Financial Regulation in a System Context

Questions & answers

Q1. What is the paper’s central objection to the traditional, capital-requirement-based approach to bank regulation?

The authors argue that the “familiar truism” that ensuring the soundness of each individual institution ensures the soundness of the system as a whole is, in their words, “unhelpful… since it does not address how the soundness of all individual institutions is to be achieved simultaneously,” because actions that secure one institution’s safety can directly undermine another’s (p. 234). They formalize this as Proposition 1: “Actions that enhance the soundness of an individual financial institution may undermine the stability of the system as a whole.” They illustrate the point with a simple two-bank example in which Bank 2, suffering unrelated credit losses, prudently (from its own, “microprudential” perspective) cuts its lending to Bank 1; if Bank 1 lacks alternative funding and its assets are illiquid, “a large withdrawal of lending by Bank 2 will feel to Bank 1 no different from a run” (p. 234).

Q2. How did Bear Stearns actually fail, and why does the paper say this contradicts the traditional regulatory story?

The paper states that Bear Stearns “met the letter of its regulatory capital requirements,” yet “the risk-based capital requirements that underpin the Basel approach to bank regulation fail to distinguish between the inherent riskiness of an asset and its systemic importance” (Abstract). They document that Bear Stearns’ cash holdings “dropped sharply, from $18 billion to only $2 billion” over just three days, from March 10 to March 13, 2008, driven substantially by the defection of hedge-fund prime-brokerage clients – payables that made up “fully 22 percent” of its total funding – rather than by any newly discovered asset losses (pp. 245-246). They conclude: “contrary to the traditional focus on credit risk on the asset side of the balance sheet, what mattered in the Bear Stearns case was the run on the liabilities side” (p. 246).

Q3. How does the paper use a global-games framework to formalize when a run occurs, and what two parameters determine the outcome?

Building on Lawrence Summers’s (2000) thought experiment and the authors’ own earlier global-games work (Morris and Shin 1998, 2002), the model’s two key parameters are the coordination threshold k (the proportion of creditors who must stay in for the good, no-run outcome to hold) and the cost of miscoordination c (what a creditor loses by guessing wrong relative to the reward from guessing right); the analysis shows a unique equilibrium outcome determined jointly by these two parameters, with successful coordination (no run) occurring only when both k and c are sufficiently low (pp. 236-238, Figure 3). Proposition 2 states: “A run is more likely when the coordination threshold is high or when the cost of miscoordination is high. Policies that lower the coordination threshold or the cost of miscoordination are likely to promote system stability.”

Q4. Why does holding more cash reduce run risk through two separate channels, and why is the second channel distinctively a “system” insight?

The paper shows that higher cash holdings at a debtor bank lower the coordination threshold k by letting the bank meet moderate withdrawals from its own liquid assets, while higher cash holdings at the creditor banks lower the cost of miscoordination c by making those creditors themselves less vulnerable to a deterioration in their own funding conditions – and the authors state explicitly that “recognition of the second channel is an insight that can only be gained in a system context” (p. 239), since it depends on modeling creditors’ own balance sheets rather than treating them as outside the system.

Q5. What distinction does the paper draw between an asset’s credit risk and its systemic importance, and how does the repo-chain example illustrate it?

Proposition 3 states: “There is a distinction between risky assets and systemically important assets. Even safe assets can be systemically important.” In the paper’s worked example, Bank 2 funds a reverse repo to Bank 1 (collateralized by mortgage-backed securities) by itself repo-ing the same securities to Bank 3; from Bank 2’s own point of view its position is “extremely safe” – short-maturity, fully collateralized, and maturity-matched on both sides of its balance sheet – which under Basel’s risk-weighting logic justifies very high leverage for Bank 2 (pp. 239-241). But the authors argue that Bank 2’s assets are “the mirror image of Bank 1’s liabilities”: if Bank 2 declines to roll over its reverse repo, Bank 1 is forced into a fire sale of illiquid MBS unless it finds alternative funding, so an asset that is safe in isolation can still be a major conduit of systemic stress (p. 241).

Q6. Why does the paper argue the triparty repo arrangement with money market mutual funds made the Bear Stearns run more likely, and what does this imply for regulatory design?

The paper notes that money market mutual funds are, by charter, generally barred from holding illiquid securities, so a Bear Stearns default risked forcing funds to sell pledged mortgage-backed collateral at a loss and “break the buck” – making the cost of miscoordination c “extremely high” for these specific creditors, so that “liquidity requirements on them are unlikely to have much effect,” which the authors say “suggests a strong case for regulating their role in the triparty repo market” directly (pp. 250-251) rather than relying on liquidity rules addressed to banks alone.

Q7. What is the paper’s proposed rationale for a maximum leverage ratio, and how does it differ from the traditional justification for capital requirements?

The authors argue the rationale for a raw, risk-unweighted leverage constraint “derives its rationale not from the traditional view that capital is a buffer against losses on assets, but rather from the importance of stabilizing liabilities in an interrelated financial system” (Abstract). They show that the damage from a given percentage-point increase in repo haircuts is far larger when haircuts start from a very low base – an increase from 1 to 2 percent cuts allowable leverage in half, from 100:1 to 50:1, while an increase from 20 to 21 percent only nudges leverage from 5.0:1 to about 4.8:1 – so that “the chasing of yield at the peak of the financial cycle is especially precarious,” making a binding leverage cap during good times a way of preventing the subsequent crash in haircuts from being so destructive (pp. 252-253).

Q8. What do the authors conclude about the relationship between liquidity requirements, leverage constraints, and the cost such rules impose on banks?

The authors describe both liquidity and leverage requirements as functioning like a Pigovian tax on the externalities that drive systemic fragility, explicitly conceding that banks subject to a binding constraint “will complain of being prevented from pursuing higher profits,” but arguing “this is as it should be, since any Pigovian tax is just that – a tax” (p. 253). In their concluding remarks they state that “more systematic study will reveal how onerous the corresponding Pigovian taxes will have to be, but the severity of the current financial crisis suggests that the optimal Pigovian taxes will not be zero” (p. 259).