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Pdfjean-Charles Rochet Commentary: Rethinking Capital Regulation Jean-Charles Rochet It is a privilege to be here today to discuss this stimulating article of my distinguished colleagues Kashyap, Rajan and Stein, and to partic- ipate in this very interesting conference on how to maintain financial stability after the current credit crisis. Many influential commentators1 have advocated for fundamental reforms of financial regulatory/supervisory systems as a necessary re- sponse to the crisis. Capital regulations are clearly a crucial element of these systems, and the article by Kashyap, Rajan and Stein offers several important insights and a specific proposal on how to improve these regulations. This article is therefore particularly timely. I will organize my comments in three parts: 1. The objectives of capital regulation. 2. The regulatory treatment of capital insurance. 3. Reorganizing the financial infrastructure. 1. The objectives of capital regulation Capital regulation is a fundamental component of the financial safety net, together with deposit insurance, supervisory interven- tion, liquidity support by central banks and in some cases capital 473 08 Book.indb 473 2/13/09 3:58:56 PM 474 Jean-Charles Rochet injections by the Treasury. This financial safety net has officially two objectives: • To protect small depositors against the failure of their bank (micro- prudential objective), • And to protect the financial system as a whole against aggregate shocks (macro-prudential objective). As pointed out by Kashyap, Rajan and Stein, individual bank fail- ures and systemic crises cannot be eliminated altogether, which raises two questions: • What should be their “optimal” frequency? • How should we manage individual failures and, more impor- tantly, systemic crises when they occur? Existing capital regulations, notably Basel 2, have only offered a relatively precise answer to the first question, at least for individual bank failures. In particular, the IRB approach to credit risk in the pil- lar one of Basel 2 implies more or less explicitly a quantitative target for the maximum probability of default of commercial banks (0.1% over one year). This focus on the probability of default is consistent with traditional actuarial methods in insurance, with the practice of rating agencies and with the VaR approach to risk management de- veloped by large banks (see also Gordy, 2003). However, I want to suggest that focusing on a exogenously given probability of default is largely arbitrary and has many undesirable consequences. For example, Kashyap and Stein (2003), among oth- ers, argue that it would make more sense to implement a flexible approach where the maximum probability of failure would not be constant but would instead vary along the business cycle (concretely, to allow banks to take more risks during recessions and less during booms). This is obviously related to the procyclicality debate. Moreover, the VaR approach can be easily manipulated and has led to many forms of regulatory arbitrage. In particular, it gives in- centives for banks to shift their risks towards the upper tails of loss distributions, which increases systemic risk. In fact, VaR measures 08 Book.indb 474 2/13/09 3:58:56 PM Commentary 475 may be appropriate from the perspective of a bank shareholder (who is protected by limited liability) but certainly not from that of public authorities (who will ultimately bear the costs of extreme losses). From a conceptual viewpoint, capital requirements should be seen as a component of an insurance contract between regulators and banks, whereby banks have access to the financial safety net, pro- vided they satisfy certain conditions. The capital of the bank can be interpreted as the “deductible” in this insurance contract, namely the size of the first tranche of losses, that will be entirely borne by share- holders. The failure of the bank occurs exactly when incurred losses exceed this amount. In property casualty insurance, the level of deductibles on an insur- ance contract is not determined by a hypothetical target probability of claims (here bank failures), but instead by a trade-off between the expected cost of these claims (including transaction costs), the cost of self-financing the deductible (here the cost of equity for banks) and the benefit of insurance for customers that includes being able to in- crease the level of their risky activities (here the volume of lending). By analogy, the capital requirement (CR) for banks should not be computed as a “VaR” but as an expected shortfall (or Tail VaR), which takes fully into account the tail distribution of losses, and thus does not give perverse incentives to shift risks to the upper tail of the loss distributions. Moreover, this “economic” approach to CR is much more flexible than the dominant “actuarial” approach. As in the case of insurance (see Plantin and Rochet, 2008), optimal CRs can in this way be determined by trading off the social cost of bank failures against the social benefit of bank lending, which are both likely to vary across the business cycle. They can also incorporate incentive considerations, on which I will comment below. 2. The regulatory treatment of capital insurance As shown by Kashyap, Rajan and Stein (2008), the macro-pruden- tial component of financial regulation is not sufficiently taken into account in existing capital regulations. They rightly point at the ag- gregate effects of the behavior of banks (especially large ones) during 08 Book.indb 475 2/13/09 3:58:56 PM 476 Jean-Charles Rochet crises. When these large banks face binding solvency constraints, they tend to react by reducing too much (from a social welfare per- spective) their volume of assets (lending less and selling securities, even at a depressed price), rather than by issuing the amount of new equity that would allow them to keep the same volume of assets. This is because banks do not internalize the negative impact of their fire sales on the prices of these assets, which may itself force other banks to liquidate some of their assets, provoking a credit crunch and a downward spiral for asset prices (Brunnermeier, 2008; Adrian and Shin, 2008). Kashyap, Rajan and Stein (2008) put forward a specific proposal for improving capital regulation: encouraging banks (on a voluntary basis) to purchase capital insurance contracts that would pay off in states of the world where the overall banking system is in bad shape. The idea behind this proposal is that whereas banks’ preferred form of financing during tranquil times is short-term debt (because it is a better disciplining tool than equity or long-term debt, given the complexity of banking activities), equity capital becomes too scarce during recessions and banking crises. Banks tend to respond to these negative shocks by reducing the size of their balance sheets rather than by issuing new equity, both because investors are reluctant to provide it during stress periods and because banks do not internalize the negative impact on the economy. In the capital insurance contracts proposed by Kashyap, Rajan and Stein, the insurer would commit to provide a given amount of cash when some aggregate measure of banks’ performance falls below a pre-specified threshold. Banks would be less inclined to sell assets, and the need for public authorities to step in would be reduced. This proposal (which resembles an earlier proposal put forward by Flannery, 2005) is a particular form of the new Alternative Risk Transfer (ART) methods that provide hybrid instruments (with both insurance and financing components) to large firms, not exclusively in the financial sector. These ART instruments (such as contingent capital, catastrophe bonds and options) have been promoted by sev- eral re-insurers (notably Swiss Re) but have not so far been used ex- tensively in practice. 08 Book.indb 476 2/13/09 3:58:56 PM Commentary 477 The proposal of Kashyap, Rajan and Stein is a good idea, but several questions have to be answered more precisely. For example, isn’t it too demanding to impose that the insurer post a 100% collateral deposit in a custodial account, considering that the probability of a claim is (hopefully) very small and the duration of the contract presumably quite long? On the other hand, how can regulators guarantee that the insurer will always fulfill its obligations, unless the insurer’s capital itself is also regulated? Also, the pricing of these capital insurance contracts is likely to be difficult, given that claims will have a low probability of occurrence, but will occur exactly when the overall economic situation is very bad. Finally, the authors should clarify whether they think the main reason why banks do not issue more capital during crises is that they cannot or that they do not want to. In the first case, capital insur- ance contracts make a lot of sense, but then why is it that the banks themselves have not already come up with the idea? In the second case (i.e. if banks do not want to issue more capital during crises), capital insurance can still be good from a regulatory perspective (if not from a private perspective), but regulators have to be given the power to pre- vent the banks from distributing dividends with the money collected from the capital insurance contract. I would like to put forward a similar proposal, inspired by Holmström and Tirole (1998), which could be viewed as a complement to the capital insurance proposal of Kashyap, Rajan and Stein. Suppose indeed that the Treasury issues a new type of security, namely a contingent bond that would pay off only conditionally on some trigger (that could be related to aggregate bank losses like in the proposal of Kashyap, Rajan and Stein, or more generally to other indicators of macroeconomic stress). The in- surance properties of this security would be exactly the same as the one suggested by Kashyap, Rajan and Stein, but it would be provided by the Treasury and not by private investors such as sovereign funds or pension funds.
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