An idea for enforcing ‘skin in the game’

Joining the growing chorus of economists who are calling for financial institutions to finance themselves with more equity and less debt, a new study recommends two levels of capital.

To the core capital requirements already applied to banks today, the authors would add a special capital account that would belong to the bank’s shareholders as long as the bank was solvent and would belong to the regulators (not the creditors) if the bank failed.

The basic idea … is to exploit both the role of equity in reducing the risk-taking appetite of banks (by requiring more capital) and the role of uninsured debt in monitoring bank managers (by ensuring that a part of the capital does not belong to creditors so that they have enough “skin in the game” to monitor.)

This comes from “Robust capital regulation” by Viral Acharya at New York University, Hamid Mehran at the Federal Reserve Bank of New York, Til Schuermann at Wharton Financial Institutions Center, and Anjan Thakor at Washington University in St. Louis, published by the New York Fed in April 2011.

The special account would be built up by putting aside earnings and would be invested in Treasuries or the equivalent. Anytime a financial shock depleted the core capital, money would automatically transfer from the special capital account to the core capital account, and dividend payouts to shareholders would be restricted until the capital accounts are rebuilt through putting aside earnings.

Here’s the Achilles heel of this proposal, in RepoWatch’s view:

Regulators would need to be explicitly directed, by the force of regulation and law, to take possession of the special capital account in the event of bank insolvency, just as FDICIA (Federal Deposit Insurance Corporation Improvement Act, 1991) instructs regulators to shut down sufficiently undercapitalized banks.

But regulators ignored the 1991 Act during the financial crisis of 2007-2008 and bailed out banks instead of closing them. It would be just as easy for regulators to ignore this proposed rule and give the special capital to creditors.

Financial institutions have a long history of gaming their capital requirements. It’s hard to believe regulators could ever force them to have enough equity to survive a run.