FDIC Vice Chair Hoenig Considers Risks Associated with Regulatory Capital
Commentary by Steven Lofchie
FDIC Vice Chair Thomas M. Hoenig asserted that "while there has been progress in improving capital regulation, much remains undone." In remarks made before the 18th Annual International Banking Conference at the Federal Reserve Bank of Chicago, he argued: "there is no place for complacency regarding the stability of our financial system."
Vice Chair Hoenig emphasized that global banks "are not as well capitalized as some within the industry would have you believe." As to:
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Risk Prediction: Vice Chair Hoenig questioned "whether the effect of such a requirement that is designed to make a firm more resolvable once that firm has failed, could - prior to failure - increase the firm's leverage and thereby its likelihood to default" and noted that it would be unlikely that "regulators would . . . successfully anticipate the source of future crises."
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Equity Capital: Vice Chair Hoenig stressed that this approach: (i) is "based on equity capital and thus would not require such extraordinary insight from regulators"; (ii) "acknowledges that regulators cannot predict events and it ensures a safer system because well capitalized institutions are better able to withstand shocks and survive crises"; and (iii) uses simple leverage measures instead of risk-based capital measures, "which eliminates relying on the best guesses of financial regulators to guide decisions."
Vice Chair Hoenig described the "ever-changing sources of risk" in the derivatives market and highlighted "the potential for unanticipated events and risks, including resolution challenges, associated with the growing use of Central Counterparties." Among other issues, Vice Chair Hoenig stressed that "we cannot ignore the reality that international financial linkages across countries are more important now than they were even just five years ago" and urged global banks to adjust their risk models accordingly.
In addition, Vice Chair Hoenig called on regulators to promote "trust built on equity capital" and argued that "the system-wide benefits of strong equity capital would appear to far exceed the aggregate economic costs over the business cycle and thus should not be ignored." He stated that "contrary to some claims, equity capital, in fact, supports sustainable risk taking over the course of the cycle by removing the necessity of regulators to pick winners and losers, thus allowing the owners of the capital to take their own risks, run their own firms and absorb their own losses without public support."
Commentary
While the tone of this speech suggests that the regulators should be praised for their accomplishments in making the financial system better, one may also make a fair argument that the speech describes a series of regulatory mis-judgements and regulatory over-confidence, with the result being a financial system that is in many respects more fragile than it was before the crisis.
Let's start with central clearing. In the words of Vice-Chair Hoenig: "Increased use of clearing has changed the locus of these exposures, it has not lessened risks to the system. The migration of standardized derivatives to clearing was a policy decision intended to make the system safer, but without question it elevates the systemic importance of safe and sound operations by central counterparties (CCPs). The potential for unanticipated events and risks, including resolution challenges, associated with the growing use of CCPs is a subject of concern to many observers and is being studied by international groups."
Contrast Vice-Chair Hoenig's current realization, with, for example, a snippet from a 2012 piece written by Craig Pirrong:
"[In] the aftermath of the financial crisis, clearing has become a deus ex machina to solve all the problems inherent in derivatives markets. In particular, clearing has been advanced as a panacea for systemic risk arising from derivatives markets; that is, the risk that derivatives contracts can serve as the cause of insolvency of major financial institutions, and a channel of contagion by which the failure of one institution could cause the failure of others. There is considerable room for skepticism about these claims. They are not predicated on a thorough analysis of the economics of clearing. Indeed, many of the claims made on behalf of clearing are patently wrong."
It should be noted that the above quote from Mr. Pirrong is fairly representative of his remarks over the last several years.
How is it that Mr. Pirrong can be so out front on this issue? One possibility is that banking regulators tend not to fully consider the multiplicity of reactions that market participants may have to regulatory change; i.e., regulators calculate that if one raises the capital ratio for banks, banks will be safer (not considering that liquidity will be reduced, credit will move outside of banks and the economy will be generally dampened). This does not mean that increasing capital is a zero sum game; rather, it probably is beneficial to a point, but at another point, it can arguably turn harmful as liquidity is reduced. Mr. Pirrong, by contrast, seems to think of the markets in more fluid terms; when one condition (or rule) is changed, market participants react to that change. For the most part, those changes are reasonably predictable; i.e., raise fixed costs/reduce the number of market participants, and Mr. Pirrong, at least as to central clearing, has done a reasonably good job at thinking through the consequences.