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I’ve thought about the issue for a while, and I want to summarize what the key areas for bank reform are, so that you all can know why legislation like the Dodd Bill won’t achieve much. There are five key areas that have to be addressed to avoid “Too Big to Fail”:

  1. Limit short-dated funding, and encourage liquid assets. Place strict limits on banks regarding funding that is likely to run in a crisis. Encourage asset-liability match across the whole yield curve. For the cognoscenti, match partial durations. For bank CEOs, hire some life actuaries to help you. (We’re cheap — for what you get! Plus, we have an ethics code superior to others in the financial sector. Wait. You don’t want that?!)
  2. Limit the ability of operating banks/thrifts to lend to, invest in or enter into derivative transactions with other financial companies. This is the critical provision to avoid contagion-type effects. Most proposals ignore this.
  3. Fix the accounting. Go to a principles-based approach, and reveal the complexity embedded in securitization and derivatives. Limit the amount of derivatives that can be written for purposes that do not reduce risk.
  4. Raise the capital required as a percentage of assets, and make the capital required disproportionately rise with the assets.
  5. Fix the risk-based capital [RBC] formula. The banks should copy the appointed actuary function of Life Insurance Companies. Then do industrywide experience studies on asset performance, so regulators will know how risky the assets really are, and then the regulators can feed the results into the risk-based capital formulas, and benchmark what banks lend well and badly by category, which would lead to much better overall risk control, and very frustrated bank managements, because capital would go up, and ROEs down.

Note that I have not mentioned Glass-Steagall. My view is let banks do what they want with assets, but let the RBC formula limit risky asset categories. Equitylike risks should be funded with equity. What could be simpler? Such a policy would have commercial banks out of equitylike businesses in a flash.

That is the heart of the matter. But I want to expand on point 3. Imagine a bank that has bought a Single-A slice of a trust-preferred collateralized debt obligation, 5% of the tranche. Rather than placing the asset on the balance sheet at the amount paid, the following should happen:

  • The asset side of the balance sheet should have an asset equal to 5% of the assets of the CDO.
  • The liability side of the balance sheet should have two entries — one for 5% of the AAA and AA part of the deal, which are loans levering up the single-A interest, and one for 5% of the BBB and below part of the deal, which provide protection to the single-A tranche.

That is the real economics of the deal, though it is far messier than reporting one single-A bond. As it happened with the not-so-hypothetical CDO that I describe, the liability for BBB and below is zero now, and the AAA and AA part of the deal have value equal to the loans.

As for swaps, they are an exchange of this for that. Place this and that on the balance sheet. Let RBC limit the exposures.

We can get really complex about preventing bank defaults, but the main trick is making sure short-term funding does not run. A close second is preventing investment in other financials, which destroys the possibility of contagion.

If we can do those two things, preventing too big to fail will be a breeze. But who has the guts to do that?

Source: What Bank Reform Should Be