Make Banks Responsible for Their Own Problems

The unfortunate losses at JPMorgan Chase & Co. have been featured heavily in the media and sparked investigations by various government bodies. Many are already pointing to this event as proof of the need for even tougher bank restrictions – before the new regulations enacted since 2008 have been fully implemented.   

We have no details on what happened at JPMorgan beyond the few facts in the public domain. But we do have a strong view that many commentators are missing the point. Legislating to outlaw risk and eliminate mistakes is doomed to fail.  But there are other, more powerful tools in the new regulatory toolbox, which can be used to properly protect depositors and taxpayers.

Policymakers must act on two fronts.

First, implement strong and consistent capital rules in the spirit of the new Basel III reforms. A tough capital regime will help internalize mistakes, so that the costs of any losses are borne by the bank and its shareholders – not by governments or their taxpayers.  It will also help control risk buildups and make it more transparent, so that the markets can provide real discipline. 

Second, fix the old "too big to fail" regime so there is a failsafe if even tough capital rules ever prove insufficient. While some have dismissed this goal as "pie in the sky," we believe that the government is now putting the critical tools in place to put bailouts behind us.

A tough, globally consistent capital regime would strengthen the banking system and make it more resilient. Fitch, the rating agency, recently estimated that a full implementation of the Basel III reforms would require the biggest global banks to hold a further $566 billion of capital, or reduce their risk taking. This would ensure that the private sector has enough resources to absorb mistakes and to handle political uncertainties and economic downturns.   

At a bank that complies with Basel III, rigid capital multipliers hang over virtually every transaction, especially in complex areas like derivatives, collateralized debt obligations, proprietary trading, and risky credit positions, the capital costs of these activities escalate to the point where they either become uneconomic or must be much reduced in size. Hence, these risk-sensitive multipliers act as a ceramic breaking system to the build-up of excessive risk inside each institution.

Strong capital requirements will be far better at limiting risk and excess leverage than other measures being considered today such as the Volcker rule, which tries to "outlaw" certain types of mistakes.

Unfortunately, we see worrying signs of inconsistencies and slippage in implementing the Basel III reforms in both the U.S. and the European Union. Inconsistent capital rules and timetables can lead to significant problems – mispricing risk across different jurisdictions, encouraging arbitrage across markets and creating bubbles that eventually pop. A consistent implementation timeline will help avoid national differences that can lead to cross-border "arbitrage" and "risk dumping."  

As investors who provide capital to the sector, we need a common and transparent set of capital rules. The purpose of the Basel accords is to ensure globally consistent standards that all banks can be measured by. That will encourage investment in sound, well-managed institutions and go a long way to reducing overall systemic risk. 

The other key tool in the arsenal is a process that allows large institutions to fail safely. We have seen huge progress in fixing this problem since 2008. The recent speech by Federal Deposit Insurance Corp. Chairman Martin Gruenberg is to be commended. In it, he sets out a practical and workable approach to resolving large failed banks. His approach is a clear path that protects taxpayers, while avoiding both the systemic repercussions of a Lehman-like failure and the moral hazard of taxpayer bailouts. We need to advance this effort around the world, to ensure that no institution is too big to fail, no matter how big.

These are real solutions that will work in the real world. They will ensure that banks are organized to be responsible for their own problems, not inflict damage on taxpayers or on the real economy. These solutions align regulation with market forces, so that regulators have an ally in controlling risk. They don't rely on ever-tighter regulations in a vain quest to make banks error–free. That will never happen. Instead, they work on time-tested principles that work in other parts of the economy, and ensure that the inevitable mistakes and misjudgments can be absorbed by the companies who make them. 

We don't need more rules and regulations. We need consistent application of tough fundamental tools that can work.

John Tiner and Richard Thornburgh are, respectively, an advisory director and vice chairman at Corsair, a global investor in financial institutions. Tiner is CEO of the Resolution Group, an investment firm in London, and a former CEO of the U.K. Financial Services Authority. Thornburgh is former chief financial officer of Credit Suisse, where both men are nonexecutive directors.