A Better Choice

Roll up your shirtsleeves, financial economists. As reported by Elizabeth Dexheimer at Bloomberg, Rep. Jeb Hensarling is “interested in working on a 2.0 version,”  of his financial choice act, the blueprint for reforming Dodd-Frank. “Advice and counsel is welcome."

The core of the choice act is simple. Large banks must fund themselves with more capital and less debt. It strives for a very simple measure of capital adequacy in place of complex Basel rules, by using a simple leverage ratio. And it has a clever carrot in place of the stick. Banks with enough capital are exempt from a swath of Dodd-Frank regulation.

Market based alternatives to a leverage ratio

The most important question, I think, is how, and whether, to improve on the leverage ratio with simple, transparent  measure of capital adequacy. Keep in mind, the purpose is not to determine a minimum capital level at which a bank is resolved, closed down, bailed out, etc. The purpose is a minimal capital ratio at which a bank is so systemically safe that it can be exempt from a lot of regulation.

The "right" answer remains, in my view, the pure one: 100% equity plus long term debt to fund risky investments, and short term liabilities entirely backed by treasuries or reserves (various essays here). But, though I still think it's eminently practical, it's not on the current agenda, and our task is to come up with something better than a leverage ratio for the time being.

Here are my thoughts. This post is an invitation to critique and improve.

Market values. First, we should use the market value of equity and other assets, not the book value. Risk weights are complicated and open to games, and no asset-by-asset system captures correlations between assets. Value at risk does, but people trust the correlations in those models even less than they trust risk weights. Accounting values pretend assets are worth more than they really are, except when accounting values force marks to market that are illiquid or "temporarily impaired."

Market values solve these problems neatly. If the assets are unfairly marked to market, equity analysts know that and assign a higher value to the equity. If assets are negatively correlated so the sum is worth more than the parts, equity analysts now that and assign a higher value to the equity.


Liabilities not assets. Second, we should use the ratios of liability values,  not ratios to asset values.   Rather than measure a ratio of equity to (accounting) asset values, look at the ratio of equity to the debt that the bank issues. Here, I would divide market value of equity by the face value of debt, and especially debt under one year. We want to know, can the bank pay off its creditors or will there be a run.

In principle, the value of assets = the value of liabilities so it shouldn't matter. Accountant and regulator assets are not the same as liabilities, which raises the important question -- if you want to measure asset values rather than (much simpler) liability values, then why are your asset values not the same as my liability values?

So far, then, I think the ratio of market value of equity to (equity + face value of debt) is both better and much simpler than the leverage ratio, book value of equity to complex book value of assets.

One can do better on ratios. (Equity + 1/2 market value of long-term unsecured debt ) / market value    of short term debt is attractive, as the main danger is a run on short-term debt.

Use option prices for tails. Market value of equity / face value of debt is, I think, an improvement on leverage ratios all around. But both measures have a common problem,  and I think we can do better.

A leverage (equity/assets) ratio doesn't distinguish between the riskiness of the assets. A bank facing a leverage constraint has an incentive to take on more risk. For example, you can buy a stock which costs $100, or a call option which costs $10, each having the same risk -- when the stock market moves 1%, each gains or loses $1 of value. But at a 10% leverage the stock needs $10 of capital and the call option only $1.

The main motivation of risk-weights is to try to measure assets' risk -- not the current value, but the chance of a big loss in value -- and make sure there is enough equity around for all but the worst risks. So let's try to do this with market prices.

A simple idea: So, you're worried that the same value of equity corresponds to a riskier portfolio? Fine: use option prices to measure the banks' riskiness. If bank A has bought stock worth $100, but bank B has 10 times riskier call options worth the same $100, then bank B's option prices will be much larger -- more precisely, the implied volatility of its options will be larger.

So, bottom line: Use the implied volatility of bank options to measure the riskiness of the bank's assets. As a very simple example, suppose a bank has $10 market value of equity, $90 market value of debt, and 25% implied volatility of equity. The 25% implied volatility of equity means 2.5% implied volatility of total assets, so (very roughly) the bank is four standard deviations away from wiping out its equity. Yes, this is a simplistic example, and the refinements are pretty obvious.

(For non-finance people: An option gives you the right to buy or sell a stock at a given price. The more volatile the stock, the more valuable the option. The right to sell for $80 a stock currently going at $100 is worth more, the more likely the stock is to fall below $80, i.e. the more volatile the stock. So option prices tell you the market's best guess of the chance that stocks can take a big fall.  You can recover from option prices the "implied volatility," a measure of the standard deviation of stock returns.)

We might be able to simplify even further. As a bank issues more equity and less debt, the equity gets safer and safer, and stock volatility goes down, and the implied volatility of options goes down. Perhaps it is enough to say "the implied volatility of your at the money options shall be no more than 10%."

Here's the prettiest rule I can think of. A put option is the right to sell stock at a given price. Assemble the minimum cost of put options that give the bank the right to issue stock sufficient to cover its short-term debt. For example, if the bank has $1,000 of short-term debt, then we could look at the value of 10 put options, each giving the bank the right to sell its stock at $100. If the market value of equity is greater than the cost of this set of put options, then the bank is ok.

(It would be better still if banks actually bought these put options, so they always had sitting there the right to issue equity in bad times. But then you might complain about liquidity and counterparty risk, so let's just use this as a measurement device.)

That's probably too fancy, but one should always start with the ideal before compromising. (Back to 100% equity.... )

In summary, I think we could improve a lot on the current leverage ratio by 1) using market values of equity 2) using ratios of liabilities, not accounting asset values at all and 3) using option prices to measure risk.

I left out the use of bond yields or credit default swaps to measure risk. The greater a chance of default, the higher interest rate that markets charge for debt, so one could in principle use that measure. It has been proposed as a trigger for contingent bonds or for regulatory intervention. I'm leery of it for lots of reasons. First, we're here to measure capital adequacy, so let's measure capital. Second, credit markets don't provide good measures of whether you're three or four standard deviations from default. Third, credit markets include not just the chance of default, but also the guess about recovery in default, and thus a guess about how big the bailout will be. But there is no reason in principle not to include bond information in the general picture -- so long as we can keep to the rule simple and transparent .

Our first step is to get our regulators to trust the basics: 1) stock markets provide good measures of total value -- at least better than regulators 2) option markets provide good measures of risk -- at least better than regulators.

Why not? I think our regulators and especially banks don't trust market values. They prefer the central-planning hubris that accountants and regulators can figure out what the market value and risk are better than the actual market.

If so, let's put this on the table in the open and discuss it. If the answer is "your proposal to use market value of equity and options is perfect in theory but we trust regulators to get values right a lot more than markets," then at least we have made 90% progress, and we can start examining the central question whether regulators and accountants do, in fact, outperform market measures. The question is not perfection or clairvoyance, it's whether markets or regulatory rules do a less bad job. Markets were way ahead of regulators in the last crisis.

What if market gyrations drive down the value of a bank's stock? Well, this is an important signal that bank management and regulators should take seriously by gum! Banks should have issued a lot more equity to start with to make sure this doesn't happen; banks should have issued cocos or bought put options if they think raising equity is hard. And when a bank's equity takes a tumble that is a great time to send the regulators in to see what happened. The choice act very nicely sets the equity ratio up as the point where we exempt banks from regulation, not a cliff where they get shut down.

Let's also remember, when you read the details, the leverage ratio is not all that simple or transparent either. Here is a good summary.

And let's also remember that perfection should not be the enemy of the much better. Current Basel style capital regulations are full of distorted incentives and gaming invitations. If there are small remaining imperfections, that

Or maybe not

 Is fixing the leverage ratio all important?  What's wrong with a leverage ratio? Right now, banks have to issue capital if they take your money and hold reserves at the Fed or short term Treasury debt. That obviously doesn't make much sense as it is a completely riskless activity. More subtly, a leverage ratio forces banks to issue capital against activities that are almost as safe, such as repo lending secured by Treasuries.  Required reading on these points: Darrell Duffie Financial Regulatory Reform after the crisis: An Assessment

... the regulation known as the leverage ratio has caused a distortionary reduction in the incentives for banks to intermediate markets for safe assets, especially the government securities repo market, without apparent financial stability benefits....I will suggest adjustments to the leverage ratio rule that would improve the liquidity of government securities markets and other low-risk high-importance markets, without sacrificing financial stability.

The natural response is to start risk-weighting lite. The Bank of England recently exempted government securities from their leverage ratio.  The natural response to the response is, once we start making exceptions, the lobbyists swarm in for more. You can see in Duffie's writing that an exemption for repo lending collateralized by Treasuries will come next. Given the fraction of people who understand how that works, the case for resisting more exemptions will be weak.

The poster child for the ills of risk-weighted asset regulation: Greek sovereign debt still carries no risk weight in Europe. Basel here we come.

Interestingly, Duffie does not see banks currently shifting to riskier investing, the other major concern, though that may be because the Volker rule, Basel risk weights and other constraints also apply. So perhaps I should state the market-based measures not as alternatives to the leverage rule, but as measures to add to the leverage rule, in place of the other constraints on too much risk.

But how much damage is really done by asking capital for safe investments? Recall the Modigliani-Miller theorem after all. If a bank issues equity to fund riskfree investments, the equity is pretty darn risk free too, and carries a low cost of capital.  Yes, MM doesn't hold for banks, but that's in large part because of subsidies and guarantees for debt, and it's closer to true than to totally false -- the expected return on equity does depend on that equity's risk -- and the social MM theorem is a lot closer to holding and that's what matters for policy.

And even if funneling money to safe investments costs, say, an extra percent, does that really justify the whole Dodd-Frank mess?

In the end, it is not written in stone that large, systemic, too big to fail banks must provide intermediation to safe investments. A money market fund can take your deposits and turn them in to reserves, needing no equity at all. A bank could sponsor such a fund, run your deposits through that fund, and you'd never notice the difference until the moment the bank goes under... and your fund is intact.

Duffle again:

These resiliency reforms, particularly bank capital regulations, have caused some reduction in secondary market liquidity. While bid-ask spreads and most other standard liquidity metrics suggest that markets are about as liquid for small trades as they have been for a long time, liquidity is worse for block-sized trade demands. As a trade-off for significantly greater financial stability, this is a cost well worth bearing. Meanwhile, markets are continuing to slowly adapt to the reduction of balance sheet space being made available for market-making by bank-affiliated dealers. [my emphasis] Even more stringent minimum requirements for capital relative to risk-weighted assets would, in my view, offer additional net social benefits. 

I emphasized the important sentence here. There are many other ways to funnel risk free money to risk free lending activities. The usual mistake in financial policy is to presume that the current big banks must always remain, and must always keep the same scope of their current activities -- and that new banks, or new institutions, cannot arise when profitable businesses like intermediation open up.

So, in the worst case that a liquidity ratio makes it too expensive for banks to funnel deposits to reserves, to fund market-making or repo lending, then all of those activities can move outside of big banks.

More Choice act

The Choice act has some additional very interesting characteristics.

Most of all, it offers a carrot instead of a stick: Banks with sufficient equity are exempt from a swath of regulation.

That carrot is very clever. We don't have to repeal and replace Dodd-Frank it its entirety, and we don't have to force the big banks to utterly restructure things overnight. Want to go on hugely leveraged? The regulators will be back in Monday morning. Would you rather be free to do things as you see fit and not spend all week filling out forms? Then stop whining, issue some equity or cut dividends for a while.

More deeply, it offers a path for new financial institutions to enter and compete. Compliance costs and a compliance department are not only a drag on existing businesses, they are a huge barrier to entry. Are markets illiquid? Are there people who can't get loans? The answer, usually forgotten in policy, is not to prod existing businesses but to allow new ones to enter. A new pathway -- lots of capital in return for less asset-risk regulation -- will allow that to happen.

Both politically and economically, it is much easier to let Dodd-Frank die on the vine than to uproot and replant it.

In the department of finish sanding, I would also suggest a good deal more than 10% equity.   I also would prefer a stairstep -- 10% buys exemption from x (maybe SIFI), 20% buys you exemption from y, and so forth, until at maybe 80% equity + long term debt you're not even a "bank" any more.

Remember, the issue is runs, not failure. Banks should fail, equity wiped out, and long-term debt becomes equity. The point of regulation is not to make sure banks are "safe" and "don't fail." The point of regulation is to stop runs and crises. So ratios that emphasize short term debt are the most important ones.

Duffle (above) also comes down on the side of more capital still. The "Minneapolis plan" spearheaded by Minneapolis Fed President Neel Kashkari (Speech, report by James Pethokoukis at AEI) envisions even more capital, up to 38%.