Published in The Australian Financial Review
In (“Change the structure of the banking system”, January 27), renowned Yale University professor of economics, Robert Shiller, supports a proposal from the Squam Lake Working Group for a new bank debt funding instrument called regulatory hybrid securities. It’s a form of debt that converts automatically to equity in the issuing bank but at a time when both the bank and the financial system are under stress.
The idea can smooth a few bumps in a banking crisis but while hailed by Shiller as a “major new idea that might fix the problem of banking instability”, I believe it may even make things worse overall.
The intention is to protect the public from the cost of bank rescues. However it’s unclear if this saving will offset the implementation cost. Shiller admits these instruments will raise the cost of capital to banks. This means higher interest rates that will hurt national economies in normal times. The precise specification of the conversion trigger is messy and exposed to unintended risks such as market manipulation to force conversion triggers.
The idea attempts to shift more risk to the private sector. However wealth is still destroyed which means lost jobs. Net bank equity can still be negative even after conversion. It’s a more formal coding of what inevitably happens when a bank too-big-to-fail gets into trouble. One way or another, the market or a regulator causes the bank to restructure. The idea does nothing to fix the root cause of bank failures — that is, the ease with which banks can create dangerous hidden risk.
An idea which does attack the root weakness in the banking system is to force banks to make bank risk transparent. Real transparency is an online virtual place where all banks too-big-to-fail must report daily their exposure to wide-ranging movements in all economic variables to which they are exposed. What’s needed is a transparent, continuous stress analysis. This idea will immunise the global banking system against excessive risk in the most effective way possible. The cost to implement this idea is while it guarantees a net reduction in dangerous bank risk and the first integrated global management of bank risk.
Shiller often mentions the importance of human psychology in understanding market bubbles. However the psychology that causes bankers and regulators to fear transparency gets little attention.
Tags: bank debt, bank failure, banking industry, banking system
