06 July 2011

Charles Goodhart: Basel on wrong path to tackle systemic risk

An enduring deficiency of our regulatory system has been that it has focused unduly on attempts to improve the resilience of individual banks and other systemically important financial intermediaries to shocks rather than concentrating on the stability of the financial system as a whole.

In doing so, regulation may unwittingly have actually added to procyclicality and systemic fragility, for example by encouraging all banks to behave in similar ways.

There is a danger that we may be about to reprise this same tendency in the shape of the Basel Committee on Banking Supervision and Financial Stability Board support for low-trigger contingent convertible bonds (cocos), which convert to equity once a pre-agreed measure of financial stress has been breached, and bail-inable bonds, which require bondholders to take losses should a bank collapse.

The phrase ‘low trigger’ implies that conversion does not occur until the value of the bank is really very low, i.e. near bankruptcy. There is no question that such instruments would be extremely helpful in the context of the potential failure of any individual bank. Indeed, by helping to avoid deadweight bankruptcy costs, they could often benefit those facing the bail-in haircut. But occasions of idiosyncratic failure of just one bank are quite easily handled by existing mechanisms. Problems arise instead when the system as a whole is facing a generalised macro shock, and a large segment of the financial system is under threat, usually causing fear and incipient panic.

There are at least two, possibly many more, approaches to maintaining stability in the face of future systemic shocks. The first is to encourage much more equity, especially after the shock has hit, and to aim to intervene well before such equity becomes exhausted. The second is to allow a bit less equity (though much more than in Basel II) but to make up the leeway with low-trigger cocos and bail-inable bonds. The BCBS/FSB has been taking the second route. They would have done better to follow the first.

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