12 April 2012

Goodhart/Wagner: Regulators should encourage more diversity in the financial system

This column argues that financial institutions have become too similar to each other, making financial crises more likely. It proposes a regulatory approach based on relative stock market correlations that would encourage greater diversity in the financial system.

The latest round of international financial regulations – known as Basel III – is making important steps towards a safer financial system. However, authors Charles A E Goodhart and Wolf Wagner believe it ignores a key aspect of systemic risk – the lack of diversity across financial institutions.

While up to a few decades ago the financial system consisted of predominantly small institutions that specialised in different businesses and had relatively few interlinkages with each other, this picture has dramatically changed. Financial institutions – in particular the very large ones – have become very similar to each other. The biggest institutions are now operating in the same global markets, undertake similar activities, and are exposed to the same funding risks. This process has made their survival very intertwined – also owing to the manifold types of connections modern financial institutions form with each other.

This lack of diversity is very costly for society. Similar institutions are likely to encounter problems at the same time. This makes systemic crises – such as the crisis of 2007-2009 – more likely. After all, we are not concerned with isolated bank failures but only with systemic events where a large part of the financial system comes under severe strain. When many institutions are facing difficulties, the policy options are very limited as regulators cannot afford to let a large number of institutions fail.

A more homogenous financial system also means that contagion effects are likely to be more pronounced. This is because a failure of one institution is then more likely to occur at times when other institutions are operating under stress. As a result, spillovers from institutional failures will be larger.

There are several margins at which diversity in the financial system can be improved. To start with, diversity could be achieved if financial institutions were to specialise more in different activities rather than all undertaking the same type of activities. Another key area where greater diversity can be improved is risk management. The liability side of financial institutions is also an important source of diversity – or lack thereof. 

The authors advocate an approach where financial institutions will be subjected to capital requirements that condition on how correlated their overall activities are with the rest of the financial system. This may be in the form of a surcharge on existing capital requirements or, preferably, a redefinition of current risk weights that keep average capital requirements unchanged. Such capital requirements would serve a dual purpose. They would make banks that are systemic because of high correlations less risky by forcing them to hold more capital. More importantly, they would also provide banks with proper incentives to increase diversity in order to reduce capital charges. The appeal of this approach is that it would leave it open for banks how they can achieve diversity, allowing them to choose the most cost-effective way.

Conclusion

The authors believe that encouraging diversity is desirable and feasible for regulation. A key advantage compared to other forms of regulation is that encouraging diversity directly tackles the root of systemic risk. It also does not punish risk-taking in general. It is the primary business of the financial system to finance activities that are inherently risky. Simply raising capital requirements – such as proposed by Basel III -- thus necessarily poses a trade-off. Increasing diversity, in contrast, can be achieved without reducing the level of risky activities. Regulation that promotes diversity may also be welcomed by financial institutions as it corrects incentives that would otherwise produce a financial system that is too homogenous – and one that displays excessive shock amplification and contagion.

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