Would it be costly to require banks to raise equity to 30 percent of total assets?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig make a strong case that in order to reduce the risk of insolvency in major financial institutions, shareholders should be required to fund their lending and other investments to a much greater extent.

The authors argue that government regulation to reduce the risk of insolvency of major financial firms is desirable because failure of such firms has adverse effects that are analogous to those that can arise from accidents in nuclear power plants. When I discussed that analogy in an earlier post, I accepted (somewhat reluctantly) that it is appropriate. As a result of the interconnectedness of financial markets, it would probably not be possible to avoid major economic disruption if large financial institutions were allowed to fail when they became insolvent. That makes it desirable to find the least cost way of regulating them to make it less likely that they will become insolvent. Governments are thus presented with problems that are similar to those involved in regulating the nuclear power industry to reduce the risk that serious nuclear accidents will occur.

Admati and Hellwig suggest that the best way to reduce the risk of insolvency of major financial institutions is to require them to raise shareholder equity from current levels (which under Basel III can apparently still be as low as 3 percent of total assets) to 20-30 percent of total assets. The higher ratio of shareholder equity to total bank assets would provide greater scope for any future fall in the value of bank assets to be accommodated without insolvency.

The authors suggest that requiring banks to rely more on equity funding would impose little, if any, cost to society. In this post I want to focus specifically on the reasons they give for that view. I encourage readers who are interested in a broader discussion of this important book to read John Cochrane's review.

The authors argue that requiring banks to rely more on equity funding would impose little cost on society because it would offset the bias in favour of borrowing provided by government guarantees and tax systems. Banks and their creditors benefit from explicit guarantees to protect depositors as well as implicit guarantees associated with the 'too big to fail' concept. These guarantees enable banks to borrow on more favourable terms than would otherwise be possible. Tax systems tend to favour borrowing because they make interest paid a tax deductible expense.  (The dividend imputation system in Australia reduces this bias to some extent but, as acknowledged by the Henry Tax Review, there is still a bias in favour of foreign borrowing and Australian banks rely heavily on this source of funds.)

The authors point out that equity ratios of banks were generally much higher in the 19^th century, prior to the existence of government guarantees.  In the US, until the middle of the 19^th century, equity levels around 40-50 percent of banks' total assets were typical and early in the 20^th century it was still common for banks to have equity of around 25 percent. The picture seems to have been broadly similar in Australia. Data presented in an article by Charles Hickson and John Turner shows (apparently) that the average equity to deposit ratio of Australian banks declined from around 60 percent in the 1860s to around 20 percent in 1892. The subsequent depression would presumably have substantially depleted the equity of those banks that managed to remain in business. Adam Creighton, a journalist, implies that the surviving banks re-built their capital ratios following the depression, so that a century ago they maintained capital ratios of between 15 per cent and 20 per cent. (See: 'Time to Force the Big Banks to Hold More Capital', 'The Australian', 23 November, 2012.)

Admati and Hellwig point out that the proposed increase in bank equity would not interfere with core banking functions of accepting deposits and making loans. Given the current structure of balance sheets, the increase in equity levels would tend to displace additional borrowing from sources such as money market funds rather than bank deposits.

The authors point out that bankers' claims that equity is more costly than debt are flawed because they don't take account of the effect of increased equity in reducing the risk of bank failure and thus reducing the rate of return required by shareholders. Equity only seems costly because government guarantees provide an implicit subsidy on debt. The increase in equity could be accomplished without significantly disadvantaging existing shareholders by requiring banks to retain earnings rather than pay dividends, until equity levels have reached the minimum level.  

I am normally sceptical of claims that governments can improve matters when they attempt to offset the adverse effects of previous interventions by adding a further layer of regulation. It seems, however, that Anat Admati and Martin Hellwig have found an instance where the theory of second best provides a valid guide to policy action. There are strong grounds to argue that if governments cannot credibly bring the 'too big to fail' policy to an end, they should take decisive action to offset the effects that policy has had in encouraging banks to become more fragile.  In my view the authors' proposals deserve strong support.

How can individuals learn to manage their self-control problems?

The essential characteristic of a self-control problem is failure to do what you want to do, even though you have sufficient knowledge, skill and opportunity. If you opt to have an additional glass of wine after weighing up the short term pleasure against the longer term pain that might result, that doesn't qualify as a self-control problem. But if after choosing to deny yourself the additional glass you often give in to an impulse and have it anyhow, you may have a self-control problem.  

Opinions differ about the extent that individuals can exercise will-power to deal with self-control problems, with support from their families, friends and professional advisors. For many thousands of years self-control problems were often viewed as evidence of possession by evil spirits. More recently, the observation that action precedes thought has brought into question the concept of free will and provided many people with a pseudo-scientific reason to doubt their own capacity to exercise will-power. This has been accompanied by a tendency for many people to re-define individual self-control problems as social problems. For example, individual health problems associated with nicotine addictions, alcoholism and obesity are frequently referred to as public health problems.

The advent of behavioural economics and happiness economics has unfortunately contributed to the view that individual self-control problems are social problems that should be dealt with by public policies. In my view, the efforts of economists to move beyond MaxU, the profession's conventional assumption that individuals maximize their utility, should be welcomed. It has become increasingly difficult to defend MaxU in many contexts in the face of evidence (e.g. a paper by Alois Stutzer and Bruno Frey) that people who are experiencing self-control problems tend to be relatively unhappy.

However, practitioners of behavioural and happiness economics take a step too far when they imply that identification of self-control problems is sufficient justification for government intervention to control people's lives, or remove temptations from them. I have presented my views on why that is so in Free to Flourish. In brief, the nature of humans is such that individuals need to exercise their capacity to make choices and to accept responsibility for them if they are to realise their potential. In other words, humans need to be in control their own lives if they are to flourish. It is also in the nature of humans to make mistakes, but the experience of learning from mistakes has potential to make individuals more competent in making decisions. By contrast, attempts by governments to protect people from themselves run the risk of making them increasingly dependent on government.

One possible objection to the view that people should be free to flourish is that this would be likely to result in worse outcomes for those who have had self-control problems from an early age. The famous marshmallow experiment, conducted at Stanford by psychologist Walter Mischel, suggests that children who have difficulty in deferring gratification to obtain greater reward at four years of age are likely to be prone to self-control problems throughout their lives. Findings of the Dunedin longitudinal study, reported byTerrie Moffitt et al, suggest that childhood self-control predicts such things as physical health, substance dependence and personal finances later in life (at age 32) about as well as intelligence and social class origins.

The findings of the Dunedin study also suggest, however, that it is possible for people to learn to exercise greater self-control. Some children moved up in self-control rank over the years of the study and this had a positive impact on their well-being as adults.

There has been previous discussion on this blog of research findings relating to ways in which people can learn to exercise greater self-control. For example, on the basis of extensive psychological research, Roy Baumeister argues strongly that individuals have the potential to exercise a great deal of self-control if they know how and want to do so.

Research by another psychologist, Tim Wilson, suggests that autonomy support can be helpful. This involves helping young people understand the value of different alternatives facing them and conveying a sense that they are responsible for choosing which path to follow.

Another relevant area of research, that I have recently begun to read about, concerns the role of construal. Research by Kentaro Fujita et al suggests that self-control is enhanced by high-level construal (the use of cognitive abstraction to extract the essential and goal-relevant features common across a class of events) rather than low-level construal (the process of highlighting the incidental and idiosyncratic features that render a particular event unique). What that means is that I would be more likely to maintain my resolve to have only one glass of wine with dinner (except for special occasions) if I construe the second glass as a bunch of calories that will require me to make greater sacrifices later to achieve my BMI target, rather than construing it as an immediate pleasure and entitlement.

If high level construal can help people to manage their self-control problems, that suggests to me that it is important for individuals to find ways to inspire themselves to pursue higher level goals. Techniques such as mBraining, discussed on this blog a few weeks ago, could help.

Is the regulatory problem in banking similar to that in the nuclear power industry?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig suggest that the causes of the global financial crisis were similar in some respects to the causes of the nuclear power disaster in Japan in 2011. In the case of the nuclear power disaster, the authors suggest that corrupted politicians and regulators had colluded with the Tokyo Electric Power Company to ignore known safety concerns. They comment:

'When an earthquake and tsunami occurred in 2011, this led to a nuclear disaster that was entirely preventable.

Weak regulation and ineffective enforcement were similarly instrumental in the buildup of risks in the financial system that turned the U.S. housing decline into a financial tsunami'.

It might seem obvious to just about everyone that government regulation of the nuclear power industry is desirable to prevent outcomes such as those experienced in Japan (even though regulation was spectacularly unsuccessful in this instance) but I feel inclined to step back a little to consider why such regulation is desirable. What is the problem that the regulation is intended to remedy in the nuclear power industry?

The obvious answer is that in conducting their business of providing electric power to their customers, there is a risk that nuclear power firms may accidentally cause harm to other people. But that is also true of many other business activities. Firms have an incentive to take precautions to avoid such incidental harm because they know that potential victims can sue for compensation.

So, why is additional government regulation needed in the nuclear power industry? Leaving aside the possibility of nuclear material getting in to the wrong hands, a need for additional regulation may arise because of the potential magnitude of the harm that might occur as a result of a nuclear accident. The harmful consequences of a nuclear catastrophe might be so great that the responsible firm would be unable to pay full compensation. That would pose a problem for government of whether to step in and help the victims, but it also poses the problem of how to ensure that the managers of the firm have a greater incentive to take precautions to avoid a catastrophe that would bankrupt the firm twice over, than to avoid a catastrophe that would bankrupt the firm only once. So, there might be a case for the government to step in to attempt to ensure that adequate precautions are taken.

Is there a similar case for regulation of major financial institutions? When I looked at this question a few weeks ago I suggested that when the failure of one bank leads to loss of confidence in other banks that have taken similar risks might just reflect a process in which the market is taking appropriate account of new information. For example, if a financial institution becomes insolvent because a decline in property values causes a decline in the asset backed securities in its balance sheet, that information could be expected to bring about a re-assessment of the value of assets of other financial institutions. It should not be surprising that those financial institutions that are considered to be at greater risk of becoming insolvent would suffer from a loss of confidence and have greater difficulty in conducting their business. That is the way an efficient market could be expected to weed out firms that can no longer be trusted to pay their bills. There does not seem to be anything in that scenario that is analogous to the harmful pollution released as a result of a nuclear accident.

Why do the authors argue that major financial institutions ought not be allowed to fail? The main reason they give is contagion, which adversely affects the broader economy. When a major financial institution collapses it is unable to meet its obligations to other institutions, which are also weakened. As more financial institutions anticipate liquidity problems and attempt to sell assets, there is likely to be a further decline in asset values. As financial institutions cut back lending, the broader economy is adversely affected.

Those effects on the broader economy would be dampened, in my view, if central banks were doing a good job of maintaining public expectations of steady growth of aggregate demand. Central banks were slow to use tools such as quantitative easing to do this during the global financial crisis. Even if central banks had made a more determined effort to manage expectations, however, it is doubtful whether they would have been entirely successful in countering fears that failure of several major financial institutions was likely to have severe adverse impacts on aggregate output and employment.

The authors make the point that it would be extremely difficult to allow large complex financial institutions to fail without major disruption when they became insolvent. Proposals that they could be taken over by public authorities until they were placed under new ownership would be difficult to implement because these firms have thousands of subsidiaries and other related entities spread over different countries. Separate resolution procedures would be required for different subsidiaries in different countries. Massive problems of coordination would be involved.

Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent. That does present governments with problems that are similar to those involved in regulating the nuclear power industry.

In a later post I will discuss Anat Admati and Martin Hellwig's views of how governments can reduce the risk of insolvency in financial institutions that are too big to be allowed to fail.

Postscript

I am writing this postscript before I have posted the article because I have had some further thoughts about market failure, a concept that I was tempted to mention above. An earlier post about financial crises led to a discussion with Jim Belshaw about the meaning of market failure. During the course of that discussion I conceded that the concept of market failure is of limited use and made the point (attributed to Harold Demsetz) that the relevant choice is not between an existing imperfect market and an ideal norm of a perfect market, but between real world outcomes under current institutional arrangements and a proposed alternative set of institutional arrangements. My new point (new to me anyhow) is that if some feasible outcome is superior to that which exists at present, then past failure to implement the changes necessary to achieve that outcome should be viewed as government failure rather than market failure.

How do you know when your brains are out of alignment?

You might think that is an odd question to ask a person who has only one brain. But how do you know you have only one brain?

In their book, 'mBraining: Using Your Multiple Brains to do Cool Stuff', Marvin Oka and Grant Soosalu have assembled some fairly impressive evidence that we have brains in our hearts and guts as well as in our heads.

At this point some readers might be thinking that a book with such a title is an unlikely place to find impressive evidence of anything. My own scepticism was heightened when I first saw information being presented as a 'cool fact'. I found it hard not to chuckle. Later, I wondered whether Ross Garnaut's laugh test – which he applies to economic modelling - involves the gut brain. At the time, I wondered how I had come to be reading such a book, but I was comforted by the memory that 50 years ago I had a strong desire to be cool. It is better for our heads to be cool, rather than too hot or too cold, even if the optimal temperature for a heart is warm.

The 'cool fact' that we have brains in our hearts and guts as well as our heads is based largely on the observation that the nervous systems in our hearts and guts are relatively autonomous. They perform their functions without a great deal of direction from our brains. They also link strongly to parts of the brain concerned with emotions and instinctive reactions.

The authors refer to the discovery of neural pathways whereby input from the heart can inhibit or facilitate the brain's electrical activity.  Research by Rollin McCraty and his colleagues at Heartmath suggests that as people learn to sustain heart-focused positive feeling states, the brain can be brought into entrainment with the heart, bringing about improvements in cognitive performance. Research findings also suggest that emotion and cognition can best be thought of as separate but interacting functions or systems, each with its unique intelligence. The power of emotion as a motivational force is reflected in the greater number of neural connections going from the emotional centres of the brain to the cognitive centres than vice versa.

There is evidence that the nervous system in the gut releases chemicals that are capable of relieving anxiety and pain and sends signals to the brain that affect feelings of sadness and stress. There is also evidence that gut bacteria can influence neural development, brain chemistry and a wide range of behavioural phenomena. For example, the balance between beneficial and disease-causing bacteria in an animal's gut can alter its brain chemistry, leading it to become either more bold or more anxious.

Michael Gershen, a pioneer of research relating to the gut brain, argues that while 'gut feelings' originate in the brain rather than the gut, our emotions can trigger a primitive response in the gut. That rings true to me when I remember what disgust feels like. Even though the gut brain is not doing any reasoning it can help us to make decisions.

The way Marvin Oka and Grant Soosala describe them, the prime functions of the various brains line up neatly with common metaphorical usage. The heart brain is the seat of love and desires, goals, dreams and values. The head brain is concerned with cognition and making meaning. The gut brain is concerned with what we should move toward and what we should move away from, with what should be assimilated into the self and what should be excreted from the self, with mobilization, self-preservation and core identity. When we are considering our options we need to be sure our hearts are in the right place, our heads are screwed on properly and that we take notice of our gut reactions. We should follow our hearts, keep cool heads and be gutsy.

So, how do we know when are brains are out of alignment? The answer provided by the authors is much as might be expected. When our brains are out of alignment we experience internal conflict between thoughts, feelings and actions, motivational problems, procrastination, unwanted behaviours and habits, self-sabotage and disempowering emotional states.

The more interesting question is how to get our brains into alignment. The first step that the authors recommend is to allow our breathing to become balanced – calmly breathing in for about six seconds and breathing out for the same length of time. That recommendation is based on the view of breathing as a bridge between mind and body.

In order to deal with motivational problems, the authors suggest that we conduct what seems to me like a high level meeting at which the leader offers inspiration, advisors provide an assessment of the options and the line manager brings the discussion down to earth. As the meeting of minds progresses, we feel the passion in our hearts, entertain curious thoughts about how to express that passion, allow curiosity to harmonize with and enhance our passion, allow our instincts to move us toward action, and then feel how the growing congruence between passionate feelings, curious thoughts and motivated action influences our feelings about who we are and what it is possible for us to achieve.

That is a highly abbreviated version of an exercise suggested by the authors to bring our brains into alignment. In addition to exercises to help bring our brains into alignment, the authors also propose exercises to promote higher expressions of creativity, compassion and courage, and ultimately achieve greater wisdom.

In reading the book I felt that there could have been greater recognition that the central nervous system involves more than just a head brain – it extends down our spines. This links to the importance of proprioception - the sense of the relationship of the body parts to each other – in helping to restore balance between our minds and bodies.

Something else that is missing from the book, in my view, is a discussion of the role of humour in restoring harmony between our conscious and unconscious minds. Since we are fallible humans, it is inevitable that there will be times when our conscious minds get in the way of our unconscious minds. This occurs, for example, when trying too hard (too much conscious effort) adversely affects performance when we are playing sports. If we can see the humour of getting in our own way, that may help us to wipe the slate clean and to trust ourselves to a greater extent in future.

My overall view is that this book is well worth reading to see how that the common metaphors of multiple brains link neatly with both ancient wisdom and modern science. The exercises presented seem to make sense as ways to help people to overcome motivational problems and to manage their own lives. In other words, mBraining is cool!