In a very good Financial Times post, Willem Buiter weighs in on "leverage", "asymmetry", and the very important need to create institutional means to disallow financial entities from capitalizing via leverage on the upside of credit booms while running for the protective cover of the government on the often sudden downsides.
Buiter has three recommendations, highlighted below, that ought to be vetted carefully as we work our way from the 'wilds' of our current deregulated escaped-from-regulation system into a relatively tamer future-world of once-again, reasonably 'structured finance'. In short, Butier recommends (shortening his commentary a wee bit): (1) common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements imposed on all large institutions whose leverage exceeds a given value, (2) minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions, and (3) all large leveraged institutions deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. To Butier:
Restraining asset and credit booms, Willem Buiter, ft.com, May 25, 2008: … [There is] a major asymmetry in the macroeconomic policy and financial stability framework. This asymmetry is not that interest rates respond more sharply to asset market price declines than to asset market price increases. Even if there were no 'Greenspan-Bernanke put', such asymmetry should be expected because asset price booms and busts are not symmetric. Asset price busts are sudden and involve sharp, very rapid asset price falls. Even the most extravagant asset price boom tends to be gradual in comparison. So an asymmetric response to an asymmetric phenomenon is justified. This does not mean that there has been no evidence of a 'Greenspan-Bernanke' put, of course. In fact I believe that phenomenon - excess sensitivity of the Federal Funds target rate to sudden declines in asset prices, and especially US stock prices - to be real, unfortunately.Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.
Operationally, the asymmetry is that there exists a panoply of liquidity-and credit-enhancing measures that can be activated during an asset market bust and during a credit crunch, to enhance the availability of credit and to lower its cost, but no corresponding liquidity- and credit-restraining instrumentarium during a boom. When financial markets are disorderly, illiquid or have seized up completely, the lender of last resort and market maker of last resort can spring into action. …
Leverage is the key
These asymmetries have to be corrected through regulatory measures, effectively by across-the board credit controls. Every asset and credit boom in history has been characterised by rising leverage. The one we are now suffering the consequences of is no exception. Leverage is a simple concept which may be very difficult to measure, as those struggling to quantify the concept of embedded leverage will know. …Traditional sources of leverage include borrowing, initial margin (some money up front - used in futures contracts) and no initial margin (no money up front - when exposure is achieved through derivatives).
I propose using simple measures of leverage, say a measure of gross exposure to book equity, as a metric for constraining capital insolvency risk (liabilities exceeding assets) of all large, highly leveraged institutions. Common risk-adjusted Basel II-type capital adequacy requirements and reporting requirements would be imposed on all large institutions whose leverage, according to this simple metric, exceeds a given value. These capital adequacy requirements would be varied by the monetary authority in countercyclical fashion.
To address the second way financial entities can fail, what the CRMB calls liquidity insolvency, meaning they run out of cash and are unable to raise new funds, I propose that minimal funding liquidity and market liquidity requirements be imposed on, respectively, the liability side and the asset side of the balance sheets of all large leveraged financial institutions. These liquidity requirements would also be tightened and loosened by the monetary authority in countercyclical fashion.
Finally, I would propose that all large leveraged institutions that are deemed too large, too interconnected, or simply too well-connected to fail, be made subject to a Special Resolution Regime along the lines that exists today for deposit-taking institutions through the FDIC. … [emphasis mine]
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