The Globe and Mail interviewed Julia Dickson for today’s paper:
That is good – to focus on too big to fail and market discipline – but some of the suggestions for dealing with that are not appropriate, such as determining which institutions are systemic [too big to allow to fail] and trying to assess some sort of capital charge on them.
There are various reasons for that, but I think that designating institutions as systemic will lead them to take more risk, and I think that coming up with the capital charge would be hugely challenging.
Ms. Dickson’s opposition to Treasury’s proposal to designate systemically important institutions is well known, but the fact that “coming up with the capital charge would be hugely challenging” is hardly a reason to ignore the issue.
OSFI has already specified Operation Risk Requirements, which are included in risk weighted assets. One formulation considered acceptable is:
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk,66 but excludes strategic and reputational risk.
…
Banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.68 The charge may be expressed as follows:
KBIA = [Σ(GI1…n x α)]/n
Where
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
α = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator.
Gross Income is a better-than-random proxy for systemic importance and I thing many people will agree that a major part of the Credit Crunch was “inadequate or failed internal processes” related to risk control. If setting α to 15% has proved to be inadequate, try doubling it and see how the back-tests work out. That’s one way. I still prefer a progressive surcharge on Risk-Weighted Assets starting at, say, $250-billion.
We would be more in favour of promoting the idea of contingent capital internationally. So that’s where you have a big chunk of subordinated debt that converts into common equity if the government feels that it has to step in to protect an institution or inject money into the institution. So that’s the kind of position we’re taking internationally, and it’s a huge issue.
I guess if you quantify your proposal simply as a “big chunk of subordinated debt”, the challenge becomes less huge.
Of more interest is the proposed trigger: “if the government feel it has to step in”. The Squam Lake double trigger has attracted some support, but as noted in my commentary on the BoE Financial Stability Report, I feel that such a determination will amount to a death sentence for the affected bank and will therefore come too late to be of use … as well as putting a ridiculous amount of power in the hands of regulators. Let the trigger be the market price of the common; the market understands that, can hedge it and, most importantly, will have some certainty in time of stress.