How to make big banks safer

By Lee Chae-woong

Nearly six years after the global financial crisis, regulators have adopted a lot of new rules that might make individual banks a little safer.

None of the measures, though, adequately addresses a more troubling and hard-to-recognize problem: the risk lurking in the linkages between financial institutions. New capital and liquidity rules will make banks marginally more resilient to losses and somewhat less susceptible to runs.

Measures such as the Volcker Rule in the U.S. will limit big banks' ability to make speculative bets with taxpayer-insured funds. Taken together, the new rules might also encourage the largest banks to become a bit smaller.

The systemic risk posed by a financial company, however, depends on more than its own health and size. The detailed pattern of financial linkages between companies can determine how vulnerable they and the whole system are to shocks.

The complex web of the financial network, for example, allowed the 2008 bankruptcy of Lehman Brothers Holdings Inc. to trigger the near-demise of giant insurer American International Group Inc. and a money-market freeze that cut off credit to companies around the world.

With precious little information on the investments and derivative contracts that connected financial institutions to one another, regulators were reduced to the role of firefighters.

With little understanding of how far the damage could spread, governments had no choice but to risk trillions of taxpayer dollars on emergency guarantees and bailouts.

The experience led authorities to build better monitoring systems. The challenge, then is to encourage financial institutions to rewire their interconnections to make the financial network safer. As it turns out, there is a way.

Conceptually, it might not even be that hard. Some economists offer a relatively simple idea: Make banks recognize systemic risk by charging them for creating it.

Currently, lenders worry only about the risk they face from a default by the borrower, as opposed to the risk the loan may present to the larger financial system by making cascades of default more likely. They suggest that a small tax, proportionate to the systemic risk a loan entails, could help rebalance the incentives.

Others, however, insist that taxing big banks won't make them safer. While a levy on assets might encourage some banks to get smaller, it also risks enshrining bailouts: As long as a bank pays up, it can operate with dangerously low levels of capital and feel entitled to receive support if it runs into trouble.

Worse, the tax might push banks to take greater chances, using more borrowed money to invest in riskier assets, in the hope of generating enough added profit to cover the cost of the tax.

A better way to take bank risk off taxpayers' shoulders would be to make banks less likely to fail in the first place. Regulators have proposed raising the minimum capital requirement for big banks higher than other lenders.

There's good reason to believe that higher levels would benefit the economy by lowering the risk of crisis.

Global regulators recently put JPMorgan Chase & Co. and HSBC Holdings plc at the top of a list of 29 too-big-to-fail banks that face tougher capital rules than other lenders. These banks are those whose collapse would threaten the global economy.

The capital surcharges for globally systemic lenders add an extra layer of safety beyond beefed-up standards known as Basel III that emerged in the wake of the 2008 global financial crisis.

Regulators said the additional buffers were vital to protect taxpayers and prevent crises from cascading through the financial system. Banks can change their scores by becoming smaller, less interconnected, less complex, and if they become more complex and larger, relative to others, their capital surcharges go up the list.

Responsible institutions could carry out their business with no impediment, as the capital surcharges would apply only to transactions that increase systemic risk. This scheme should significantly reduce systemic risk not just for global big banks but for local big banks in a country, too.

The writer is professor emeritus of economics at SungKyunKwan University. His email address is chaewlee@naver.com.