Regulatory complexity undermined efforts to strengthen financial stability before the crisis. Nonetheless, post-crisis reforms have greatly exacerbated regulatory complexity. Using the example of capital regulation, this paper shows how complexity has grown geometrically from the introduction of the Basel Accord on Capital Adequacy in 1988 to the introduction of Basel III and the total loss-absorbing capacity (TLAC) proposal in 2015. Analysis of the current welter of required capital ratios leads to a proposal to eliminate 75 % of them without jeopardizing the safety and soundness of the system. Quite possibly, regulators might argue that one or more of these deleted ratios does make an important incremental contribution to the safety and soundness of the system. But these important debates are not taking place in public, in part because we lack systematic measures of the costs of regulatory compliance and effective sunset laws that would require that regulations meet a rigorous cost-benefit test periodically. The concluding section poses the more speculative question of why, despite the evident advantages of a simpler, more transparent regulatory system, the authorities layer on ever more complexity.
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Although the Treasury engaged in the ritual of denying that such guarantees existed, in the summer of 2008 it felt obliged to honor these implicit guarantees in the hope of stabilizing the financial system. Of course, this justified expectations that the guarantees would be honored despite the disavowals and further eroded confidence in official statements.
This abbreviated account omits several other important elements such as the reliance on flawed credit ratings and mortgage insurance that could not be honored in a crisis.
This was naïve because even if the regulators succeeded in getting the risk weights “right” from the bank’s perspective, the weights would not capture the externalities that might be imposed on the broader economy if a bank approached insolvency. Indeed, the architects of Basel II exacerbated this problem by rigging the risk weights so that large banks that adopted the Advanced Measurement Approach would have lower capital requirements than smaller banks. This is precisely the opposite of what regulators should have done if they wanted banks to internalize the costs of failure.
A truly risk-sensitive measure of capital adequacy would have shown deterioration to the extent that increases in risk-absorbing capital in the numerator failed to offset the substantial increase in properly risk-weighted assets in the denominator. Large banks failed to increase retained earnings. Indeed, in several egregious cases they paid dividends that exceeded their earnings and they issued negligible equity during the crisis. Thus, risk-weighted capital ratios should have declined markedly.
TruPS are hybrid securities that combined features of both debt and equity. In 1996, the Federal Reserve Board ruled that TruPS satisfying specified conditions could meet a portion of bank holding companies’ (BHCs’) Tier 1 capital requirements. TruPS are a financing structure in which a BHC creates a wholly owned special purpose entity (SP) that issues cumulative preferred stock to investors. The BHC then borrows the proceeds from the SPE using a long-term subordinated note. Looking through the SPE, in effect the BHC issues term-subordinated debt into the market place and this subordinated debt was being permitted as Tier 1 capital. For additional details see French et al. (2010).
It should be noted that most banks refrained from taking full advantage of the more permissive leverage ratio and banks in the United States were constrained by a capital requirement that their limited leverage.
The regulators did succeed in eliminating some of the more dubious account entries such as deferred tax losses from the computation of regulatory capital.
Defined in the Dodd-Frank Act as a BHC with consolidated assets ≥ $50 billion.
It is troubling that, despite the number of ratios, the regulators have not included any ratios based on market rather than accounting measures of capital. These measures could be observed and verified in real time. Moreover, they gave timely warnings of the impending crisis during 2007 and 2008. It could certainly be argued that not only have the regulators produced an excessive number of regulatory ratios, but also they have focused on the wrong ratios. This point is important, but beyond the scope of this paper.
Table 2 is based on the assumption that all capital requirements have been fully implemented. The table would have been even more complex if transitional arrangements had been taken into account.
Of course, banks must deal with a number of other regulatory requirements and constraints in addition to these required capital ratios.
Alternatively, if CETI and additional Tier 1 are deemed equivalent in their ability to sustain the bank as a going concern, it is not necessary to set requirements with regard to CETI.
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I am grateful to Robert Eisenbeis and Edward Kane for helpful comments on the presentation that preceded this draft.
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Herring, R.J. Less Really Can be More: Why Simplicity & Comparability Should be Regulatory Objectives. Atl Econ J 44, 33–50 (2016). https://doi.org/10.1007/s11293-016-9488-4
- Basel Accord
- Basel II
- Basel III
- Capital regulation
- Financial crisis
- Safety and soundness
- Prudential regulation and supervision
- G28 (Government Policy and Regulation)