Another Way to Shore Up Lenders

Last week, I discussed why capital requirements -- requiring firms to have capital equal to some percentage of their assets -- cannot prevent financial crises.

One way that regulated firms can get around such restrictions is to shift to riskier assets (such as subprime mortgages) within the categories defined by the regulations. Discretionary actions by regulators to offset such shifts during a bubble would be extremely disruptive, requiring more foresight and political courage than we have any reason to expect from public servants.

There have been proposals to shore up this weakness by automating adjustments. This would require tying capital requirements to one or more statistical measures. When the measures indicated that a bubble was underway, capital requirements would increase automatically. When the measures indicated that markets were contracting, requirements would decline.

While there are many good indicators of a contracting system that follows a bubble, there are no universal indicators of bubbles themselves.

Bubbles can arise anywhere, and they can involve financial instruments that did not exist before. Because of this, automating capital requirements would not work.

An alternative to capital requirements that has worked is transaction-based reserving, which is used in the insurance industry. Under such a system, financial firms would be obliged to contribute to a reserve account in connection with every asset they acquire. The portion of the cash generated by the asset that is allocated to the reserve account depends on the potential future outflows associated with the asset. For example, a life insurance company that sells a policy to a 70-year-old allocates a larger portion of the premiums it receives to a reserve account than it would for the same policy sold to a 30-year-old.

As applied to a depository institution, the required allocation to a contingency reserve would be, say, 50 percent of the portion of any charge that is risk-based. If a prime mortgage were priced at 6 percent interest and zero points, for example, the reserve allocation for a 7 percent, two-point mortgage might be 0.5 percent plus 1 point.

Contingency reserves can't be touched for a long period, perhaps 15 years, except in an emergency. Of course, income allocated to reserves would not be taxable until it was withdrawn.

A great advantage of transaction-based reserving, relative to capital requirements, is that it does not depend on discretionary actions by the regulator to offset the excessive optimism that feeds bubbles. A shift to riskier loans during periods of euphoria automatically generates larger reserves because riskier loans carry higher risk premiums.

Another advantage of transaction-based reserving is that it applies to every transaction with a risk component, whether it is shown on the firm's balance sheet or not. The principal responsibility of the regulator is to establish the risk component of every type of transaction. When credit default swaps appeared, for example, the regulator should immediately have realized that the premium was 100 percent risk-based, and sellers would have been obliged to reserve 50 percent of their premium income.

Private mortgage insurance companies are subject to much the same kind of mortgage default risks as depository institutions that invest in mortgages. But where those institutions have been subject to capital requirements, mortgage insurers have been subject to transaction-based reserving. These insurers allocate 50 percent of their premium income to a contingency reserve for 10 years.

These reserves have allowed the mortgage insurers to meet all their obligations in connection with the extraordinary losses suffered by lenders during the current crisis. While their shareholders have taken a beating, the insurers are doing exactly what they were chartered to do: cover losses out of their reserves.

In retrospect, the major shortcoming of the transaction-based reserving rules under which they operate is that 10 years is too short. Given the infrequency of major crises, 15 years seems more appropriate.

A recent report by the Center for Responsible Lending claims that the Office of Thrift Supervision should be closed because it failed to prevent major thrifts from engaging in "increasingly risky lending practices that harmed borrowers, undermined the institutions' own financial health and ran up enormous costs that have landed in the taxpayer's lap."

I disagree. While the Office of Thrift Supervision hardly distinguished itself, the Federal Reserve, Comptroller of the Currency and Federal Deposit Insurance Corp. did no better. None of them acted to deflate the housing bubble that laid the groundwork for the crisis, until it was too late.

As I have argued this week and last week, we can't rely on regulators to prevent financial crises. What is needed is a system that automatically dampens bubbles and strengthens the capacity of firms to deal with their aftermath.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag; Distributed by Inman News Features