ECON430-Topic #4: I'm So Stressed!

In the wake of the 2008 financial crisis banks that are deemed to be systemically important financial institutions (“SIFIs”) are required to undergo periodic stress tests. The comprehensive capital analysis and review (“CCAR”) stress tests are designed to see how large shocks to the economy would damage these large bank-holding company balance sheets. The 2014 CCAR tests had very mixed results on the 30 banks that took part in the test, with Citigroup having their capital plan rejected and others banks facing capital shortfalls.

While most met the capital targets under the very severe economic conditions proposed in the stress tests, there has also been a new push to raise capital at major US financial institutions:

Under the rule, banks with over $700 billion in assets will have to raise their capital, measured by the leverage ratio, to 5 percent of their overall assets. The ratio will have to be 6 percent at the banks’ federally insured banking subsidiaries, where many of their riskiest activities are.

Raising capital is costly however, and many in the financial services industry are opposed to the idea first put forth in the Basel III agreement in 2011. This is all complicated by moral hazard and the too-big-to-fail problem. So, there is an apparent trade-off between freedom for an institution to do what it wants and the regulation that authorities see fit to put in place to protect the integrity of the system itself. In all likelihood there is not one correct level or way to calculate capital requirements or regulation. Therefore, it seems that this debate will never end.

Questions you might answer:

  • How should regulators or banks determine the proper amount of capital or leverage? Should regulators set these guidelines or should they be left up to the private market?
  • How does “too big to fail” enter into this problem? When banks are deemed TBTF they likely expect to be bailed out even if they do not have the capital to remain solvent. This is a moral hazard argument that begs the question if we can actually end “too big to fail” as suggested by President Obama after passing the Dodd-Frank Act.
  • What about the European banks in these tests? Why aren’t they being tested by their own authorities? Are they tested by the ECB? What right or responsibility do we have to regulate these firms?

12 thoughts on “ECON430-Topic #4: I'm So Stressed!”

  1. Before the 2008 crisis, banks were loaning out so much of their money that many of them would have failed if the government didn’t deem them too big to fail. A main problem of too big to fail is the moral hazard it creates. If banks know that they are too big to fail then they are likely to take more risk as they know the worst-case scenario is a government bailout. The only way to really prevent any kind of repeat crisis like 2008 is to make sure all of the “too big to fail” banks are highly regulated so they don’t end up becoming insolvent. If we can ensure that these TBTF banks are operating at a level that can withstand a shock to the economy, then we don’t really have to worry about bailing them out again. However if these banks don’t keep themselves to the exact requirements that they are regulated to, then we should not help them when they come calling for a bailout in times of crisis. Helping them after not following the regulations would set a bad precedent and likely lead to something very similar to what happened in 2008. While regulation should help drastically in helping keep “too big to fail” banks solvent, it does nothing to help small local banks in times of crisis. This also leads to another problem with TBTF. How exactly do we determine which banks are too systematically important to let fail in times of crisis? During the latest crisis, we managed to keep these “too big to fail” banks afloat, while hundreds of smaller banks were forced to close down because they were deemed as not that important. Hopefully regulation will make it so that a government bailout doesn’t ever need to occur again in the banking system.
    Sources;
    https://www.minneapolisfed.org/publications_papers/studies/tbtf/index.cfm
    http://www.forbes.com/sites/tedkaufman/2013/07/18/an-unhappy-birthday-for-dodd-frank-the-too-big-to-fail-problem-gets-bigger/

  2. Too Big to Stress Out

    While stress tests put certain checks against systematically important financial institutions (SIFI), banks have become too big to stress. The stress tests conducted by the Federal Reserve determine whether SIFI’s have enough capital to survive different economic scenarios. One of the adverse conditions the Fed includes is a RGDP decline of 4 ¾ percent, an increase in the unemployment rate to 11.4%, and a fall in the stock market of 50%. In addition to being able to survive these scenarios, banks must raise their capital ratios to at least 5%. By increasing the amount of capital, these financial institutions are contributing to the too big to fail problem.
    The moral hazard problem behind this issue is that banks recognize that policy makers will support them in a time of crisis to contain and prevent any spillover effects in the banking industry. Knowing that they have government support, banks engage in excess risk-taking. The stress tests are ensuring the SIFI’s survivals by requiring them to increase their capital, increasing their systematic importance in the market. The tests are designed to reduce the likelihood of spillover effects by requiring banks to have enough capital to survive dire situations. These measures ignore the major issue with the moral hazard problem; the stress tests do not reduce the impact of spillover effects. By reducing the likelihood, but not the impact of spillover effects, stress tests fail to reduce the too big to fail problem, letting excess risk-taking by banks and uninsured creditors go unpunished.
    Sources:
    http://www.federalreserve.gov/bankinforeg/bcreg20131101a1.pdf
    https://www.minneapolisfed.org/publications_papers/studies/tbtf/index.cfm
    http://www.washingtonpost.com/wp-dyn/content/article/2009/08/27/AR2009082704193_2.html?nav=rss_email/components&sid=ST2009082800437

  3. Economists and policy makers have learned that Systemically Important Financial Institutions pose a great threat to the financial stability of the United States financial system since the market collapsed in 2008. Naturally, these institutions are going to be subject to more stringent capital, leverage, and liquidity requirements as to be recommended by the regulatory agencies who oversee these guidelines. Of most relevance to this topic, however, is how these regulatory authorities direct “SIFIs” to be treated in the event they seem headed towards failure. If the institution’s solvency must be maintained in a crisis, then the regulatory authorities should divest some of its holdings, presumably making the institution less systemically significant if it has been broken up into separate pieces. Before or after a crisis, breaking up these institutions and leveling the playing field can be achieved through incentives. This can be accomplished by reducing or removing, through regulatory taxes, the benefits of being systemically important.

    Sources:
    http://online.wsj.com/news/articles/SB10001424052702304640104579487881119559064
    http://www.investopedia.com/terms/s/systemically-important-financial-institution-sifi.asp
    http://www.clevelandfed.org/research/policydis/pdp27.cfm

  4. Because the economic downturn had no real efficacy in deterring banks from pursuing risky investments, sufficient capital requirements are a financial necessity. An increase from three to five percent of debt to equity can be looked at as a significant step in reducing the risk of insolvency of systemically important financial institutions (SIFIs), though it is certainly not a wholesome maneuver in making banks that are “too big to fail” any less opaque. Dodd-Frank has not shown effective in regulating these investment giants as derivative trading has increased from around $500 trillion in 2007 to over $700 trillion now. This is the exact same behavior that was experienced during the housing bubble and crash of 2008. The bureaucratic red tape of Dodd Frank has taken four years to unroll to implement only 40 percent of its proposed rules and as a consequence big banks have only gotten bigger. However, the stress tests conducted as a product of Dodd Frank will prove to be a vital protector against the moral hazard of large scale credit defaults. Hopefully the regular inspection of these banks and the hypothetical tests they undergo will protect consumers from a taxpayer funded bailout that occurred in 2008. The Dodd Frank Act is forward looking and prudent because it serves as the main protector against another financial crisis, in which now the United States government is much more cash strapped than it was six years ago. If regulators take action to split up banks that are growing too large, (such as Bank of America), then government is following up on its promise of taking preventive action, ex ante, to protect U.S. citizens from an illiquid, insolvent, and opaque bank. In the past, banks have grown to benefit from economies of scale by participating in risky ventures by purchasing and selling assets that were not backed by any capital, relying heavily on defective mathematical models to make their decisions. It was this process that allowed these banking giants to grow TBTF by making these precarious investments that could not be properly priced or risk assessed. If Dodd Frank is not successful in its preventive methods then we are likely due for another crash that will beg the question of another bailout and the age old problem of moral hazard intertwined in government and finance.

    http://www.telegraph.co.uk/finance/financialcrisis/6263315/Theres-no-such-thing-as-too-big-to-fail-in-a-free-market.html
    http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-big-sharks/
    http://www.economist.com/node/21547784#footnote1
    http://www.forbes.com/sites/tedkaufman/2013/07/31/dodd-frank-and-the-next-financial-meltdown/
    http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/?single_page=true
    http://www.businessinsider.com/surprise-too-big-to-fail-is-bigger-than-ever-2011-10

  5. Because the economic downturn had no real efficacy in deterring banks from pursuing risky investments, sufficient capital requirements are a financial necessity. An increase from three to five percent of debt to equity can be looked at as a significant step in reducing the risk of insolvency of systemically important financial institutions (SIFIs), though it is certainly not a wholesome maneuver in making banks that are “too big to fail” any less opaque. Dodd-Frank has not shown effective in regulating these investment giants as derivative trading has increased from around $500 trillion in 2007 to over $700 trillion now. This is the exact same behavior that was experienced during the housing bubble and crash of 2008. The bureaucratic red tape of Dodd Frank has taken four years to unroll to implement only 40 percent of its proposed rules and as a consequence big banks have only gotten bigger. However, the stress tests conducted as a product of Dodd Frank will prove to be a vital protector against the moral hazard of large scale credit defaults. Hopefully the regular inspection of these banks and the hypothetical tests they undergo will protect consumers from a taxpayer funded bailout that occurred in 2008. The Dodd Frank Act is forward looking and prudent because it serves as the main protector against another financial crisis, in which now the United States government is much more cash strapped than it was six years ago. If regulators take action to split up banks that are growing too large, (such as Bank of America), then government is following up on its promise of taking preventive action, ex ante, to protect U.S. citizens from an illiquid, insolvent, and opaque bank. In the past, banks have grown to benefit from economies of scale by participating in risky ventures by purchasing and selling assets that were not backed by any capital, relying heavily on defective mathematical models to make their decisions. It was this process that allowed these banking giants to grow TBTF by making these precarious investments that could not be properly priced or risk assessed. If Dodd Frank is not successful in its preventive methods then we are likely due for another crash that will beg the question of another bailout and the age old problem of moral hazard intertwined in government and finance.

    -Devin Cates

    http://www.telegraph.co.uk/finance/financialcrisis/6263315/Theres-no-such-thing-as-too-big-to-fail-in-a-free-market.html
    http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-big-sharks/
    http://www.economist.com/node/21547784#footnote1
    http://www.forbes.com/sites/tedkaufman/2013/07/31/dodd-frank-and-the-next-financial-meltdown/
    http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/?single_page=true
    http://www.businessinsider.com/surprise-too-big-to-fail-is-bigger-than-ever-2011-10

  6. The too big to fail problem is a moral hazard because if a bank is deemed too big to fail they will expect to be bailed out by the Fed, even if they do not have enough capital to remain solvent. One way the central bank is trying to solve this problem is by raising the capital requirement for the world’s largest banks. The theory behind this is that if these banks deemed TBTF have high enough levels of capital they won’t need to be bailed out if they take too much risk. While in theory this could eliminate the moral hazard there are many people who oppose this idea. The TBTF banks themselves oppose this idea because a higher capital requirement would decrease shareholder profits, and reduce their ability to lend causing slower economic recovery. Rochdale analyst Dick Bove another opposed to increased capital requirements for large banks claims that this would limit large banks growth and could even break many of them up. With the possible negative effects of increasing capital requirements for TBTF banks, there have been other possible proposals of ways to decrease the spillover of bank risks. The Minneapolis Fed for example recommends early identification, enhanced prompt corrective action, and stability-related communication. This is to reduce spillover through increased supervision and regulation efforts. The moral hazard created by TBTF banks is clear, however, the solution may not be so easy to find. While increasing the capital requirement for TBTF banks may solve this Moral hazard I believe that efforts to reduce spillover are a safer way to accomplish this goal.

    References:

    https://www.minneapolisfed.org/publications_papers/studies/tbtf/index.cfm

    http://www.foxbusiness.com/markets/2011/06/29/debate-rages-over-bank-capital-requirements-huh/

  7. The US has a history of regulating and deregulating banks. For instance, in the 1980s, deregulation under Jimmy Carter’s Depository Institutions Deregulation and Monetary Control Act led to the Savings and Loans Crisis of the 1980s. All businesses will lobby for less regulation, so when there has been a long passage of time since a banking crisis, they have a tendency to get their way. However, there have been two recent instances where deregulation has led to a banking crisis.
    The most recent crisis was the 2008 financial crisis. “In the late 1990s, Congress demolished the barriers between commercial and investment banking, a change that encouraged risky investments with borrowed money.” While the main contributing factor to the 2008 crisis was the fact that mortgage companies would lend to almost anyone, regardless of their financial state, the deregulation prior to the crisis had a major impact. Of course, deregulation also played a big role in causing the Great Depression in the 30s.
    Rather than continuing to deregulate banks and then overregulate after a crisis, the US should try to find some middle ground where they regulate banks a moderate amount consistently.

    http://www.presidency.ucsb.edu/ws/index.php?pid=33206#axzz1mquUfO88
    http://www.fdic.gov/bank/historical/s&l/
    http://www.fdic.gov/bank/historical/history/3_85.pdf
    http://www.britannica.com/EBchecked/topic/1484264/The-Financial-Crisis-of-2008-Year-In-Review-2008

  8. American branches of European banks HSBC, Santander, and Royal Bank of Scotland unfortunately failed the recent round of stress tests conducted by the Fed, with Deutsche Bank and Barclays on track to participate in the future. Further yet, these large Euro-banks along with about 119 others are set to undergo probes later this year from the European Banking Authority (EBA) which develops rules and methodologies in cooperation with the European Systemic Risk Board (ESRB), European Central Bank (ECB), and European Commission (EC). Certainly the different regulatory frameworks and capital requirements (the U.S. at 5%, the Europeans at 5.5% of overall assets) will prove to be a burden for compliance, although some have argued that European regulators tend to be more accommodating than American counterparts in terms of classifying core capital. Representing €30.9 trillion, there is certainly a case for performing periodic checks to gauge the health of Euro-banks, and from the Fed’s perspective, especially those which have extensive operations or holdings within the United States. Although there will likely be redundancies between Fed and EBA methods, one would hope that both will make meaningful contributions on issues such as asset quality. Both bodies have a vested interest in ensuring good banking practice, and as many would agree (in light of the recent financial crisis), a responsibility.

    http://www.economist.com/blogs/freeexchange/2014/01/european-banking-stress-tests
    http://www.bloomberg.com/news/2014-01-31/european-banks-face-5-5-capital-requirement-in-eba-stress-test.html
    http://www.cnbc.com/id/101544281
    http://www.ft.com/intl/cms/s/0/3550f1f6-b597-11e3-a1bd-00144feabdc0.html#axzz2zU3qj9t4
    http://www.eba.europa.eu/risk-analysis-and-data/eu-wide-stress-testing

  9. In its current state, the comprehensive capital analysis and review (CCAR) stress tests use a variable known as the leverage ratio; a measure of the amount of capital that a bank holds against its assets. These stress tests present hypothetical economic situations to observe the solvency of systemically important financial institutions (SIFIs) under adverse and very adverse conditions. These institutions must hold a 5% leverage ratio through these stress tests to be deemed adequately capitalized.

    What about firms that are “too big to fail”? The moral hazard issue remains in that if banks are deemed “too big to fail,” they likely expect to be bailed out by taxpayers when they do not have the capital to remain solvent. I believe, contrary to President Obama, that the passing of the Dodd-Frank Act and the capital requirements associated with it does not effectively eliminate moral hazard in the SIFIs. This is because although the additional capital being held by these institutions act as a buffer to adverse economic conditions, it does not discourage the institutions into taking unnecessary risk within its capital requirements. Thus, the root of the moral hazard issue remains at large; unless individual actions by the SIFIs can be regulated, banks that are “too big to fail” will continue to take unnecessary risks with the insurance of the taxpayer.

    SOURCES:
    http://www.federalreserve.gov/bankinforeg/stress-tests/ccar/November-1-2013-Introduction.htm
    http://www.foxbusiness.com/markets/2011/06/29/debate-rages-over-bank-capital-requirements-huh/
    http://dealbook.nytimes.com/2014/04/08/regulators-set-to-approve-new-capital-rule/?_php=true&_type=blogs&smid=tw-share&_r=0

  10. 25 out of the 30 banks tested had capital plans that were approved by the Fed after annual stress tests. Currently banks are required to raise at least 5 to 6 percent of their overall assets as capital, and there are those on both sides that believe this number isn’t correct.
    The Banks themselves would argue that higher capital requirements would reduce profits for shareholders while also stymieing their ability to lend. This would slow down activity in the marketplace and in turn economic recovery. Furthermore, such regulation would aid in shrinking the amount of big banks, as this along with the passage of the Dodd-Frank banking reform bill lowers the amount of profits for banks. This is a valid argument to consider, as someone will need to pick up the lending pace if the amount of institutions that do so is reduced.
    However there are those who would object to these claims, such as Gerald Epstein, who say that capital requirements should be double what they are now. In addition, regulators should also target limits on leverage and demand more transparency in derivatives markets. There is also the opinion that the market should be left alone. By using mark to market accounting, asset values would be determined at their current market price and not by the value in which they were purchased. This would be a way of holding banks accountable for their assets value at all times as they would have to react to fluctuations immediately to deleverage or raise capital to cover losses.
    But who is to say that any one of these opinions is right? Every side makes a reasonable case as to why capital requirements should be at a certain level. Unfortunately, as is with everything, only time will tell which side makes the best case. Also let us all go back to class on Thursday and remember what Professor Neveu was talking about, with regards to simulations and forecasting, we are wrong 50 percent of the time. So these so called “stress tests” may not be accurate as to what might actually happen.
    References:
    http://www.bloomberg.com/news/2014-03-26/citigroup-fails-fed-stress-test-as-goldman-bofa-modify-plans.html
    http://www.foxbusiness.com/markets/2011/06/29/debate-rages-over-bank-capital-requirements-huh/

  11. How should regulators or banks determine the proper amount of capital or leverage? Should regulators set these guidelines or should they be left up to the private market?

    In 2010, the Basel III Accord required banks to have a minimum 6% Tier I capital ratio and last July the minimum requirements for the leverage ratio for eight Systemically Important Financial Institutions (SIFI) banks was 6%, with 5% for their insured bank holding companies.

    Prior to the required leverage ratio in 2010, the Basel Committee’s deemed a leverage ratio as unnecessary due to the lack of distinction between risks. For example, a bank would have to hold the same amount of capital for B- 10-year Sears bond as it would for a AAA 10-year U.S. Treasury, which makes no sense. The facts state these two ratios are a minimum requirement concerning liquidity but, in my opinion, are an emotional, knee-jerk reaction from a severe recession.

    The severely adverse scenario stress test features a formidable recession spanning two years with peak unemployment at 11.25%, a 4.75% decrease in real GDP in one quarter, a 50% decrease in equity prices, and a peak market volatility index level of 68%. The requirements should prevent any bailouts, yet what if the new requirements hinder banks? Imagine banks are not able to spur the economy through lending, or unable to borrow to make interest payments, because they did not meet their capital, or leverage, requirements. I believe the stress tests provide a baseline to work and the next step is to evaluate each firm individually. Mandating a broad requirement, such as 6% leverage ratio, across the industry is equivalent to giving 10 people with different illnesses the same anti-biotic, without a diagnosis, and hoping it works. Then compare firms of similar size to one another to see their historic ratios in economic expansions and recession. Ask the firms their assessment of themselves, their competitors, and the entire industry so firms feel involved. The firms are the experts of finance, so I believe by evaluating each other it will result in insightful, honest work. It is impossible to determine the perfect amount of capital, or any other, requirements but a combination of inputs by regulators and the private sector will provide the best solution.

    http://www.federalreserve.gov/bankinforeg/bcreg20131101a1.pdf
    http://www.federalreserve.gov/bankinforeg/stress-tests/ccar/November-1-2013-Introduction.htm
    http://www.bloomberg.com/news/2014-03-26/citigroup-fails-fed-stress-test-as-goldman-bofa-modify-plans.html
    http://dealbook.nytimes.com/2014/04/08/regulators-set-to-approve-new-capital-rule/?_php=true&_type=blogs&smid=tw-share&_r=0
    http://www.foxbusiness.com/markets/2011/06/29/debate-rages-over-bank-capital-requirements-huh/
    http://www.investopedia.com/terms/t/tier-1-capital-ratio.asp
    http://www.investopedia.com/terms/t/tier-1-leverage-ratio.asp

  12. The too-big-to-fail (TBTF) problem poses a serious threat to the future credibility of the United States’ financial system. The Systematically Important Financial Institutions (SIFI) are deemed by Gary H. Stern as those with the potential that their financial and operational weaknesses can spill over to other financial institutions, capital markets, and the rest of the economy. The potential for negative externalities in the form of those spillovers means that regulation of these institutions is necessary. Excessive risk-taking occurs in part because of an abundance of creditors who face limited to no real loss. Moral hazard arises because uninsured creditors of these institutions “expect government protection from loss.” When neither the institutions nor the creditors are held accountable when they (SIFIs) are operating inefficiently there is no incentive to operate inefficiently. This wastes valuable resources that could otherwise be used for much-needed improvements in the countries aging infrastructure or lagging education. If the institutions and creditors expected and received special government protection than it is unreasonable for them to deny regulation. While the problem may never fully end, the negative spillovers can only be contained if there is supervision to identify failing institutions early, initiate “prompt corrective action (PCA),” and a regulatory agency to mediate between the creditors and the institutions.

    https://www.minneapolisfed.org/news_events/pres/sterntestimony05-06-09.cfm
    https://www.minneapolisfed.org/publications_papers/studies/tbtf/index.cfm

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