Insolvency, not liquidity, is the problem

Lest the worst financial crisis in history repeat itself, a Washington University in St. Louis researcher reviewed existing literature and concluded that two issues must be addressed:

• U.S. and European banks need to understand that insolvency was the issue that rocked the world, not liquidity.
• The current standards for bank capital are all wrong as a result and require adjustment.

Reviewing empirical and theoretical papers in the aftermath of the 2007-09 financial crisis, Anjan Thakor, the John E. Simon Professor of Finance at Olin Business School, cites a twofold finding from his study published online March 20 in the Journal of Financial Stability.

First, he said the so-called trade-off between financial stability and economic growth is “overblown”, meaning we can have higher stability by imposing higher capital requirements on banks without sacrificing high levels of bank lending that support economic growth.

Second, “the current emphasis on liquidity requirements is misplaced and stems from the erroneous belief that the 2007-09 financial crisis was a liquidity crisis,” he wrote. “Rather, it was an insolvency risk crisis that caused liquidity to flee the system.”

Hundreds of billions of dollars are essentially being wasted, languishing as liquid assets, because of counterproductive liquidity-requirement regulations resulting from the mischaracterization of the crisis, he found.

So Thakor, a member of the European Corporate Governance Institute, recommends specific pre-emptive and post-crisis measures to replace standards or accentuate the Third Basel Accord, or Basel III, regulatory framework for banks:

• Increase capital requirements for shadow banks and depository institutions and make them countercyclical.
• Eliminate liquidity requirements.
• Improve consumer literacy and restrict consumer leverage.
• Create a Chapter 11 bankruptcy for banks.
• Design a more integrated regulatory structure.
• Focus on bank governance and culture.

And, in response to issues:

• Temporarily resolve a financial crisis by imposing dividend restrictions and by providing government capital support that dilutes shareholders.
• Enforce greater consequences on executives of failing banks.

“Some of these changes have not yet been put in place because of three factors: a lingering misunderstanding that this was a liquidity crisis; the lack of political willingness to tackle consumer financial literacy issues (which might lay some of the blame for the crisis on uninformed consumers making bad personal financial decisions); and a lack of appreciation for the role of ‘soft’ issues like bank culture,” Thakor said.

Liquidity regulations are sapping the potential growth of banks. This requirement for banks to hold a certain percentage of tangible assets — cash, Treasury bonds and such — prevents them from lending more to corporations and individuals.

“As a result, Main Street suffers,” Thakor said. “Small businesses are denied some of the credit that would flow to them to expand their operations, and lower- and middle-income borrowers — even those who want to borrow prudently — are not getting sufficient access to credit.

“Paradoxically, bank shareholders also suffer,” Thakor said. “Research shows that higher capital levels lead to higher bank shareholder value, whereas higher levels of liquidity simply constrain banks from doing what they are meant to do — take in deposits and lend them out to help the economy grow.”

Consumers also play a role in the cause of the crises … and in a remedy for the future. His review showed how U.S. household consumption increased by nearly 50 percent between the periods of 1980-99 and 2001-07, and Americans borrowed at a faster rate than their house prices grew. Thakor posited that perhaps consumers didn’t comprehend the risks of being highly leveraged, and they underestimated the financial burden created by taking on adjustable-rate mortgages with low teaser rates that rose in the future. Improve consumer literacy, and they’ll make more prudent decisions, he maintained.

As we approach the 10-year anniversary of mighty Lehman Brothers filing for bankruptcy, Thakor wrote that banking also needs something analogous to Chapter 11 bankruptcy and reorganization. Moreover, regulators need to be willing to allow some banks to fail, or, in other words, let Darwinian evolution work. Strong banks will thus survive, others will fail occasionally. It’s a cycle necessary for a healthy, vibrant financial system, Thakor wrote.

In addition to streamlining the liquidation process, another positive of the Dodd-Frank Act is the consolidation and coordination of the various prongs of the financial system: commercial banks, investment banks, insurance companies, securities broker-dealers and so on. But Thakor said that Dodd-Frank does not do enough. “More needs to be done to deal effectively with the possible future occurrences of insolvency-driven stresses in the repo market,” he said.

As for addressing a culture change, Thakor noted that existing papers show how such a nebulous effect could be made tangible if regulators limited interbank competition, increased capital requirements and reduced the probability of bailouts. By developing a safety-oriented culture with such changes, there likely would be a “contagious” reaction throughout banking, starting with the large institutions.

When reacting to a crisis, the government can assist by backing up an infusion of money with a second requirement aimed at shareholders.

“Capital support by the government should be followed by dividend freezes at the banks in question to enable capital levels at these banks to be refurbished,” Thakor wrote.

One consistent post-crises cry over the past decade has revolved around executives who escaped punishment. Thakor proposed two penalties: clawing back their compensation packages, and imposing fines for “reckless” risk-taking, though not going so far as to make banks excessively risk-averse.

“Doing all of this will require integration not only among various U.S. financial service industry regulators, but also between regulators in Europe and the U.S.,” Thakor said. “Otherwise, there is sometimes a ‘race to the bottom,’ as different regulatory jurisdictions compete for banks by lowering regulatory standards, thus leading to ‘regulatory arbitrage’ — where banks go to the lowest-regulation jurisdiction.”