|Wolf's concluding comments are another indication of how regulatory capture,
once mainly the province of the left, has become a major concern of
mainstream analysts and big institutional investors. The crisis has driven
home that lax regulation magnifies counterparty risk and the potential for
systemic crisis. For Wolf and others, the worrisome question is whether the
financial system is still amenable to state control, or whether the size and
power of the banks deemed too big to fail is now such that effective
regulation, even by would-be reformers, is no longer possible, threatening
"another and possibly still bigger financial crisis in the years ahead."
Why Obama’s conservatism may not prove good enough
By Martin Wolf
“If we want things to stay as they are, things will have to change.” Thus
wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems
to me the guiding principle of the Obama presidency. To many Americans, he
seems a flaming radical. To me, he is a pragmatic conservative, albeit one
responding to extraordinary times. In his own way, Mr Obama is following the
path trodden by Franklin Delano Roosevelt.
Nowhere is his conservatism more obvious than in the handling of the
economic crisis. What we have seen unfolding, from the president’s choice of
Lawrence Summers and Tim Geithner as his principal policy advisers, to last
week’s “stress tests”, is classic conservative policymaking. The aim is
simply to get the show back on the road. As Mr Obama told The New York
Times: “I’m absolutely committed to making sure that our financial system is
stable.” Stability is a quintessentially conservative aim. Many radicals on
the right and left insist that undercapitalised banks should be
recapitalised right now. But Mr Obama sees this as far too risky.
The results of the stress tests were a big step along the road the
administration is taking. They impose enough pain to appear credible, but
not enough to be disruptive. The 10 affected banks will easily raise the
needed money: a total of $75bn (€55bn, £59bn). Their market valuations duly
Douglas Elliott of the Brookings Institution has provided a comparative
analysis of how the US regulators reached their conclusions.* He contrasts
their numbers with those of the International Monetary Fund, in its latest
Global Financial Stability Report, and Nouriel Roubini of RGE Monitor and
New York University. He also allows for the fact that the IMF and Mr Roubini
look at all losses in US banking, while the tests apply to 19 institutions
that hold some 70 per cent of US banking assets.
Estimated losses for 2009 and 2010 by the US regulators, the IMF and Mr
Roubini are $535bn, $321bn and $811bn, respectively. So regulators were
noticeably more risk-aware than the IMF, albeit less so than Mr Roubini.
Against these losses are set the expected earnings (after dividends) over
these years, plus a provision for 2011 losses. Here the regulators estimate
earnings at $363bn, against an assumed $210bn for the IMF and Mr Roubini.
This means the reduction in capital is estimated at $172bn by the
regulators, $111bn by the IMF and $601bn by Mr Roubini. But, after allowing
for planned capital-raising and excess earnings in the first quarter of
2009, the final reduction in capital is just $62bn for the regulators and a
mere $1bn for the IMF, but as much as $491bn for Mr Roubini.
There are two important numbers in the above analysis: possible losses, and
the buoyancy of earnings. Yet there is a final number of no less
significance: how much capital does a bank need? The answer is: how long is
a piece of string? Since many of these banks are deemed too big to fail,
taxpayers are risk-bearers of last resort. The capital requirement depends
partly on how well the government wants to be cushioned against possible
losses and partly on how well bond-holders want to be insured against the
possibility that government might refuse a rescue.
At the end of 2008, the ratio of total common equity to US banking assets
was 3.7 per cent. Without the explicit and implicit insurance provided by
government, it would surely have been higher. As the IMF notes, in the
mid-1990s, before the leverage boom, the ratio was 6 per cent. In the 19th
century, before deposit insurance, it was much higher still.
The conclusions are three: first, the government’s exercise is more
conservative on losses than that of the IMF, albeit far less so than Mr
Roubini’s; second, most of the capital to be raised will come from the
earnings of a banking system able to borrow on the favourable terms arranged
by the central bank and then to lend more expensively to its customers; and
third, the target capital ratios – Tier 1 risk-weighted capital of 6 per
cent of assets and Tier 1 common equity capital of 4 per cent – are not
The purpose of the exercise was indeed conservative: to make it credible,
though not certain, that the existing banking system and assets can survive
the likely battering. This has been done well enough to satisfy the markets.
But these banks will also be unable to expand their balance sheet
significantly in the near future.
The biggest question is how far this exercise will help restore the economy.
Commercial banks provide only a quarter of financial sector credit in the
US, down from close to 40 per cent in the mid-1990s (see chart). Much of the
rest came from various forms of securitisation. Unless and until the latter
markets reopen fully, private sector credit is likely to be constrained. How
far that constraint is binding depends on how far highly leveraged borrowers
are willing to borrow, particularly when the collateral against which they
borrow has lost value. For this reason, it is the huge stimulus – the least
conservative parts of the economic package – that will deliver the recovery.
These are also the least upsetting to the interests of powerful lobbies,
particularly in finance.
More radical approaches – allowing more banks to default, for example –
would have increased uncertainty in the short run and so undermined the
return to stability Mr Obama craves. But here the president must reckon on a
longer-term danger: that the rescued financial system will, in time, start
to lay the foundations for another and possibly still bigger financial
crisis in the years ahead.
Ensuring the rescue of a financial system packed even more than before with
complex and “too-big-to-fail” institutions may well be the cautious response
to this crisis. But it leaves the government with the even more onerous task
of imposing effective regulation in future. Unhappily, the record of
regulation of generously insured financial systems is extremely poor. The
mobilised self-interest of highly rewarded players easily overwhelms the
constraints imposed by far less well-rewarded and almost certainly less able
The more the crisis unfolds, the more evident it is that incentives in the
financial system were (and are) badly distorted. I sympathise with the
conservative approach to crises, but not if it leaves in place the plethora
of perverse incentives that created them. At the end of this, then, there
will be one big test: will the number of institutions thought “too big to
fail” be as large as now and, if so, how will they be controlled? If the
answers are still not clear, there will need to be yet more change.
*Implications of the Stress Tests, May 11 2009, www.brookings.edu