in enough

private capital to eliminate the return dierentials. One reason why capital is immo-

bile once a crisis is underway is the debt overhang problem identifed by Myers

(1977). Once a bank is in serious trouble and its debt is impaired in value, the

bank is reluctant to raise new equity even to und investments that have a positive

net present value. This is because much o the value that is created is siphoned o

by the more senior creditors. Given the debt overhang problem, banks that act in

the interests o their shareholders will tend to fx their damaged capital ratios by

shrinking assets rather than by raising new capital, even when the latter is more

desirable rom a social perspective.

I so, why dont banks voluntarily build up adequate buer stocks o excess

capital in good times, when debt overhang is not yet a concern, so they can absorb

losses in bad times without having to either shrink assets or raise new capital underduress? Ater all, such a dry-powder strategy would allow them to exploit proftable

opportunities should a crisis arise. This question is addressed in Stein (2010a), who

extends the fre-sale model to consider banks initial choices o capital structure.

He shows that i short-term debt is a cheaper orm o fnance than equity, banks

will tend to take on socially excessive levels o debt: while the banks capture the

benefts o cheap debt fnance, they do not internalize all o its costs.1 In particular,

when Bank A takes on more debt, it does not account or the act that by doing

so, it degrades the collateral value o any assets it holds in common with another

Bank Bsince in a crisis state o the world, As fre-selling o its assets lowers the

liquidation value that B can realize or these same assets.2

1 The assumption that short-term debt is a cheap orm o fnance represents a particular deviation romthe ModiglianiMiller (1958) capital-structure irrelevance ramework. In the context o fnancial frms,this deviation can arise to the extent that their short-term claims are money-like and carry a premiumthat reects their useulness as a transactions medium. We discuss this point in greater detail below.2A subtlety is that this is a pecuniary externalitythat is, it works through prices. For a pecuniaryexternality to cause a misallocation o resources, one requires a departure rom the standard assump-tions that deliver the undamental welare theorems (Geanakoplos and Polemarchakis, 1986). In Stein(2010a), this departure is in the orm o a collateral constraint: banks ability to raise short-term debt isconstrained by the collateral value o their assets.


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A Macroprudential Approach to Financial Regulation 7

In sum, a model based on fre sales and credit crunches suggests that fnancial

institutions have overly strong incentives 1) to shrink assets rather than recapitalize

once a crisis is underway, and 2) to operate with too thin capital buers beore a

crisis occurs, thereby raising the probability o an eventual crisis and systemwidebalance-sheet contraction. Thereore, the macroprudential approach to capital

regulation aims to counterbalance these two tendencies. With this in mind, we turn

next to some o the individual items in the macroprudential toolkit.

Beore doing so, however, we should emphasize that, in contrast to the tradi-

tional view, nothing in this alternative theory relies on the existence o deposit insurance.

In other words, in a model o crises based on fre sales, there is socially excessive

balance-sheet shrinkage, and a rationale or regulation, even absent government

deposit insurance. Thus, there is a strong presumption that macroprudential regu-

lation should apply to more than just insured deposit-takers. The broader point

(stressed by Tucker, 2010, and Kashyap, Berner, and Goodhart, orthcoming) is

that regulators need to pay attention to all the channels through which the actions

o fnancial institutionsboth those who are insured and those who are notcan

cause damage.

Macroprudential Tools

We now discuss six sets o tools that can be helpul in implementing a macro-

prudential approach to fnancial regulation. Our goal here is not to provide acomprehensive laundry list o reorm proposals, but rather to show how a particular

conceptual ramework provides a unifed way o thinking about what otherwise

might seem like a hodgepodge o dierent fxes.

As a prelude, note that i the goal o regulation is to prevent fnancial frms

rom shrinking their balance sheets excessively in an adverse state o the world, a

simple accounting identity imposes a lot o discipline on our thinking. In particular,

when a bank is hit with a shock that depletes its capital, there are only two ways to

prevent it rom shrinking its assets: 1) it can raise new capital to replace that which

was lost; or 2) it can let its ratio o capital to assets decline. Many o the tools that we

discuss are just dierent mechanisms or acilitating adjustment on one o these twomargins. We start with capital proposals and then broaden the discussion to other

options that have heretoore been outside o the regulatory toolkit.

Time-Varying Capital Requirements

One intuitively appealing response to the problem o balance-sheet shrinkage

is to move to a regime o time-varying capital requirements, with banks being asked

to maintain higher ratios o capital to assets in good times than in bad times. Under

such a rule, banks can draw down their buers when an adverse shock hits and

continue operating with less pressure to shrink assets. Kashyap and Stein (2004)

argue that time-varying capital requirements emerge as an optimal scheme in a


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model where the social planner maximizes a welare unction that weights both

1) the microprudential objective o protecting the deposit insurance und and

2) the macroprudential objective o maintaining credit creation during recessions.

A planner concerned with both objectives should be willing to tolerate a higher

probability o bank ailure in bad times, when bank capital is scarce and credit

supply is tight, than in good times.

One challenge in designing such a regime is that, in bad times, the regu-

latory capital requirement is oten not the binding constraint on banks. Rather,as the risk o their assets rises, the market may impose a tougher test on banks

than do regulators, reusing to und institutions that are not strongly capitalized.3

Table 1 shows that, as o the frst quarter o 2010, the our largest U.S. banks had

an average ratio o Tier 1 common equity to risk-weighted assets o 8.2 percent and

an average ratio o total Tier 1 capital (including preerred stock, or example)

to risk-weighted assets o 10.7 percent. These are both well above the pre-crisis

regulatory standard, which required a ratio o total Tier 1 capital to risk-weighted

assets o 6 percent or a bank to be deemed well capitalized. Thus, even as the

U.S. economy was emerging rom a deep fnancial crisis in early 2010, the regula-

tory constraint was nonbinding.This pattern implies that to achieve meaningul time variation in capital ratios,

the regulatory minimum in good times must substantially exceed the market-imposed standard

in bad times. Thus, i the market standard or equity-to-assets in bad times is 8 percent,

and we want banks to be able to absorb losses o, say, 4 percent o assets without

pressure to shrink, then the regulatory minimum or equity-to-assets in good times

3 This tendency may be amplifed by the widespread use o Value at Risk (VaR) models by banks. Asmeasured volatility and hence VaR go up in bad times, such models mechanically call or banks to holdhigher ratios o capital. Thus, banks own internal risk management practices might compel shrinkageeven i market unding remains available.

Table 1

Capital Ratios or Top Four U.S. Banks, 2010Q1

Bank oAmerica Citigroup

JPMorganChase

WellsFargo

Weightedaverage

Total risk-weighted assets($ millions)

1,519 1,023 1, 147 988

Tier 1 common equity torisk-weighted assets (%)

7.6 9.1 9.1 7.1 8.2

Tier 1 capital to risk-weightedassets (%)

10.2 11.2 11.5 10.0 10.7

Sources:Data is rom the websites o individual banks.Note:This table lists the capital ratios or the our largest U.S. banks as o 2010Q1.


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would have to be at least 12 percent. A loss on the order o 4 percent o assets is

actually less severe than the experience o the major banks during the recent crisis;

the IMF (2010) estimates that cumulative credit losses at U.S. banks rom 2007 to

2010 were on the order o 7 percent o assets. Using this fgure, one could argue ora good-times regulatory minimum ratio o equity to assets o 15 percent. Either way,

these are high values, signifcantly higher than obtained rom a microprudential

calculation that asks only how much capital is needed to avert outright ailure. (We

examine the potential costs o raising capital requirements by this much below, in

the penultimate section o the paper.)

Higher-Quality Capital

Traditionally, the capital metric given the most attention by regulators has

been the ratio o total Tier 1 capital to risk-weighted assets. In addition to common

equity, total Tier 1 capital includes, among other items, preerred stock. Thus, both

equity and preerred have counted in the same way towards satisying capital

requirements. From a microprudential perspective, this makes perect sense. I the

only concern is avoiding losses to the deposit insurer in the event o bank ailure,

so long as both common and preerred holders are strictly junior in priority to the

deposit insurer, they will provide the desired loss-absorption cushion.

However, in the wake o the fnancial crisis, many investors and regulators

have discussed the quality o a banks capital base and how common stock is a

higher-quality orm o capital than preerred. While this distinction is hard to

understand rom a microprudential loss-absorption perspective, it ows naturallyrom the macroprudential approach, which ocuses less on a static ailure scenario

and more on enabling troubled institutions to recapitalize dynamically and remain

viable as going concerns. Common equity is more riendly to the recapitalization

process than preerred stock because it is more junior and hence less problematic

in terms o the debt overhang problem described above.

To see this point, consider two banks, A and B. Both begin with total assets o

$100 and total capital o $6. But As capital is composed entirely o equity, while B

has $2 o equity and $4 o preerred. Now suppose both banks lose $3. To avoid

shrinking their assets, they would like to raise new capital. Suppose they do so by

trying to issue equity. This will be harder or Bank Bwhose entire pre-existingequity layer has been wiped out and whose preerred stock is, as a result, now trading

at a steep discount to its ace valueor any new equity that B brings in will largely

serve to bail out the position o its more senior preerred investors.

This logic suggests that given the goal o promoting rapid recapitalization by

going-concern banks that run into trouble, it is entirely reasonable or regulators

to require that most o the capital requirement be satisfed with common equity.

Indeed, one can argue that essentially allo what is now the Tier 1 requirement

should be in terms o equity, or instruments that are contractually guaranteed to

convert into equity in a bad state (see below or a discussion), while more senior

securities like preerred stock should or the most part not count.


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Corrective Action Targeted at Dollars o Capital, Not Capital Ratios

When regulators are vigilant, banks that all below a designated capital threshold

may be subject to a variety o sanctions (or example, restrictions on dividends)

until they repair their capital ratios. The principle o rapid regulatory interventionis undoubtedly a good one, but the orm o the intervention matters a great deal.

I a bank is put in the penalty box until it manages to fx its capital ratio, it may well

choose to fx the ratio not by raising the numerator (capital) but by reducing the

denominator (assets).4A better approach is to create incentives or the bank to raise

incremental dollarso new capital.

One way to implement this policy would be with a capital ratio requirement that

reers to the maximumo current and lagged assets. Imagine a bank that starts with

assets o $100 and capital o $8 at the end o year t, and suppose that the threshold or

corrective action is a capital ratio o 6 percent. Now assume that the bank has losses o

$4 over year t+ 1, so it ends the year with $4 o capital. Normally regulators would push

the bank to get its ratio back to 6 percent, which it might do by shrinking its assets to

$66.67. Under our alternative, the bank would only get out o the penalty box when

its ratio o capital to the maximum o year t assets or year t+ 1 assetsexceeded 6 percent.

Given that year tassets were $100 and cannot be reduced retroactively, the bank would

have to raise $2 o new capitalit could not avoid sanctions by shrinking assets.

A dramatic illustration o this dollars-based corrective action principle comes

rom the Supervisory Capital Assessment Program (SCAP), the stress tests that

the major U.S. banks underwent in spring 2009.5 The output o the SCAP was, or

each bank being tested, a dollartarget or new equity capital that had to be raised,via equity issues or asset sales. For some o the banks involved, the numbers were

very largeor example, Bank o America was required to raise $33.5 billion. The

penalty box in this case was that any bank ailing to raise the capital rom the private

markets would be required to accept an equity injection rom the Treasury, which

would have involved strict limits on executive compensation. Remarkably, in the

ew weeks ollowing the release o the SCAP results, the banks involved were able to

raise nearly $60 billion in new common equity; by the end o 2009 this fgure had

risen to over $125 billion.

Here is a case where a strong regulatory hand appears to have had highly

benefcial eects. Indeed, by being tough and giving banks no choice, regulatorsprobably made it easier or banks to do the capital raising. This is because absent

discretion, the adverse selection problem normally associated with equity issues

disappears. I a bank has a choice o whether to issue equity, its decision to do so

may signal that management believes it to be overvalued, and hence this issuance

may knock down the stock price (Myers and Majlu, 1984). But i it has no choice,

4 Hart and Zingales (2010) recommend orcing banks to issue equity whenever their credit risk (asmeasured by spreads on credit deault swaps) goes above a certain level. However, this does not address

the shrinkage problem, because a bank can also reduce its credit spreads by selling risky assets.5See Hirtle, Schuermann, and Stiroh (2009) or a uller discussion o the lessons learned rom the SCAP.


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there is no inormation content, and hence no negative price impact. We hope that

this lesson can be incorporated into regulatory policy going orward. As we note

below, it may be especially helpul in thinking about the phase-in o higher capital

requirements under Basel III.

Contingent Capital

A dollars-based corrective action policy amounts to an attempt to orce banks

to recapitalize on the y when they get into trouble. A closely related idea is to pre-

wire the recapitalization with a contingent instrument that automatically increases

a banks equity position when some prespecifed contractual provision is triggered.

Two broad types o contingent capital instruments have been proposed. The frst,

sometimes called reverse convertibles or contingent convertibles, involves a bank

issuing a debt security that automatically converts into equity i a measure o either

the banks regulatory capital or stock market value alls below a fxed threshold

(Flannery, 2005; French et al., 2010).6 For example, in November 2009, Lloyds Bank

issued 7.5 billion in contingent convertible debt, with conversion to equity to be

triggered i Lloyds Tier 1 capital ratio alls below 5 percent.

A second type o contingent capital is capital insurance, which involves a bank

purchasing an insurance policy that pays o in a bad state o the world (Kashyap,

Rajan, and Stein, 2008). To address concerns about the insurer deaulting, the policy

would be ully collateralizedthat is, the insurer would put the ull amount o the

policy into a lock-box up ront. For example, a bank might contract with a pension

und to buy a capital insurance policy that pays $20 billion in the event that an econo-mywide index o bank stock prices alls below some designated value any time in the

next fve years. At initiation, the pension und would turn the $20 billion over to a

custodian; i the bad state is not realized within fve years, the $20 billion reverts back

to the pension und, and i it is realized, the unds are transerred to the bank.

These designs share a common motivation. The premise is that banks view

equity capital as an expensive orm o fnancein other words, there are one or

more violations o the ModiglianiMiller (1958) conditions that make banks reluc-

tant to carry large precautionary buers o equity. (We discuss the precise nature

o these violations in detail below.) In principle, regulation could simply mandate

that banks maintain very large equity buers. However, it may be more efcient todevelop a fnancing arrangement that delivers more equity only in those bad states

where it is most valuable.

I these orms o contingent capital are such a good idea, why havent we seen

more o them? One simple answer is that they would have to be allowed to count

towards regulatory capital requirements. Consider the ollowing approach. The

capital requirement or a bank in good times might be set at a relatively high level,

6 There are many important design issues associated with the specifcation o the trigger in a contingentconvertible security, with both pros and cons to using a trigger based on stock prices as opposed toregulatory accounting numbers. See McDonald (2010) or a detailed discussion o these issues.


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say 20 percent. Banks would then be given a choice: they could satisy the entire

requirement with equity, or they could satisy up to say 10 percentage points o it

with a reverse convertible so long as it was contractually guaranteed to turn into

equity in a well-defned bad state. (As we discuss below, Swiss banking regulatorsrecently announced new rules o exactly this orm.) The reverse convertible might

be seen as more costly than straight debtwhich is why banks would not use it i it

did not count as regulatory capitalbut as long as it was cheaper than equity, there

would be an efciency gain.

Finally, it is worth noting the close connection between contingent capital and

proposals to reorm executive compensation by imposing bonus holdbacks on key

employees o fnancial frms. For example, French et al. (2010) suggest withholding

a signifcant share o each senior managers total compensation or several years.

The withheld compensation would not take the orm o stock or options, but would

instead be a fxed dollar amount. And, managers would oreit their holdbacks i

the frm were to ail or to receive extraordinary government assistance.

Structurally, this holdback proposal is similar to the capital insurance scheme

o Kashyap, Rajan, and Stein (2008), with the key dierence being that it requires

frm managersrather than, say, a pension undto be the insurance provider.

The merit o this approach is that not only does the held-back compensation

create an extra, contingent capital buer, it also helps to improve incentives

within the frm. In particular, by making insiders bear downside risk without any

additional upside potential, it aligns their ortunes with those o taxpayers and

other creditorsand in so doing, leans against the heads I win, tails you loserisk-taking incentives created by more conventional orms o stock- and proft-

linked compensation.

Regulation o Debt Maturity

One important lesson rom the recent crisis is that the distinction between

short-term and long-term debt had been given insufcient attention by regula-

tors. Table 2 presents a snapshot o the aggregate liability structure o the U.S.

banking system, including not only traditional commercial banks but also broker-

dealer frms. Clearly, the majority o their debt is short-term: either in the orm o

deposits or wholesale unding, which includes commercial paper and repurchase(repo) agreements. While deposits are generally insured and hence not likely to

run at the frst sign o trouble, the same is not true or wholesale unding. Indeed,

wholesale unding runsa reusal o repo and commercial paper creditors to roll

over their loansplayed a key role in the demise o Northern Rock, Bear Stearns,

and Lehman Brothers, among other high-profle ailures (Shin, 2009; Gorton and

Metrick, 2010; Dufe, 2010).

The case or regulating the use o short-term debt by fnancial frmsabove

and beyond regulating total leveragerests on two observations. First, the ability o

short-term lenders to run leads to more ragility than in the case with an equivalent

amount o long-term debt (Diamond and Dybvig, 1983). It is hard to imagine that


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Northern Rock, or Bear Stearns, or Lehman would have aced the same problems

had they done most o their borrowing on a long-term basis. Second, in the pres-

ence o marketwide fre sales, the choice o debt maturity creates an externality.

When an individual bank or broker-dealer opts to fnance largely with short-term

debt, it ails to internalize that in a crisis, an inability to roll over short-term debt

will orce it to liquidate assets, thereby imposing a fre-sale cost on others whohold the same assets and who see the value o their own collateral diminished. The

result is a level o short-term fnancing that is socially excessivehence the role or

regulation (Stein, 2010a).

Regulating the Shadow Banking System

The fre-sale risk associated with excessive short-term unding comes rom not

just insured depositories, but rather, any fnancial intermediary whose combina-

tion o asset choice and fnancing structure may exacerbate a systemic fre-sale

problem. A narrow interpretation o this principle would say that regulation should

cover large, systemically signifcant nonbank institutions such as Bear Stearns and

Table 2

Liability Structure o U.S. Bank Holding Companies, 2009

$ trillion % o assets

Assets 15.927 100.0%

Liabilities

Deposits 7.502 47.1%

Short-term wholesale undingRepurchase agreements and ederal unds purchased 1.658 10.4%Other short-term wholesale unding 0.880 5.5%Trading liabilities 0.736 4.6%

Total 3.274 20.6%

Long-term unding

Long-term wholesale unding 1.718 10.8%Subordinated debt and trust preerred 0.416 2.6%

Total 2.134 13.4%

Other liabilities 1.570 9.9%

Total liabilities 14.480 90.9%

EquityCommon stock 1.309 8.2%Preerred stock 0.137 0.9%

Total equity 1.446 9.1%

Sources:The table is based on data rom the FR Y-9C reports that Bank Holding Companies are required

to fle with the Federal Reserve.Note:This table summarizes the liability structure o U.S. bank holding companies as o December 31,2009.


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Lehman Brothers, who did not fnance themselves with insured deposits but who

were nevertheless subject to wholesale fnancing runs. While this specifc point is

now well appreciated, the principle has broader application. From the perspective

o credit creation and macroeconomic impact, some o the most damaging aspects

o the crisis arose not just rom the problems o individual large frms, but also rom

the collapse o an entire marketnamely the market or asset-backed securities.

Figure 1 illustrates this collapse.7 The market or traditional asset-backed secu-

rities, those based on credit-card, auto, and student loans, averaged between $50 and$70 billion o new issues per quarter in the years prior to the crisis (total issuance or

2007 was $238 billion). However, in the last quarter o 2008, ollowing the demise

o Lehman, issues in this category ell to just over $2 billion. The disappearance o

this market represented a major contraction in the supply o credit to consumers.

The investors who buy tranches o asset-backed securities requently do so

by relying on short-term borrowing. Entities known as structured investment

vehicles or conduits, which in the past tended to be afliated with sponsoring

7 The discussion in the remainder o this section is a much-abridged version o material in Stein (2010b).

Figure 1

Quarterly Issuance o Asset-Backed Securities, 20002010Q2

Source:The data underlying this fgure come rom Thompson SDC.Notes:The fgure plots the quarterly issuance o traditional versus nontraditional asset-backed securities(ABS). Traditional ABS includes securitizations backed by auto loans, credit card receivables, andstudent loans. Nontraditional issuance includes ABS backed by subprime mortgages, collateralized debtobligations (CDOs), and collateralized loan obligations (CLOs). While the nontraditional categoryincludes securitizations backed by subprime mortgages, it does not include securitizations backed byprime mortgages, such as mortgage-backed securities guaranteed by Fannie Mae or Freddie Mac.

350

300

$

billion

250

200

150

100

50

0Mar.00

Mar.01

Mar.02

Mar.03

Mar.04

Mar.06

Mar.05

Mar.10

Mar.09

Mar.08

Mar.07

Traditional (auto, credit cards, student loans)

Nontraditional (subprime, CDOs, CLOs)


13/27


commercial banks, hold tranches o asset-backed securities and fnance them with

commercial paper, which typically has a maturity o only days or weeks. Hedge

unds and broker-dealer frms may fnance their holdings o asset-backed securities

with repurchase agreements, a orm o overnight collateralized borrowing. Collec-tively, these various investors who acquire asset-backed securities and fnance them

with short-term debt are oten reerred to as the shadow banking system. Moreover,

as emphasized by Gorton (2010), Gorton and Metrick (2010), and Covitz, Liang,

and Suarez (2009), the collapse o the asset-backed securities market eatured the

essential elements o a classic bank runnamely an inability o investors in asset-

backed securities to roll over short-term fnancing.

One maniestation o the withdrawal o short-term lending to the asset-backed

securities market comes rom the behavior o haircuts in repurchase agreements.

When an investor borrows in the repo market, the investor is required to post a

margin, or down payment, known as the haircut. Haircuts on most highly rated

asset-backed securities were very low prior to the crisis, on the order o 2 percent.

Thus, i a hedge und wanted to buy $1 billion o AAA-rated, auto-linked asset-

backed securities, it only needed to put up $20 million o its own capital. The other

$980 million could be borrowed on an overnight basis in the repo market; in many

cases the ultimate lenders were money-market mutual unds.8

In the midst o the crisis, haircuts skyrocketed. Even haircuts on consumer

asset-backed securitieswhich were not linked to subprime problemsrose to over

50 percent. From the perspective o the hedge und holding $1 billion o such

securities, all o a sudden it could only borrow $500 million, and instead o having topost a $20 million down payment, had to put up $500 million. I it did not have the

cash to do so, it would be orced to liquidate its holdings. These liquidations, and

the eect they had on the level and volatility o prices, in turn justifed the increased

skittishness o the lenders in the repo market, since their protection depends on

the collateral value o the assets they lend against. In other words, the disruption to

the asset-backed securities market may have been what Brunnermeier and Pedersen

(2009) call a margin spiral.

From a macroprudential perspective, it would be a mistake to ocus too

narrowly on the largest fnancial institutions while paying insufcient attention

to potential vulnerabilities in the rest o the system.9 What concrete steps mightbe taken in this regard? A useul frst principle is that an eort should be made to

impose similar capital standards on a given type o credit exposure irrespective o

8 This is not to say that the hedge unds overallleverage would be 50 to 1, as in this exampleonly thatit could borrow aggressively against certain highly rated assets that were seen as low risk and hence as

very good collateral.9 Some have advocated a narrow banking model, whereby tightly regulated banks are restricted tocore deposit-taking and lending activities, and a substantial chunk o their other business is pushed outto a more lightly regulated periphery. While such an approach may keep certain unctions (such as thepayments system) sae, the risk is that the overall process o credit creation may be made more vulner-able, not less, to shutdown in the event o a crisis.


14/27


who winds up ultimately holding the exposurebe it a bank, broker-dealer, hedge

und, or special purpose vehicle. This task is not easy, but one tool that would help

is broad-based regulation o haircuts on asset-backed securities.10

Consider the case where the exposure is a consumer loan. I this loan is madeby a bank, it will be subject to a capital requirement. Now suppose instead that

the loan is securitized by the bank and becomes part o a consumer asset-backed

security whose tranches are distributed to investors. The regulation we have in mind

would stipulate that whoever holds a tranche o the asset-backed security would

be required to post and maintain a minimum haircut against that tranchewith

the value o the haircut depending on the seniority o the tranche, the quality o

the underlying collateral, and so orth. Such a requirement is nothing conceptually

new and should not be difcult to enorce; indeed, it is closely analogous to the

initial and maintenance margin requirements that are currently applicable to inves-

tors in common stocks. For models that suggest a role or haircut regulation, see

Geanakoplos (2010) and Stein (2010a).

I these requirements are well-structured, they would have two benefts. First,

they could help to harmonize regulation across organizational orms, thereby

reducing the incentive or lending activity to migrate into the shadow banking

sector. Second, or those assets that do end up in the shadow banking system,

haircut regulation can dampen the destabilizing dynamics described above. I hair-

cuts start out at 2 percent and then jump to 50 percent in a crisis, this creates a

powerul orced-selling pressure on owners o asset-backed securities. I haircuts are

set instead at a higher value beore the crisis, this orced-selling mechanism and thevicious spiral it unleashes might be attenuated. Note that central banks, through

their discount window and emergency-lending acilities, have already developed

signifcant expertise in determining prudent values o haircuts on various kinds o

asset-backed securities.

While we have ocused on regulations that address fre-sale externalities, the

problems o the asset-backed securities market arguably go beyond fre sales. Hanson

and Sunderam (2010) show that the tranching process, by which large ractions

o underlying collateral pools are turned into AAA-rated securities, can blunt the

incentives o investors to become inormed about what they are buyingbecause

AAA-rated securities are ostensibly so low risk that the returns to becoming inormedare minimal. A lack o inormed investors can in turn make securitization markets

more ragile when times turn bad and the need to analyze securitization cash ows

rises. This implies that regulators should worry about the structure o securitiza-

tionsparticularly the amount o AAA-rated securities being manuactured rom

any given collateral pool.

10A more general version o this observation is that a regulatory toolkit with only a capital ratio and asingle liquidity ratio will be inadequate or controlling instability arising rom deposit deaults, fre sales,and credit crunches (Kashyap, Berner, and Goodhart, orthcoming).


15/27


What Are the Costs o Higher Capital Requirements?

We have argued that a macroprudential approach involves imposing substan-

tially higher capital requirements on fnancial frms, particularly in good times.But will these higher capital requirements lead to increased costs or borrowers? In

what ollows, we ocus on the long-run steady-state consequences o higher capital

requirements, setting aside the transitional issues associated with phase-in o a new

regime.11 To preview, our reading o the theory and relevant empirical evidence

suggests that while increased capital requirements might be expected to have some

long-run impact on the cost o loans, this eect is likely to be quite small.

A ModiglianiMiller Perspective

Modigliani and Miller (1958) amously showed that under certain conditions, a

frms capital structure is irrelevant or its operating decisions. In the banking context,

this would imply that the rate that a frm charges on its loans should be independent

o its capital ratio. The Modigliani and Miller conditions are stringent, including

no taxes, symmetric inormation, rational risk-based pricing, and cashows that are

independent o fnancial policy. Thus, they are not meant as an accurate depiction

o reality. Rather, the value o the Modigliani and Miller ramework is that it orces

one to be precise about which o the conditions is violated, and this allows or a more

disciplined analysis o the eects associated with changes in capital structure.

In particular, the Modigliani and Miller paradigm exposes the aw in the

ollowing reasoning: Equity is more expensive than debt because it is riskier. Thus,i a bank is orced to rely more on equity, its overall cost o fnance will go up, and

it will have to charge more or its loans. The allacy here is that the risk o equity,

and hence its required return, is not a constant, but rather declines as leverage

alls.12 Indeed, when all the Modigliani and Miller conditions hold, this eect is just

enough to oset the increased weight o the more-expensive equity in the capital

structure so that the overall cost o capital stays fxedas bank leverage varies.

With this caveat in mind, we discuss two deviations rom Modigliani and

Millers idealized conditions that are likely to be relevant in the present context.

First, interest payments on corporate debt are tax deductible while dividend

payments on equity are not. This eect lends itsel to easy measurement. Supposethat new equity capital displaces long-termdebt in a banks capital structure and

that the only eect on the banks weighted average cost o capital comes rom the

lost tax shields on the debt. I the coupon on the debt is 7 percent, and given a

corporate tax rate o 35 percent, each percentage point o increased equity raises

11 This section draws on material rom our unpublished working paper, Kashyap, Stein, and Hanson(2010).12 In Kashyap, Stein, and Hanson (2010), we show that this holds empirically in the banking sector: in apanel o large banks, those with less leverage have signifcantly lower values o both beta and stock-return

volatility.


16/27


the weighted average cost o capital by .07 .35 = .0245 percent, or 2.45 basis

points. Thus, even a 10 percentage-point increase in the capital requirement only

boosts the weighted average cost o capitaland hence loan ratesby 25 basis

points, which is a small eect.To generate a higher fgure, consider a case where equity displaces short-

term debt; this can be interpreted as capturing the joint eects o an increase

in both capital and liquidity requirements. Moreover, ollowing Gorton (2010),

Gorton and Metrick (2010), and Stein (2010a), assume thatin violation o the

Modigliani and Miller conditionsthere is a non-risk-based money premium

on wholesale short-term bank debt that reects its useulness as a transactions

medium. (Commercial paper and repo are oten held by money-market mutual

unds, who in turn issue checkable deposits.) An upper-bound estimate o this

money premium might be on the order o 100 basis points.13 Now, a 10 percentage-

point increase in capital requirements raises the weighted average cost o capital

by an added 10 basis points relative to the previous taxes-only case, and we are up

to 35 basis points. This number is still quite modest.

Time Variation in Bank Capital Ratios and Lending Rates

Our calibrations based on the ModiglianiMiller paradigm suggest that the

long-run eects o higher capital requirements on loan rates should be small. A

complementary approach is to examine the historical record. Figure 2A, which is

adapted rom Berger, Herring, and Szego (1995), shows the ratio o book equity to

book assets or U.S. commercial banks rom 1840 to 2009. Capital ratios exceeded50 percent in the 1840s and ell steadily or the next 100 years, reaching 6 percent

by the 1940s. Have these large uctuations in capital ratios translated into big dier-

ences in the cost o bank credit? To address this question, we have examined the

behavior o various proxies or the markup that banks charge on loans. In a variety

o regression specifcations (not shown here), we ound no reliable time-series

correlation between these markup variables and bank capital ratios. The historical

data is simply too noisy, and our proxies or loan spreads too crude, or us to draw

any confdent conclusions about whether a correlation between equity ratios and

loan rates even exists.

To illustrate the loose ties between loan costs and capital ratios, Figure 2Bplots capital ratios or the period 19202009 against two markup proxies: 1) the

net interest margin (net interest income over earning assets); and 2) the yield on

loans (interest income on loans over gross loans) minus the rate paid on deposits

(interest expense on deposits over deposits). As can be seen, there is no apparent

correlation between capital ratios and either measure o markups.

13 As a benchmark, Krishnamurthy and Vissing-Jorgensen (2010) estimate that Treasury securitiesimpound a money-like convenience premium o approximately 72 basis points, on top o what would beexpected in a standard risk-vs.-return asset-pricing setting.


17/27


Figure 2

U.S. Bank Capital Ratios and Loan Spreads

Sources:Data rom 1840 to 1896 is based on Berger, Herring, and Szego (1995) who use data rom theStatistical Abstracts o the United States. Data rom 1896 to 1919 is based on data or All Banks rom the AllBank Statistics, 18961955(Board o Governors o the Federal Reserve, 1959). Data rom 1919 to 1933 isbased on Federal Reserve member banks and is rom Banking and Monetary Statistics, 19191941 (Boardo Governors o the Federal Reserve, 1943). Data rom 1934 to 2010 is or all insured commercial banksand is rom the FDICs Historical Statistics on Banking.Notes:Figure 2Aplots the ratio o book equity to book assets or U.S. commercial banks rom 1840 to2009. Figure 2B plots two measures o bank loan spreads versus equity/assets rom 1920 to 2009. Wemeasure loan spreads using either the net interest margin (net interest income over earning assets)or the yield on loans minus the rate paid on deposits (interest income on loans over gross loans minusinterest expense on deposits over deposits).

A: Book Equity to Assets for U.S. Banks, 18402009

B: Relationship between Loan Spreads and Bank Equity/Assets, 19202009

60%

0%

50%

40%

30%

20%

10%

18402010

18501860

18701880

18901900

19101920

19301940

19501960

19701980

19902000

4%

16%

14%

12%

10%

8%

6%

1%

7%

6%

5%

4%

3%

2%

19202010

19301940

19501960

19701980

19902000

Bank equity/assets (left scale)

Bank net interest margins (right scale)

Bank loan yield - Deposit rate (right scale)

Equityto

assets


18/27


But Then Why Are Banks So Determined to Operate with High Leverage?

These conclusions may appear surprising, even paradoxical. I signifcant

increases in capital ratios have only small consequences or the rates that banks

charge their customers, why do banks generally eel compelled to operate insuch a highly leveraged ashion in spite o the risks this poses? And why do they

deploy armies o lobbyists to fght increases in their capital requirements? Ater

all, nonfnancial frms tend to operate with much less leverage and indeed appear

willing in many cases to orego the tax (or other) benefts o debt fnance altogether.

In Kashyap, Stein, and Hanson (2010), we argue that the resolution o this

puzzle has to do with the nature o competition in fnancial services. The most

important competitive edge that banks bring to bear or many types o transactions

is the ability to und themselves cheaply. Thus, i Bank A is orced to adopt a capital

structure that raises its cost o unding relative to other intermediaries by 20 basis

points, it may lose most o its business, (or become much less proftable, since the

return on assets in banking is on the order o 125 basis points). Contrast this with,

say, the auto industry, where cheap fnancing is only one o many possible sources

o advantage: a strong brand, quality engineering and customer service, and control

over labor costs may all be vastly more important than a 20 basis-point dierence in

the cost o capital.

One suggestive piece o evidence or this competition hypothesis comes rom

the distribution o capital ratios by bank size, as illustrated in Figure 3, which covers

the period 19762009. There is a strong inverse relationship between bank size

and capital ratios, with the smallest banks (with assets under $100 million) havingTier 1 risk-based capital ratios more than double those o the largest banks (with

assets over $100 billion) or most o the sample period. Whatever their root cause,

these large dierences in capital ratios hint at a couple o important points. First,

they suggest that several percentage points o additional capital need not imply

prohibitively large eects on lending ratesor i they did, it would be hard to

understand how the smaller community banks have managed to stay in business.

Second, the ability o small banks to survive at higher capital levels probably reects

something about the soter degree o competition in their core line o business. A

large literature argues that small banks tend to ocus on inormationally intensive

relationship lending and that the embedded sot inormation in these relation-ships creates a degree o specifcity between frms and their lenders (Rajan, 1992;

Petersen and Rajan, 1994, 1995; Berger, Miller, Petersen, Rajan, and Stein, 2005).

To the extent that larger banks deal with larger customers where competition rom

other providers o fnance is more intense, even small cost-o-capital disadvantages

are likely to prove unsustainable.

Testing the Competition Hypothesis

To urther investigate the competition hypothesis, we examine the eects o

changes in state branching regulations. We test two basic predictions. First, we expect

that a regulatory shock that increases the degree o competition in a state should


19/27


Figure 3

U.S. Bank Capital Ratios by Bank Size, 19762009

Source:The fgure is based on data rom bank Call Reports.Notes:This fgure plots capital ratios by bank size rom 19762009. Banks are placed into size groupsbased on assets in 2008Q4 dollars. Figure 3A plots book equity to book assets. Figure 3B plots Tier1 capital ratios (Tier 1 regulatory capital over risk-weighted assets). All banks owned by a given bank

holding company are combined into a single organization or the purposes o this size classifcation.

A: Book Equity to Book Assets

B: Tier 1 Risk-Based Capital Ratios

2%

4%

6%

8%

10%

12%

14%

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

2008

Assets < $100m

$10B < Assets < $100B

8%

10%

12%

14%

16%

18%

20%

6% 19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

$1B < Assets < $10B$100m < Assets < $1B

Assets > $100B


20/27


lead the averagecapital ratio o banks in that state to decline. Second, we expect a

compression eect: the decline in capital ratios should be largest or those banks in the

state that, prior to the shock, were operating with the highest capital ratios. Or said

dierently, we expect the regulatory shock to reduce the cross-sectional dispersiono capital ratios o banks in the given state.

To implement our tests, we take data on the year that various state banking

regulations were relaxed rom Stiroh and Strahan (2003). We examine two types

o deregulation: the easing o intrastate branching restrictions and the advent o

interstate banking. Prior to 1970, two-thirds o states had restrictions on intrastate

branching which were relaxed rom 1975 to 1992. Between 1982 and 1993, 48 states

entered into regional or national agreements permitting interstate bankingi.e.,

allowing out-o-state bank holding companies to own banks in their state. Given the

timing o deregulation, we ocus on bank data (rom bank Call Reports) over the

period rom 1976 to 1994. Since our source o variation is at the state-year level, we

work with state-year aggregates. We estimate reduced-orm regressions o the state-

level equity-to-asset ratio on dummies that switch on in the year that a state relaxes

its regulations, along with state and year fxed eects. We have two deregulatory

dummies: INTRASTATEis based on the year that a state allows intrastate branching

by mergers, while INTERSTATEis based on the year that a state enters a regional or

national interstate banking agreement.

Table 3 displays the results o these regressions where the dependent vari-

able in the frst column is the mean equity-to-asset ratio in state sin year t; in the

second column is the cross-sectional standard deviation o equity-to-assets; and inthe remaining columns are the cross-sectional quantiles o the equityasset ratio.

The results in the frst column imply that equity-to-assets alls by about 0.3 percentage

points ollowing intrastate branching and another 0.2 percentage points ollowing

interstate banking. Thus, equity-to-assets alls by roughly 0.5 percentage points or

the average state relaxing both restrictions. This decline can be compared to the

typical cross-sectional standard deviation o 1.08 percentage points and is economi-

cally meaningul considering that the average equity-to-assets ratio in our sample is

just over 7 percent.

The remaining columns in Table 3 show that, consistent with the notion o

a compression eect, the dispersion o capital ratios within a state alls ollowingderegulation, and capital ratios all the most or those banks that were previously

in the upper tail o the distribution. This appears to have been particularly true

ollowing the advent o intrastate banking: the capital ratios o banks in the 75th and

90th percentiles o the distribution all by 60 and 70 basis points, respectively, versus

only a 10 basis point change at the 10th and 25th percentiles.

In sum, the data support the hypothesis that when banks are aced with more

intense competition, they gravitate towards both higher and more uniorm levels

o leverage. Such competitive eects combined with our earlier ModiglianiMiller-

based calibration results suggest one reason why tougher capital regulation o

fnancial frms is appealing: it would seem to have the potential to reduce competition


21/27


on a dimension that creates negative externalities and systemic risk, while at the

same time not raising loan rates by much. However, the complication is that these

same competitive pressures also create powerul incentives to evade either the letter

or the spirit o the rules. Thus, the most worrisome long-run byproduct o higher

capital requirements will likely not be its eect on the cost o credit to borrowers, but

the pressure it creates or activity to migrate outside o the regulated banking sector.

A Financial Reorm Report Card

To conclude the paper, we briey compare our proposals to policy reorms that

emerged in the second hal o 2010. Our ocus is primarily on the recommendations

made by the Basel Committee on Banking Supervision in September 2010 as part

o the so-called Basel III process (see Basel Committee on Banking Supervision,

2010, or a summary). We will say less about the Wall Street Reorm and Consumer

Protection Actoten called the DoddFrank legislationthat was signed into law

in July 2010. This is because our analysis has been centered on capital regulation

and closely related issues, the implementation o which has been taken up in more

specifc numerical detail in Basel III; conversely, we have not attempted in this paper

Table 3

Impact o Deregulation on Distribution o Equity-to-Assets within States

Dependent variable

MeanStandarddeviation

10th%tile

25th%tile

50th%tile

75th%tile

90th%tile

Regression 1: 0.288 0.274 0.099 0.106 0.193 0.626 0.682 INTRASTATE [2.10] [2.75] [0.70] [0.81] [1.49] [2.47] [2.40]

Regression 2: 0.217 0.133 0.037 0.182 0.278 0.290 0.349 INTERSTATE [2.25] [0.68] [0.31] [1.46] [2.68] [1.96] [1.73]

Regression 3: 0.281 0.270 0.100 0.100 0.183 0.617 0.671 INTRASTATE [2.05] [2.68] [0.71] [0.78] [1.41] [2.44] [2.33]

INTERSTATE 0.203 0.120 0.042 0.177 0.269 0.261 0.317

[2.05] [0.62] [0.34] [1.43] [2.62] [1.69] [1.47]

Sources:Based on anannual state-level panel rom 19761994 assembled rom bank Call Reports.Thederegulation dummies are based on the data in Table 1 o Stiroh and Strahan (2003).Notes:The table shows regressions o equity-to-assets on dummies or deregulation. The INTRASTATEdummies switch on beginning in the year when the state frst permitted intrastate branching via mergers.The INTERSTATEdummies switch on beginning in the year when the state entered a regional or nationalinterstate banking agreement. The dependent variables are alternately the asset-weighted average, standarddeviation, and quantiles o the equity-to-assets ratio within each state-year. The table reports coefcientsrom 21 separate regressions (7 dependent variables each with 3 specifcations). All regressions include aull set o state and year eects and have 969 observations (51 states 19 years). t-statistics, in brackets, arebased on standard errors that are robust to clustering (i.e., serial correlation o residuals) at the state level.


22/27


to speak to a number o the other central elements in DoddFrank, such as consumer

protection, regulation o over-the-counter derivatives, and resolution authority.

We have stressed the importance o requiring that fnancial frms have both

more capital, and, crucially, higher-quality capital. On this score, the Basel IIIrecommendations look quite good. They would raise the minimum common equity

requirement rom 2 percent o risk-weighted assets to 7 percent (this is inclusive o

a capital conservation buer). While we have argued or a higher number, this is a

signifcant step in the right direction. Moreover, systemically important institutions

will be required to have an additional, as-yet-undetermined increment in terms o

equity capital, which, i it turns out to be material, would be urther good news.

The major shortcoming on the equity capital ront is its very slow phase-in; the

new requirements do not become ully eective until January 2019. The motivation

or this slow phase-in is the concern that i banks are asked to comply with the higher

ratios in a more compressed timerame, they will do so by shrinking their balance

sheets rather than by raising new external equity capital, thereby causing a urther

credit crunch. While we agree that this worry might be legitimate i the phase-in is

truncated and no other osetting steps are taken, our above analysis suggests an

obvious alternative: during the phase-in period, regulators should push those banks

that are shy o the new capital standards to raise new dollars o equity, rather than giving

them the option to adjust via asset shrinkage. The U.S. stress tests conducted in 2009

showed that this approach can work, and i it were applied again, the phase-in period

could be made much shorter with little adverse impact on credit supply.

We also discussed the useulness o time-varying capital requirements. Here theBasel Committee proposes an additional countercyclical buerthat will range between

0 and 2.5 percent, to be implemented on a country-by-country basis. As the report

states: The purpose o the countercyclical buer is to achieve the broader macro

prudential goal o protecting the banking sector in periods o excess aggregate

credit growth. For any given country, this buer will only be in eect when there is

excess credit growth that is resulting in a system wide build up o risk. This too is a

step in the right direction, though we worry that the wording would seem to require

an afrmative fnding o excess credit growth or the requirement to kick in; one

can imagine that it will be politically challenging or regulators to make this case

when they ought to.Other elements o the reorm package remain less well developed. For example,

on the topic o debt maturity, the Basel Committee introduces the concept o a

net stable unding ratio testa requirement that fnancial frms capital structures

have a certain amount o long-term unding, which would encompass both equity

and debt with a maturity o greater than one year. However, the details regarding

the design and calibration o this rule remain to be worked out, with an observa-

tion period to begin in 2012 and the introduction o the standard itsel put o

until 2018.

Similarly, while the Basel Committee continues to study various orms o contin-

gent capital, it has not yet reached any fnal conclusions; a review is scheduled to


23/27


be completed in mid 2011. Interestingly, however, Swiss banking regulators have

chosen to move orward on their own on this ront. The Final Report o the Swiss

Commission o Experts proposed that the two big Swiss banksUBS and Credit

Suissebe required to have 19 percent total capital by 2019. O this, 10 percentwould have to be in common equity (a higher standard than the 7 percent under

Basel III) while the remaining 9 percent could, at the banks discretion, take the

orm o contingent convertibles that would convert when the ratio o equity to assets

hit a predetermined trigger value (Morgan Stanley Research, 2010). This opting

approach to contingent capital is, both qualitatively and quantitatively, closely in

line with what we described above.

Finally, perhaps the most glaring weak spot in fnancial reorm thus arone

that cuts across both the DoddFrank legislation and the Basel III processis the

ailure to ully come to grips with the shadow banking system. As we have emphasized,

i one takes a macroprudential view, the overarching goal o fnancial regulation

must go beyond protecting insured depositories and even beyond dealing with the

problems created by too-big-to-ail nonbank intermediaries. Instead, the task is to

mitigate the fre-sales and credit-crunch eects that can arise as a consequence o

excessive short-term debtanywhere in the fnancial system.

While higher capital and liquidity requirements on banks will no doubt help to

insulate banks rom the consequences o large shocks, the danger is that, given the

intensity o competition in fnancial services, they will also drive a larger share o

intermediation into the shadow banking realm. For example, perhaps an increasing

raction o corporate and consumer loans will be securitized and in their securitizedorm will end up being held by a variety o highly leveraged investors (say hedge

unds) who are not subject to the usual bank-oriented capital regulation. I so,

the individual regulated banks may be saer than they were beore, but the overall

system o credit creation may not.

To saeguard the system as a whole, attention must be paid to not tilting the

playing feld in a way that generates damaging unintended consequences. Admit-

tedly, regulating the shadow banking sector and the other parts o the fnancial

system consistently is a complex task, and one that will require a variety o specifc

tools. As one concrete frst step, we reiterate that it would be a good idea to establish

regulatory minimum haircut requirements on asset-backed securities, so that noinvestor who takes a position in credit assets is able to evade constraints on short-

term leverage.

This discussion raises a fnal question about how such regulation might be

implemented. In the United States and in Europe, macroprudential oversight has

been delegated to large councils: the Financial Stability Oversight Committee and

the European System Risk Board, respectively. Membership o both groups consists

o the heads o many regulatory organizations. Whether either council can unction

eectively and avoid tur wars is an open question. But these committees will be

pivotal in determining whether existing weaknesses in the regulatory systemsuch

as those having to do with the shadow banking sectorcan be addressed sensibly.


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We are grateul or helpul comments rom Charles Goodhart, Arvind Krishnamurthy, Andrew

Metrick, Victoria Saporta, Hyun Shin, Andrei Shleier, Ren Stulz, Lawrence Summers, Paul

Tucker, seminar participants at numerous institutions, and JEP editors David Autor, Chad

Jones, and Timothy Taylor. Kashyap thanks the Initiative on Global Markets and the Centeror Research on Securities Prices or research support on this project.

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