Higher capital's unintended effect: enabling banks to take more tail risk without the fear of breaching the minimal capital ratio

In Capital Regulation and Tail Risk (IMF Working Paper WP/11/188), authors Enrico Perotti, Lev Ratnovski, and Razvan Vlahu, study banking risk mitigation linked to capital regulation, in a realist context where banks "may choose tail risk asserts." The authors believe that this "undermines the traditional result that high capital reduces excess risk-taking driven by limited liability."

Besides, higher capital requirements "may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations."

Excerpts of the paper's introduction:

Regulatory reform in the wake of the recent financial crisis has focused on an increase in capital cushions of financial intermediaries. Basel III rules have doubled the minimal capital ratio, and directed banks to hold excess capital as conservation and countercyclical buffers above the minimum (BIS, 2010). These arrangements complement traditional moral suasion and individual targets used by regulators to ensure adequate capital cushions.

There are two key arguments in favor of higher capital. The first is an ex post argument: capital can be seen as a buffer that absorbs losses and hence reduces the risk of insolvency. This risk absorption role also mitigates systemic risk factors, such as collective uncertainty over counterparty risk, which had a devastating propagation effect during the recent crisis. The second considers the ex ante effects of buffers: capital reduces limited liability-driven incentives of bank shareholders to take excessive risk, by increasing their “skin in the game” (potential loss in case of bank failure; Jensen and Meckling 1976, Holmstrom and Tirole 1997).

Yet some recent experience calls for caution. First, banks are increasingly exposed to tail risk, which causes losses only rarely, but when those materialize they often exceed any plausible initial capital. Such risks can result from a number of strategies. A first example are carry trades reliant on short term wholesale funding, which in 2007-2008 produced highly correlated distressed sales (Gorton, 2010). A second example is the reckless underwriting of contingent liabilities on systemic risk, callable at times of collective distress (Acharya and Richardson, 2009). Finally, the combination of higher profits in normal times and massive losses occasionally arises in undiversified industry exposures to infl ated housing markets (Shin, 2009). A useful review of such strategies is provided in Acharya et al. (2009); IMF (2010) highlights the importance of recognizing tail risk in financial stability analysis. Since under tail risk banks do not internalize losses independently of the level of initial capital, the buffer and incentive effects of capital diminish. Higher capital may become a less effective way of controlling bank risk.

Second, a number of major banks, particularly in the United States, appeared highly capitalized just a couple of years prior to the crisis. Yet these very intermediaries took excessive risks (often tail risk, or highly negatively skewed gambles). In fact, anecdotal evidence suggests that highly capitalized banks were looking for ways to put at risk their capital in order to produce returns for shareholders (Berger et al. 2008, Huang and Ratnovski 2009). Therefore, higher capital may create incentives for risk-taking instead of mitigating them.

This paper seeks to study these concerns by reviewing the effectiveness of capital regulation, and in particular of excess capital buffers (that is, above minimum ratios), in dealing with tail risk events. We reach two key results.

First, we show that the traditional buffer and incentives effects of capital become less powerful when banks have access to tail risk projects. The reason is that tail risk realizations can wipe out almost any level of capital. Left tails limit the effectiveness of capital as the absorbing buffer and restrict “skin in the game” because a part of the losses is never borne by shareholders. Hence, under tail risk, excess risk-shifting incentives of bank shareholders may exist almost independently of the level of initial or required capital.

Second, having established that under tail risk the benefits of higher capital are limited, we consider its possible unintended effects. We note that capital regulation also affects bank risk choices through the threat of capital adjustment costs when banks have to raise equity to comply with minimum capital ratios. (These costs are most commonly associated with equity dilution under asymmetric information on the value of illiquid bank assets,Myers and Majluf, 1984, or reduced managerial incentives for efficiency, Jensen, 1986).2 Similar to "skin in the game", capital adjustment costs make banks averse to risk, and may discourage risky bank strategies. However, unlike "skin in the game", the incentive effects of capital adjustment costs fall with higher bank capital because the probability of breaching the minimal capital ratio decreases.

Of course, if highly capitalized banks internalized all losses, they would have taken risk only if that was socially optimal (would have offered a higher NPV). Yet this result changes dramatically once we introduce tail risk. Then, even banks with high capital never internalize all losses, and may take excess risk. Moreover, the relationship between capital and risk can become non-monotonic. The reason is interesting. In the first place, tail risk leads to insolvency whatever the initial bank capital, so higher capital does not sufficiently discourage risk-taking for well capitalized banks through "skin in the game". At the same time, higher excess capital allows banks to take the riskier projects without breaching the minimal capital ratio (and incurring large capital adjustment costs) in the case of low (non tail) returns. So under tail risk, higher capital may create conditions where highly capitalized banks take more excess risk. Further, we show that the negative effect of extra capital on risk-taking becomes stronger when banks get access to projects with even higher tail risk.

To close the model, we derive the bank’s choice of initial capital in the presence of tail risk, and the implications for optimal capital regulation. We show that a bank may choose to hold higher capital in order to create a cushion over the minimal capital requirement so as to be able to take tail risk without the fear of a corrective action in case of marginally negative project realizations.  Then, capital regulation has to implement two bounds on the values of bank capital: a bound from below (a minimal capital ratio) to prevent ordinary risk-shifting and a bound from above (realistically, in the form of special attention devoted to banks with particularly high capital) in order to assure that they are not taking tail risk.

These results are interesting to consider in historic context. Most sources of tail risk that we described are related to recent financial innovations. In the past, tail risk in traditional loan-oriented depository banking was low (both project returns and withdrawals largely satisfied the law of large numbers), hence “skin in the game” effects dominated, and extra capital led to lower risk-taking. Yet now, when banks have access to tail risk projects, the buffer and "skin in the game" effects that are the cornerstone of the traditional approach to capital regulation became weak, while effects where higher capital enables risk-taking became stronger. Therefore, due to financial innovation, the beneficial effects of higher capital were reduced, while the scope for undesirable effects increased.

The paper has policy implications relevant for the current debate on strengthening capital regulation. The simpler conclusion is that it is impossible to control all aspects of risk-taking using a single instrument. The problem of capital buffers is that they are effective as long as they can minimize not just the chance of default, but also the loss given default. Contractual innovation in finance has enabled intermediaries to manufacture risk profiles which allow them to take maximum advantage of limited liability even with high levels of capital. The key to contain gambles with skewed returns is to either prohibit extreme bets, or to increase their ex ante cost.  Leading policy proposals now emerging are to charge prudential levies on strategies exposed to systemic risk (Acharya et al., 2010), such as extremely mismatched strategies (Perotti and Suarez, 2009, 2010), or derivative positions written on highly correlated risks.

A more intricate conclusion relates to implications for capital regulation. The results do not imply that less capital is better: this was not the case in recent years. However, they suggest the following. First, regulators should acknowledge that traditional capital regulation has limitations in dealing with tail risk. This is similar, for example, to an already-accepted understanding that it has limitations in dealing with correlation risk (Acharya, 2009). Second, banks with significant excess capital may be induced to take excess risk (in order to use or put at risk their capital), as amply demonstrated by the crisis experience. Hence, simply relying on higher and "excess" capital of banks as a means of crisis prevention may have ruinous effects if it produces a false sense of comfort. Finally, authorities should introduce complementary measures to target tail risk next to the policy on pro-cyclical and conservation buffers. In this context, enhanced supervision with a focus on capturing tail risk may be essential.

We see our paper as related to two key strands of the banking literature. First are the papers on the unintended effects of bank capital regulation. Early papers (Kahane 1977, Kim and Santomero 1988, Koehn and Santomero 1980) took a portfolio optimization approach to banking and caution that higher capital requirements can lead to an increase in risk of the risky part of the bank’s portfolio. Later studies focus on incentive effects. Boot and Greenbaum (1993) show that capital requirements can negatively affect asset quality due to a reduction in monitoring incentives. Blum (1999), Caminal and Matutes (2002), Flannery (1989) and Hellman et al. (2000) argue that higher capital can make banks take more risk as they attempt to compensate for the cost of capital. Our paper follows this literature, with a distinct and contemporary focus on tail risk.3 On the empirical front, Angora et al. (2009) and Bichsel and Blum (2004) find a positive correlation between levels of capital and bank risk-taking.

The second strand are the recent papers on the regulatory implications of increased sophistication of financial intermediaries and the recent crisis. These papers generally argue that dealing with new risks (including systemic and tail risk) requires new regulatory tools (Acharya and Yorulmazer 2007, Acharya et al. 2010, Brunnermeier and Pedersen 2008, Huang and Ratnovski 2011, Perotti and Suarez 2009, 2010).

You can order a print copy here or request a PDF copy from us.

What Killed American Lit.

What Killed American Lit. By JOSEPH EPSTEIN
http://online.wsj.com/article/SB10001424053111903999904576468011530847064.html
Today's collegians don't want to study it—who can blame them?WSJ, Aug 27, 2011

The Cambridge History of the American Novel
Edited by Leonard Cassuto, Clare Virginia Eby and Benjamin Reiss
Cambridge, 1,244 pages, $185

The Editors of "The Cambridge History of the American Novel" decided to consider their subject—as history is considered increasingly in universities these days—from the bottom up. In 71 chapters, the book's contributors consider the traditional novel in its many sub-forms, among them: science fiction, eco-fiction, crime and mystery novels, Jewish novels, Asian-American novels, African-American novels, war novels, postmodern novels, feminist novels, suburban novels, children's novels, non-fiction novels, graphic novels and novels of disability ("We cannot truly know a culture until we ask its disabled citizens to describe, analyze, and interpret it," write the authors of a chapter titled "Disability and the American Novel"). Other chapters are about subjects played out in novels—for instance, ethnic and immigrant themes—and still others about publishers, book clubs, discussion groups and a good deal else. "The Cambridge History of the Novel," in short, provides full-court-press coverage.

"In short," though, is perhaps the least apt phase for a tome that runs to 1,244 pages and requires a forklift to hoist onto one's lap. All that the book's editors left out is why it is important or even pleasurable to read novels and how it is that some novels turn out to be vastly better than others. But, then, this is a work of literary history, not of literary criticism. Randall Jarrell's working definition of the novel as "a prose narrative of some length that has something wrong with it" has, in this voluminous work, been ruled out of bounds.

Most readers are unlikely to have heard of the contributors to "The Cambridge History of the American Novel," the majority teachers in English departments in American universities. I myself, who taught in a such a department for three decades, recognized the names of only four among them. Only 40 or 50 years ago, English departments attracted men and women who wrote books of general intellectual interest and had names known outside the academy—Perry Miller, Aileen Ward, Walter Jackson Bate, Marjorie Hope Nicolson, Joseph Wood Krutch, Lionel Trilling, one could name a dozen or so others—but no longer. Literature, as taught in the current-day university, is strictly an intramural game.

This may come as news to the contributors to "The Cambridge History of the American Novel," who pride themselves on possessing much wider, much more relevant, interests and a deeper engagement with the world than their predecessors among literary academics. Biographical notes on contributors speak of their concern with "forms of moral personhood in the US novels," "the poetics of foreign policy," and "ecocriticism and theories of modernization, postmodernization, and globalization."

Yet, through the magic of dull and faulty prose, the contributors to "The Cambridge History of the American Novel" have been able to make these presumably worldly subjects seem parochial in the extreme—of concern only to one another, which is certainly one derogatory definition of the academic. These scholars may teach English, but they do not always write it, at least not quite. A novelist, we are told, "tasks himself" with this or that; things tend to get "problematized"; the adjectives "global" and "post"-this-or-that receive a good workout; "alterity" and "intertexuality" pop up their homely heads; the "poetics of ineffability" come into play; and "agency" is used in ways one hadn't hitherto noticed, so that "readers in groups demonstrate agency." About the term "non-heteronormativity" let us not speak.

These dopey words and others like them are inserted into stiffly mechanical sentences of dubious meaning. "Attention to the performativity of straight sex characterizes . . . 'The Great Gatsby' (1925), where Nick Carraway's homoerotic obsession with the theatrical Gatsby offers a more authentic passion precisely through flamboyant display." Betcha didn't know that Nick Carraway was hot for Jay Gatsby? We sleep tonight; contemporary literary scholarship stands guard.

"The Cambridge History of the American Novel" is perhaps best read as a sign of what has happened to English studies in recent decades. Along with American Studies programs, which are often their subsidiaries, English departments have tended to become intellectual nursing homes where old ideas go to die. If one is still looking for that living relic, the fully subscribed Marxist, one is today less likely to find him in an Economics or History Department than in an English Department, where he will still be taken seriously. He finds a home there because English departments are less concerned with the consideration of literature per se than with what novels, poems, plays and essays—after being properly X-rayed, frisked, padded down, like so many suspicious-looking air travelers—might yield on the subjects of race, class and gender. "How would [this volume] be organized," one of its contributors asks, "if race, gender, disability, and sexuality were not available?"

In his introduction to "The Cambridge History of the American Novel," Leonard Cassuto, a professor of English at Fordham and most recently the author of "Hard-Boiled Sentimentality: The Secret History of American Crime Stories" (2009), writes that the present volume "synthesizes the divisions between the author-centered literary history of yesterday and the context-centered efforts of recent years." Yet context is where the emphasis preponderantly falls.

One of the better essays in the book, Tom Lutz's "Cather and the Regional Imagination," is only secondarily about Willa Cather. It is primarily about what constitutes the cosmopolitan ideal in fiction, which Miss Cather embodied and which turns out to be an imaginative mixture of wide culture and deep psychological penetration, lending a richness to any subject, no matter how ostensibly provincial. This is what lifts such novels of Cather's as "My Antonia" and "Death Comes for the Archbishop" above regional fiction and gives them their standing as world literature.

"The Cambridge History of the American Novel" could only have come into the world after the death of the once-crucial distinction between high and low culture, a distinction that, until 40 or so years ago, dominated the criticism of literature and all the other arts. Under the rule of this distinction, critics felt it their job to close the gates on inferior artistic products. The distinction started to break down once the works of contemporary authors began to be taught in universities.

The study of popular culture—courses in movies, science fiction, detective fiction, works at first thought less worthy of study in themselves than for what they said about the life of their times—made the next incursion against the exclusivity of high culture. Multiculturalism, which assigned an equivalence of value to the works of all cultures, irrespective of the quality of those works, finished off the distinction between high and low culture, a distinction whose linchpin was seriousness.

In today's university, no one is any longer in a position to say which books are or aren't fit to teach; no one any longer has the authority to decide what is the best in American writing. Too bad, for even now there is no consensus about who are the best American novelists of the past century. (My own candidates are Cather and Theodore Dreiser.) Nor will you read a word, in the pages of "The Cambridge History of the American Novel," about how short-lived are likely to be the sex-obsessed works of the much-vaunted novelists Norman Mailer, John Updike and Philip Roth or about the deleterious effect that creative-writing programs have had on the writing of fiction.

With the gates once carefully guarded by the centurions of high culture now flung open, the barbarians flooded in, and it is they who are running the joint today. The most lauded novelists in "The Cambridge History of the American Novel" tend to be those, in the words of another of its contributors, who are "staging a critique of 'America' and its imperial project." Thus such secondary writers as Allen Ginsberg, Kurt Vonnegut and E.L. Doctorow are in these pages vaunted well beyond their literary worth.

A stranger, freshly arrived from another planet, if offered as his introduction to the United States only this book, would come away with a picture of a country founded on violence and expropriation, stoked through its history by every kind of prejudice and class domination, and populated chiefly by one or another kind of victim, with time out only for the mental sloth and apathy brought on by life lived in the suburbs and the characterless glut of American late capitalism. The automatic leftism behind this picture is also part of the reigning ethos of the current-day English Department.

As a former English major—"Indeed! What regiment?" asks a character in a Lionel Trilling story—I cannot help wondering what it must be like to be taught by the vast majority of the people who have contributed to "The Cambridge History of the American Novel." Two or three times a week one would sit in a room and be told that nothing that one has read is as it appears but is instead informed by authors hiding their true motives even from themselves or, in the best "context-centered" manner, that the books under study are the product of a country built on fundamental dishonesty about the sacred subjects of race, gender and class.

Some indication of what it must be like is indicated by the steep decline of American undergraduates who choose to concentrate in English. English majors once comprised 7.6% of undergraduates, but today the number has been nearly halved, down to 3.9%. Part of this decline is doubtless owing to the worry inspired in the young by a fragile economy. (The greatest rise is in business and economics majors.) Yet that is far from the whole story. William Chace, a former professor of English who was subsequently president of Wesleyan University and then Emory University, in a 2009 article titled "The Decline of the English Department," wrote:

What are the causes for this decline? There are several, but at the root is the failure of departments of English across the country to champion, with passion, the books they teach and to make a strong case to undergraduates that the knowledge of those books and the tradition in which they exist is a human good in and of itself. What departments have done instead is dismember the curriculum, drift away from the notion that historical chronology is important, and substitute for the books themselves a scattered array of secondary considerations (identity studies, abstruse theory, sexuality, film and popular culture). In so doing, they have distanced themselves from the young people interested in good books.

Undergraduates who decided to concentrate their education on literature were always a slightly odd, happily nonconformist group. No learning was less vocational; to announce a major in English was to proclaim that one wasn't being educated with the expectation of a financial payoff. One was an English major because one was intoxicated by literature—its beauty, its force, above all its high truth quotient.

In the final chapter of "The Cambridge History of the American Novel," titled "A History of the Future of Narrative," the novelist Robert Coover argues that, though the technologies of reading and writing may be changing and will continue to change, the love of stories—reading them and writing them—will always be with us. Let's hope he is right. Just don't expect that love to be encouraged and cultivated, at least in the near future, in American universities.

How is MENA destabilization affecting global markets for oil, energy, etc.?

QUESTION: With continuing uncertainty in the Middle East – in places like Libya, Syria, and Yemen – how is this destabilization affecting global markets for oil, energy, and other goods and services? What do you think are the important issues that are not being covered in the media?

---
1  Effects of instability in energy markets

There are two kinds of effects: The easily measurable ones, and the subjective, or irrational, ones.

The first are easy to see. If any of these countries of the table below [1] stop (partly or completely) their oil exports, the effects are, depending of disruption time, going to be more or less close to last column's values:





This is the table for gas [1]:




You can run your models to try to estimate how big will be the final effect in prices, and further run the models to try to ascertain the impact on growth, inflation, employment, etc., making use of the rational expectations principle.

Recent comments by Ms Jean Boivin, Deputy Governor of the Bank of Canada, at the Canadian Association for Business Economics this week [2] explains that rational expectations (in its stronger form) means that we assume that people is very sophisticated: individuals "fully understand how economies and markets work, take into account all the information available, fully appreciate the future consequences of their actions today, and make decisions that are fully consistent with this understanding."

Now, this is just a starting point, the dominant undercurrent of people's actions in economic tasks. Analysts pour over the tables above and other data to try to objectivize behaviors. But there are "perturbations" to the mathematical equations that introduce a distance between the ideal (rational expectations) and the real thing. Unfortunately, there is no easy way to introduce into the models the non-objective part.

So the summary is this: effects will gravitate around the values in the tables above, but there is a volatility in the final values that depends of how fearful are investors, and fear is non-computable.


2  Important issues not being covered in the media

Most issues not covered in the media are, IMHO, due to lack of familiarity with the MENA countries. There is not enough knowledge among investors, policymakers, and citizens of those societies: their culture, their history, who are powerful and why.

So most commentary on the risks of a jihadist takeover, or the lack of attention to countries like Mauritania, ignore basic data about those societies and the interactions in the area.


Data like this, which shows efforts (and their relative weight) to influence North Africa by countries outside the area [3], are not being discussed:

References

[1]  Michael Ratner & Neelesh Nerurkar: "Middle East and North Africa Unrest: Implications for Oil and Natural Gas Markets." Congressional Research Service, March 10, 2011.

[2]  Jean Boivin: How people think and how it matters. Remarks by Ms Jean Boivin, Deputy Governor of the Bank of Canada, presented to the Canadian Association for Business Economics, Kingston, Ontario, August 23, 2011.

[3]  The Moor Next Door, Oct 17, 2010, http://themoornextdoor.wordpress.com/2010/10/26/experiments-in-map-making > map in section 5 (http://themoornextdoor.files.wordpress.com/2010/10/screen-shot-2010-10-27-at-10-53-20-am.png?w=700&h=386)