Efforts to beef up bank regulation in the wake of the financial crisis with tougher capital rules, along with leverage and liquidity requirements, are ultimately misguided, argues a new report from the C.D. Howe Institute. Instead, policymakers should be trying to curb risk taking by reintroducing shareholder liability, and limiting deposit insurance, it suggests.
In its report, the think tank says that financial regulation has become highly complex and prescriptive, but doesn’t address the fundamental issues behind financial crises. It argues that a better way to guide bank behaviour would be to return to the historical approach to bank regulation by reintroducing shareholder responsibility for bank liabilities in the event of a crisis.
The author of the report, Finn Poschmann, recommends “greater reliance on an incentives-based approach for financial institutions, which shares the risks among bond buyers, shareholders and depositors, as a better backstop to financial stability.”
The report points out that up until the mid-20th century, bank regulation in Canada, the U.S., the UK, and elsewhere relied mostly on monitoring by shareholders and depositors. “Central banks did not necessarily exist, and where they did, they did not necessarily have a modern lender-of-last-resort function. There were financial regulators, but depositors were expected to pay attention to the behaviour of the banks that held their savings,” the report says.
Indeed, the report says that senior bank managers were often “exposed to liability for net losses incurred in the event that their financial institutions failed, as were other shareholders.” They did not enjoy limited liability. However, since then, shareholder liability has disappeared from the regulatory framework, it notes, and deposit insurance has been developed to reduce bank runs and limit their impact on depositors.
“In Canada, concerns over deposit insurance arise mostly at the provincial level,” the report notes, as several provinces have expanded the size and range of deposits they cover, in some case, promising unlimited coverage. “This expansion will pose stability risks for the provinces that oversee the insurers, and for regulators and depositors outside those provinces. Implicit and explicit federal backstops for such insurance raise cross-province concerns,” it says.
Next: Focusing on incentives
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Focusing on incentives
Given these issues, the report argues that “regulators should focus more on incentives”; and it explores the possibility that certain financial instruments could accomplish that task. “While reintroducing shareholder responsibility for bank liabilities in an insolvency seems implausible, other equity-based market instruments, such as equity recourse notes… could achieve the same effect,” it says.
Equity recourse notes (ERNs) would be a form of contingent capital, but without a regulatory capital trigger, the report explains. Instead, the issuance of equity would be geared to the bank’s stock price. When interest or principal repayments are due, if the stock price is below a pre-set level, those payouts would be made in equity rather than cash, it says.
The report argues that this mechanism would bolster financial stability. “The suspension of interest payments would increase firm liquidity exactly when needed – when under stress. The conversion of debt to equity would be entirely automatic, and determined by market forces: there would be no requirement for judgment calls with respect to a trigger point, and no requirement for valuations, accurate or otherwise, to be relied on in establishing the institution’s regulatory capital ratio. And being market-based, there would be no sudden shock to the market as the debt to equity conversion unfolded,” it notes.
“This would entirely avoid the procyclical nature of discretionary regulatory capital triggers, which inevitably force firms to limit lending and increase capital ratios at exactly the time when a firm, and likely the broader financial system, was already under threat,” it says; adding that this approach could be readily implemented in Canada through revisions to bank legislation and industry rules.
If policymakers don’t pursue this sort of mechanism, the report argues that they should at least seek to curb deposit insurance. “Jurisdictions that recently have expanded deposit insurance coverage should wind back their expansions. Jurisdictions with large insurance limits should reduce them so that small depositors are protected, bank runs are avoided, and informed investors face incentives to monitor the institutions that hold their investments,” it says.
“Overall, the key lesson is that there are simple alternatives and supplements to the current, highly prescriptive approaches to bank conduct and its regulation,” the report concludes. “Thinking more deeply about the role of incentives in steering bank behavior, and market responses to it, would likely be beneficial to all participants in the financial marketplace.”