Jeremy Stein on Regulating Large Financial Institutions

Here‘s Jeremy Stein on regulating large financial institutions.

Some have argued that the current policy path is not working, and that we need to take a fundamentally different approach.4  Such an alternative approach might include, for example, outright caps on the size of individual banks, or a return to Glass-Steagall-type activity limits.

My own view is somewhat different. While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution’s systemic footprint.

To illustrate my argument, let us take as given the central premise of those who favor size limits: namely, that society would be better off if the distribution of banks were not so skewed toward a handful of very large institutions. (To be clear, I am using the word “size” as shorthand for the broader concept of an institution’s systemic footprint, which in addition to size, might reflect complexity, interconnectedness, and global span of operations.) In other words, let’s simply posit that a goal of regulation should be to lean against bank size, and ask: What are the best regulatory tools for accomplishing that goal? As in many other regulatory settings, this question can be mapped into the “prices-versus-quantities” framework laid out by Martin Weitzman nearly 40 years ago.5 Here a size cap is a form of quantity regulation, whereas capital requirements that increase with bank size can be thought of as a kind of price regulation, in the sense that such capital requirements are analogous to a progressive tax on bank size.6

A key challenge with quantity-based regulation is that one has to decide where to set the cap. Doing so requires a regulator to take a strong stand on the nature of scale and scope economies in large financial firms. Moreover, even if one reads the empirical literature as being quite skeptical about the existence of such economies beyond a certain point in the size distribution–a proposition which itself is debatable–the most that such large-sample studies can do is make on-average statements about scale and scope economies.7  These studies still leave open the possibility of considerable heterogeneity across firms, and that some firms are able to add considerable value in a given line of business by being very big, even if the average firm in the population is not. And such heterogeneity alone is enough to create significant drawbacks to quantity-based regulation.

Consider the following example. There are three banks: A, B, and C. Banks A and B both have $1 trillion in assets, while C is smaller, with only $400 billion in assets. Bank A actually generates significant economies of scale, so that it is socially optimal for it to remain at its current size. Banks B and C, by contrast, have very modest economies of scale, not enough to outweigh the costs that their size and complexity impose on society. From the perspective of an omniscient social planner, it would be better if both B and C were half their current size.

Now let’s ask what happens if we impose a size cap of say $500 billion. This size cap does the right thing with respect to Bank B, by shrinking it to a socially optimal size. But it mishandles both Banks A and C, for different reasons. In the case of A, the cap forces it to shrink when it shouldn’t, because given the specifics of its business model it actually creates a substantial amount of value by being big. And in the case of C, the cap makes the opposite mistake. It would actually be beneficial to put pressure on C to shrink at the margin–that is, to move it in the direction of being a $200 billion bank instead of a $400 billion one–but since it lies below the cap, it is completely untouched by the regulation.

Suppose instead we attack the problem by imposing capital requirements that are an increasing function of bank size. This price-based approach creates some incentive for all three banks to shrink, but lets them balance this incentive against the scale benefits that they realize by staying big. In this case, we would expect A, with its significant scale economies, to absorb the tax hit and choose to remain large, while B and C, with more modest scale economies, would be expected to shrink more radically. In other words, price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decision on their own understanding of the synergies–or lack thereof–in their respective businesses.

This logic can be thought of as supporting the approach taken by the Basel Committee on Banking Supervision in its rule imposing a common equity surcharge on designated global systemically important banks. The exact amount of the surcharge will range from 1 percent to 2.5 percent, and will depend on factors that include a bank’s size, complexity, and interconnectedness, as measured by a variety of indicator variables.8 These progressive surcharges are effectively a type of price-based regulation, and therefore should have the advantages I just noted.

However, a proponent of size caps might reasonably reply: “Fine, but how do I know that these surcharges are actually enough to change behavior–that is, to exert a meaningful influence on the size distribution of the banking system?” After all, the analogy between a capital requirement and a tax is somewhat imperfect, since we don’t know exactly the implicit tax rate associated with a given level of capital. Some view capital requirements as quite burdensome, which would mean that even a 2 percent surcharge amounts to a significant tax and, hence, a strong incentive for a bank to shrink, while others have argued that capital requirements impose only modest costs, which would imply little incentive to shrink.9

This uncertainty about the ultimate effect of a given capital-surcharge regime on the size distribution of banks could potentially tip the balance back in favor of quantity-based regulation, like size caps. And indeed, if we were faced with a static, once-and-for-all decision, I don’t think economic reasoning alone could give us a definitive answer as to whether caps should be preferred to capital surcharges. This ambiguity is in some sense the central message of Weitzman’s original analysis.

One way to resolve this tension is to refrain from putting ourselves in the position of having to make a once-and-for-all decision in a setting of substantial uncertainty. Rather, it might be preferable to try to learn from the incoming data and adjust over time, particularly since the recent changes to capital regulation already on the books may represent an informative experiment. In my view, this observation about the potential for learning tips the balance in favor of capital surcharges. For example, the capital-surcharge schedule proposed by the Basel Committee for globally important systemic banks may be a reasonable starting point. However, if after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up.10  In principle, this turning-up-the-dials approach feels to me like the right way to go: It retains the flexibility that makes price-based regulation attractive, while mitigating the risk that the implicit tax rate will be set too low. Of course, I recognize that its gradualist nature presents practical challenges, not least of which is sustaining a level of regulatory commitment and resolve sufficient to keep the dials turning so long as this is the right thing to do.

Before wrapping up, let me briefly mention another piece of the puzzle that I think is sometimes overlooked, but strikes me as having the potential to play an important complementary role in efforts to address the TBTF problem–namely, corporate governance. Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don’t create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank’s stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn’t take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board.11  As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

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About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar. http://faculty.chicagobooth.edu/owen.zidar/index.html
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