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Ten Regulatory Lessons from the Sub-prime Crisis

The sub-prime crisis that erupted in the United States was the first manifestation of the larger financial crisis that has since swept across the world. What early lessons in regulation - on capital requirements, incentive structures, role of foreign banks, central bank regulation, governance and more - can we draw from the sub-prime collapse? A first listing of 10 lessons.

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Ten Regulatory Lessons from the Sub-prime Crisis

T T Ram Mohan

(ii) Revisiting Basel II Capital Norms: The Basel II norms are intended to align capital requirements with banks’ level of risks and to reward banks that do a better job of risk management. But this is predicated on risk assessments made by rating agencies (in the standard approach) and

The sub-prime crisis that erupted in the United States was the first manifestation of the larger financial crisis that has since swept across the world. What early lessons in regulation – on capital requirements, incentive structures, role of foreign banks, central bank regulation, governance and more – can we draw from the sub-prime collapse? A first listing of 10 lessons.

T T Ram Mohan (ttr@iimahd.ernet.in) is with the Indian Institute of Management, Ahmedabad.

A
s in the life of individuals, so also in the lives of nations, crises are manifestations of deep-rooted problems, problems that have remained unaddressed for long. The sheer enormity of the sub-prime crisis underlines the need to revisit the entire area of financial regulation and, more broadly, the management of the economy at both the national and global levels.

This is an attempt to compile an early list of possible lessons from the present crisis. It is not meant to be an exhaustive one. Besides, the lessons and prescriptions mentioned below are all the subject of i ntense research at the moment and will continue to be debated. One should, therefore, not presume any finality to any prescription. It is more important to flag the underlying issues. In that spirit, here goes.

(i) Higher Capital Requirement: Banks and all systemically important financial institutions will need to operate with higher capital than they have done so far. This means the regulatory requirement of capital will have to be raised. When the regulatory requirement is 9%, banks consider it appropriate to operate at 12%. With capital having to be provided for operational risk under Basel II and the auxiliary requirements under pillar II of the accord, we should expect to see banks operate at a capital of 15% in the medium term.

Higher capital is the first line of defence against risk but a case for higher capital can also be made as a means of limiting incentives for excessive risk-taking on the part of managers. The lower the capital and the greater the leverage in a bank, the greater are the incentives for managers to take risks. If the risky gambles pay off, managers can show a fantastic return on equity and claim proportionate bonuses. And if the gambles fail? Well, then it is the shareholders and bondholders who are left holding the can.

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on the validity of sophisticated models used by banks (in the advanced approaches). There is bound to be a question mark over both, given that the credibility of rating agencies has taken a beating in the present crisis and so have the vaunted risk management models.

There is merit in the view, already adopted in the United States (US), that the Basel II norms must be used in conjunction with conventional measures of leverage, such as the ratio of capital to total a ssets (without assigning any risk weights). No matter what level of capital follows from the Basel II approaches, leverage in conventional terms must not be allowed to exceed a prescribed limit.

We also need to examine whether, u nder the standard approach, the more r eputed banks can be permitted to rely on their own ratings of borrowers rather than the ratings provided by the rating agencies. There is room to believe that seasoned bankers may be doing a better job of rating borrowers than the agencies.

(iii) Re-design of Performance Incentives: People are aghast at the payouts made by way of bonuses and stock options to top executives in the financial sector. “Greed” has been cited as an important factor underlying the downfall of many firms. However, the issue is not the size of payments. In regulatory terms, we are not concerned about whether top management pay is inegalitarian. Our concern is with pay as a source of systemic risk. If performance is measured incorrectly and managers are rewarded inappropriately, that can pose serious risks to financial firms.

The nub of the issue is that, more than in most businesses, performance in the financial sector cannot be measured at a given point in time. It is unwise to reward bank managers, for instance, on the basis of loan growth or even profit in a given year. Any manager can ramp up loans in a

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year. But this is likely to show up as nonperforming assets down the road. Performance can be measured in banking only over a long period, say, over the entire business cycle.

Once this is grasped, the design of performance incentives falls into place. First, incentives must be linked to return on risk-adjusted capital, that is, the denominator must reflect the risk that made p ossible the return shown in the numerator. The catch, however, is that we cannot quite know that we have captured risk accurately.

Therefore, and this is the second element in incentive design, only a portion of the bonus can be paid out in a given year. The rest goes into an escrow account. In the subsequent years, bonuses will be similarly computed. If there are losses, there will be negative entries in the escrow account. At the end of an appropriate period

– say, seven to 10 years – the manager collects the balance in the account. Third, at the highest levels, the cash component in bonus must be relatively small and the stock option component must be relatively large so that incentives are aligned to long-term performance. Following from the argument given above, stock options must vest only over a long period.

  • (iv) Widening Gambit of Central Bank Regulation: In the present crisis, the US Fed found itself obliged to offer liquidity to non-bank institutions, thus extending its lender of last resort role. It then gave a banking licence to some of the investment banks so that they could convert themselves into banks. The underlying principle is that if an institution seeks or needs assistance from the central bank, then it has to submit itself to central bank regulation. Given the interlinkages in the financial system, the distinction between commercial banks and other institutions is, perhaps, inappropriate for regulatory purposes. The time may have come to examine whether all systemically important financial institutions must be subject to central bank regulation.
  • (v) Tread Warily on Foreign Bank Entry: The present crisis underlines that the R eserve Bank of India’s cautious approach to foreign bank entry as outlined in its
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    road map for foreign banks in 2005 is well merited. The dominant concern has been that foreign banks, with their superior financial muscle and expertise, will take away the best business, leaving domestic firms weakened. But this is a defensive a rgument, which some may want to brush aside on grounds of ushering in efficiency.

    In the wake of the sub-prime crisis, it does appear that it is not the superior efficiency of foreign banks so much as their inefficiency or vulnerability that emerging markets may have to fear. One important regulatory issue is monitoring crossborder exposures and transactions of f oreign banks. These entities have been in the forefront in selling derivative products to Indian firms. This has led to an exponential rise in off-balance sheet (OBS) e xposures of foreign banks. OBS assets with foreign banks are 2,800% off-balance sheet assets compared to the banking s ystem’s average of 333%. Given that OBS items have figured prominently in the subprime crisis, this is cause for concern.

    Another issue with a dominant foreign bank presence is the potential for capital flows to reverse consequent to problems at the host country, the parent bank or the country of origin. We are only too familiar with this phenomenon in the case of capital market flows. It does not make sense to introduce such a destabilising element into financial flows intermediated by foreign banks as well.

    (vi) Prudential Limits on Securitisation: Rampant securitisation is seen as one of the causes of the sub-prime crisis. Banks had no qualms about originating large volumes of low-quality loans because they knew they were not going to have these on their own books for long. The loans would be palmed off to other investors through securitisation. This transfer was, of course, facilitated by the high ratings that agencies were only too willing to give to the securitisation tranches.

    An important regulatory issue is whether we need to restrict the percentage of loans that a bank will be allowed to securitise. The regulator could stipulate, for instance, that 75% of loans should be held by the bank. Only the balance could be s ecuritised. The 75% limit would apply not just to loans in the aggregate but loans by

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    category – home loans, credit cards, car loans, etc.

    Imposing such a requirement becomes necessary because of the difficulties inherent in getting accurate rating of securitised bundles of loans. It also helps create superior incentives for banks to monitor quality – at the point of origination as well as after the loan is made. Banks that wish to transgress the regulatory limit may be subjected to higher capital requirements.

    (vii) Addressing Liquidity Risk: The present crisis had driven home the lesson that risks in banking are not confined to the asset side. They can arise on the liabilities side as well. The quality of assets at Northern Rock was above the British average when it went under. It was lack of liquidity that destroyed the bank. Similarly, it was investment banks’ dependence on short-term funds in the wholesale market that contributed to their downfall as much as their exposure to toxic assets.

    One way to address liquidity risk would be to impose higher capital adequacy requirements for banks that cross stipulated thresholds of liquidity risk, measured by a number of well-known parameters. But the Bank of International Settlements (BIS) has not favoured this approach. I nstead, in September 2008 it came out with a guidance not outlining 17 principles that might guide the management of l iquidity risk. Instead of imposing higher capital requirements for liquidity risk, the BIS would rather rely on better supervision of liquidity risk at banks. It has also e mphasised better disclosure of liquidity risks at banks.

    (viii) Regulation of Derivative Contracts: Two problems with derivatives have b ecome apparent. In the case of some products, such as credit default swaps, the contracts were a huge multiple of the u nderlying contract. A credit default swap offers protection in the event of default of, say, a bond. But such contracts came to be written even for people who did not hold the underlying instrument, in this case the bond.

    These contracts thus became a form of wild betting. The seller of the protection in the credit default swap collected a

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    fee by offering this sort of insurance to whoever was willing to buy it. Given the sheer volume of protection sold, it became i mpossible for institutions, such as AIG to honour their contracts when the bets went against them. One reasonable restriction would, therefore, be to limit credit default swaps to those who hold the underlying instrument.

    Another suggestion is that to move certain derivative contracts to exchanges and limit over-the-counter products. This would subject these contracts to the exchanges’ discipline of marking to market and meeting margin requirements on a regular basis and avoid the sort of largescale defaults on contracts we have seen.

    (ix) Risk Management is a Board Function Too: It does appear from the problems at several large institutions that the boards did not have a handle at all on the management of risk. This was left to management. It must be understood, however, that risk management is too important to be left to management. The board must have a role in monitoring risk at an aggregate level. If management’s task at a financial firm is primarily the management of risk, then monitoring of performance along that dimension automatically b ecomes a board responsibility. That is why boards in India and abroad too have a risk management committee as one of their subcommittees. It is not that boards need to look into the details of models. But they do need to know about overall risk exposures, exposures to sensitive sectors, whether higher returns reflect the a ssumption of higher risks, etc.

    (x) Board Composition Matters: One of the astonishing revelations from the crisis is about how little banking expertise the top financial institutions had at the board level. At Citigroup, two board members recently retired after together serving for a total of 59 years on the board. It is not as if either had banking expertise and was, therefore, indispensable. One came from the Ford Foundation and another from Chevron, the oil company. Lehman Brothers had a theatre impresario on the board. Most banks fell victim to the “celebrity” syndrome, thinking it was enough to have a famous name, preferably a retired corporate executive or government official, on their boards.

    In India, the Banking Regulation Act stipulates that at least 51% of board m embers should conform to certain s pecifications and boards are at least nominally required to have an appropriate mix of expertise including an economist, a banker, an SME expert and so on. It is a different matter that some of these norms are followed more in letter than in spirit. There is also a problem in not applying “fit and proper” criteria that are applied to independent board members on public sector banks to those appointed by government. But the principle of limiting board tenures to a maximum of eight years is certainly a healthy one.

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