Beware Regulatory Concentration Risk

In her recent Congressional testimony, Federal Reserve chair Janet Yellen outlined a number of reforms to the financial system, including leverage and risk-based capital rules. The reforms are emblematic of the highly technical approach being pursued by the Fed and international financial regulators in the wake of the 2007-9 crisis. This narrow approach to regulation unwittingly promotes dangerous risks that can lead to a new financial crisis. A change in framework is needed.

To see the difficultly of relying on a technical approach to financial regulation, consider a simple example. In order to ensure that banks do not take too much risk, a reasonable first step is to prevent them from borrowing too much. Like homeowners, banks borrow, and the more they borrow, the riskier they become. Regulators therefore require that banks maintain a certain amount of equity capital, just as homeowners keep a certain amount of equity in their home. If in response to regulatory requirements, a bank increases its equity capital, then it reduces its leverage, risk and profitability.

But now imagine the bank wants to increase its profitability.  An easy option is to make riskier loans. These loans are more profitable for the bank, but there is also a higher risk the bank won't get its money back. A less levered bank can be as profitable as a more levered bank if it makes higher-risk loans with higher expected returns. In other words, a bank can simply substitute risk from leverage with risk in its loan book.

The problem here is not simply that the regulator has failed to reduce risk. It is also that if the bank wishes to achieve a certain return, regulators now force it to pursue an approach of lowering loan quality over using leverage. In the financial markets, investors continually judge which method of earning returns has lower risk. But banks lack choice in the example – they are forced to choose the path of pursuing riskier loans to boost earnings, and, thus, may overallocate to these loans, creating a potential bubble. Regulatory action meant to reduce risk can simply push risk into another, more concentrated form.

Regulators may, of course, recognize this problem and, trusting in their ability to outmaneuver the markets, decide not only to regulate leverage, but also the types of loans a bank can make. For instance, new regulations might ensure banks do not allocate too heavily to second-lien loans by penalizing banks for making these loans, in the form of having them set aside more capital.

But a bank can find a way to increase profitability. It can make first-lien loans, but focus on companies with cyclical as opposed to stable cash flows. These companies are less likely to be able to repay the bank in difficult economic periods, but for this reason they also pay higher interest.

Again, regulators have failed to reduce risk. But the more worrying element is familiar: banks that want to achieve a certain level of profitability now cannot do so by using leverage or by making second-lien loans, so they are squeezed into doing so by making first-lien loans to cyclical companies. Risk is being artificially concentrated in an increasingly narrow area.

Regulators can, of course, react yet again in this cycle — perhaps relying on outside rating agencies to help determine what sorts of loans a bank can hold. But this will surely result in other clever ways to take risk, with banks guiding capital into the ever-narrowing channel that allows them to be most profitable.

Down this road lies reality. The most significant banking crisis since the Depression occurred after the Basel I guidelines to control bank risk were published — and after they were replaced by the more "sophisticated" guidelines of Basel II. And fundamental problems in the financial system occurred with mortgages, which received more favorable capital treatment under both Basel I and Basel II than almost any other private-sector asset banks held. In Europe today, banks receive very favorable capital treatment for holding European sovereign debt, and they have been flocking into this "safe" asset class.

Risk is like water, seeking the path of least resistance. If the path is narrowed, risk does not necessarily evaporate, as regulators wish, but often focuses as a more concentrated force. Accepting this alternative concept of risk – regulatory concentration risk – has far-reaching policy consequences.

First, it creates a new sense of urgency to end "too big to fail." Despite rhetoric since the financial crisis, the largest banks have stayed about the same size (as measured by share of the country's deposits). If all-seeing regulators can eliminate risk, ending "too big to fail" is not a pressing issue. However, if we abandon the notion that regulators can eliminate risk, ensuring that large bank failures can be resolved or ensuring that banks are not too big (rather than mistakenly believing we can prevent their failure) becomes a priority.

Second, regulatory concentration risk suggests we should partially replace a technical approach to regulation with a principles-based one. Under a principles-based regime, banks may still be required to maintain a specific amount of equity capital, but on the asset side would simply be told that they cannot suffer more than a certain percentage loss under various "stress" scenarios. Exactly which assets they hold in order to meet this principle would be left to their discretion. Regulators would ensure adherence through routine examinations, and could adapt their requirements in response to what institutions are actually doing.

Regulators would certainly make mistakes in enforcing a principles-based system, but the system would be much more able to withstand mistakes, as banks would not all be concentrated in the same areas of risk. As our appreciation for regulatory concentration risk grows, this system should be considered. The principles ultimately used can and should be debated, but this change in framing would allow different banks to pursue different avenues of risk control, rather than specifying rules that cause all banks to behave the same way. Toward this end, President Obama should nominate a Fed vice chair for supervision, mandated by the nearly four-year-old Dodd-Frank Act, to lead the charge. It is by acknowledging that regulators are not all-seeing, rather than putting them on a pedestal, that we can best avoid another crisis.

Glenn Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Justin Muzinich is president of the international investment firm Muzinich & Co.