Monday, March 29, 2010

Crisis Insurance?

With healthcare now out of the way, the focus of the Obama administration is shifting to financial reform. Amongst the many issues that need to be resolved (I love this word. It implies that a solution had been found earlier but since that solution isn't working anymore, the issue needs to be solved again. And this, when one is faced with issues of the kind never experienced before... Amazing language, English) is that of how regulators and regulatees respond to crises to ensure there is no risk of contagion.

Of course, many suggestions have been made in this regard but according to N. Gregory Mankiw, a Professor of Economics at Harvard, it's now down to 3 proposals which he describes as follows,

"Much focus in Washington has been on expanding the government’s authority to step in when a financial institution is near bankruptcy, and to fix the problem before the institution creates a systemic risk.

That makes some sense, but creates risks of its own. If federal authorities are responsible for troubled institutions, creditors may view those institutions as safer than they really are. When problems arise, regulators may find it hard to avoid using taxpayer money. The entire financial system might well become, in essence, a group of government-sponsored enterprises.

Another idea is to require financial firms to write their own “living wills,” describing how they would wind down in the event of an adverse shock to their balance sheets. It is hard to say whether this would work. Like real wills, the next of kin may well contest the terms when the time comes. That would slow the process and defeat much of the purpose.

MY favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance."

While I take exception to many things mentioned in this article by Professor Mankiw, I will, for the time being, restrict myself to the topic of this note.

As far as Professor Mnakiw's favorite proposal is concerned, I fail to understand who would invest in an instrument that behaves like debt in good times and equity in bad times, effectively the worst of both worlds? Wouldn't investors ideally want an instrument that is the exact opposite? And since no one is ready to issue their ideal instrument, they have to settle for instruments that behave in exactly the same manner in good times and bad so that reward is in sync with risk.

And which issuer wouldn't want to issue such an instrument? Isn't it an ideal instrument from an issuer's perspective?

The only reason why no issuer would want to issue such an instrument is that of expected returns. What kind of return will an investor demand from such an instrument? Ideally, to make sense for issuers, this return has to be higher than debt and less than equity. But would that be enough when investors know that the conversion to equity would happen only during a crisis, and would surely result in some loss of value? Or would investors demand a return equal to, or even higher than equity, knowing that this is an instrument one is sure to lose money on if one holds on to it long enough? In this case, wouldn't banks be better off raising more equity?

Pricing will be a crucial determinant in this instrument's success. Given the complexity of the instruments risk reward positioning, there is a distinct possibility that pricing will be determined through some complex algorithm which only a select few would pretend to understand, and everyone would accept in the belief that these select few know what they are doing. Suspiciously like mortgage assets that triggered the current crisis.

While Professor Mankiw does state that Banks don't particularly favor this proposal as it would increase the cost of doing business, there is no mention of what expected returns would be like or any suggestions for pricing. Nor is there any mention of other options that could have been proposed and discussed.

Being a firm believer in Occam's Razor, I think the easiest solution would be to impose asset specific capital adequacy requirements on Banks. If an asset class is new or not completely understood, the capital adequacy requirement may be kept at a very high level, even 100%. This would essentially mean that banks wouldn't be able to leverage for investments into new asset categories. As an asset category matures, it's capital adequacy requirement could decrase slowly till it reaches that of traditional banking over a period of say, 10 years. Banks could then choose to either remain in the traditional banking space (and instruments which are understood) and be subject to relatively low capital adequacy requirements or follow a more adventurous path and maintain additional capital.

Creating a complex instrument to resolve a situation arising from sub-optimal understanding of another complex instrument seems to be an exercise in futility. An exercise best avoided at this juncture.

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