Monday, September 19, 2016

Has Crisis Regulation Made Banks Less Safe?

Regulations Based on Flawed Assumptions May Make Banks Riskier

Author: David Schwartz J.D. CPA

The response to the financial crisis was a raft of new regulation aimed at reducing the risks posed by financial institutions. But now with strict new liquidity and leverage ratios, increased capital requirements, and restrictions on banking activities versus investing activities, are banks safer than they were prior to the crisis?  In a paper published for the September 15 and 16, 2016 BPEA conference, Harvard’s Natasha Sarin and Larry Summers try to answer that very question.  


Financial regulation since the crisis has been predicated on the notion that increasing regulatory capital, tightening leverage ratios, and imposing strict stress testing would lead to substantial declines in financial market measures of risk. Based on a study of financial institution stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields, Sarin and Summers, however, have found that once all these new reforms are in place, they may not be yielding safer financial institutions. Sarin and Summers found that in practice new regulations may actually be making banks less safe.  


The authors examined a number of explanations for this surprising conclusion.  Ultimately, they determined that some assumptions upon which new financial regulations have been based were flawed or inaccurate. They determined that financial markets underestimated risk prior to the crisis and that there may have been significant distortions in measures of regulatory capital. As a result, regulatory decisions based on imprecise or flawed assumptions have created a situation where financial institutions are suffering dramatic declines in franchise value, making them more rather than less vulnerable to price shocks.  The authors attribute the fall in franchise value to a variety of factors including the consequences of low interest rates, a flat yield curve for bank profitability, regulatory restrictions on bank activity, increased competition from shadow banks, and uncertainty about future regulatory actions. Underlining this finding they also found that the ratio of the market value of common equity to assets on both risk-adjusted and risk-unadjusted bases has declined significantly for most major financial institutions.   


While the authors do not suggest that their findings invalidate any particular regulatory approach already taken, if their findings are validated further, they do make clear the need to reexamine the models and assumptions on which these approaches are being based and reformulate regulations accordingly.  


“None of this suggests that the broad approach taken by the regulatory community in the wake of the 2008 financial crisis of increasing capital and seeking to contain risk taking was inappropriate. Indeed we have no doubt that but for Dodd Frank and regulatory actions, the financial system today would be much more fragile. However, if our findings stand up to the scrutiny of others, we believe they should be uncomfortable for most participants in debates about the future of financial regulation and supervision. They clearly call into question the view of many officials and financial sector leaders who believe that large banks are far safer today than they were a decade ago.”


The full text of the paper may be read via