Scare ‘Em Silly

Last week I praised the Bank of International Settlements for bluntly addressing the problems in global banking today.

BIS’s proposed solution for those problems in its tome-like annual report deserve far less praise.

Essentially, the BIS suggests that large banks be subjected to two charges in order to mitigate systemic risk and smooth out the credit cycles. The first is a systemic capital charge, or SCC. As BIS describes it, “an SCC would be designed to create a distribution of capital in the system that better reflects the systemic risk posed by individual failures.” The other charge is a countercyclical capital charge, or CCC, which “would require institutions to build up defensive buffers in good times that could be drawn down in bad times.”

I have two major problems with the BIS proposals. (I should add that BIS also calls for major upgrades in supervision of financial institutions, although that is not the subject of this post.) First, BIS offers no numbers for the SCC or CCC. It is very nice to propose charges to counter systemic risk, but the size or math behind the charges is absolutely critical to evaluating whether they can work or not. To just throw out the idea for charges is like wanting to get married, but refusing to date. Doesn’t work.

My second complaint, and this is more to the substance of an SCC and CCC, is that it might give a false sense of protection when what is really needed is a truer fear of failure. No matter what the formulas for an SCC and CCC, the charges won’t be infinite, so there is a limit to the risk protection it will provide. That limit might be a Dow decline of 2,000 points or a TED spread of 200, but there will still be a limit. Once again the financial sector will find itself wrapped in the false blanket of doomsday scenarios that are believed to be impossible to realize. And, of course, no doomsday scenario is impossible.

Rather, the BIS should accentuate the probability of failure when systemic risk amplifies. In other words, the formula for minimizing systemic risk is to make the penalties on the instigator of systemic breakdown so acute that the amassing of systemic risk is shunned. Charges for systemic risk and in countercyclical periods act as fees, not fear factors. We need fear because it, better than any other factor, counters the passions of capitalism.