Counter-cyclical measures are more in the nature of micro-prudential measures, in so far as it examines the responses of individual institutions to exogenous risks. They involve raising regulatory standards and bank capital requirements in good times and relaxing them in bad times. It is argued that this would enable financial institutions and other stakeholders to put in place adequate cushions to both contain bouts of "irrational exuberance" and tide over difficult times like the one we are presently living through.
It is felt that such counter-cyclical measures may not yield the desired result since it will drive financial institutions to indulge in regulatory arbitrage (shift activity to unregulated areas) during boom times, and in bad times the markets' aversion for risk will force institutions to hold capital than regulators require. Further, there remains the strong possibility of relaxing regulatory requirements in the face of political pressure, depending on exigencies.
In an Economist Round Table debate, Raghuram Rajan prefers more market-based, than intrusive government rule-based, approach towards cycle-proof regulation and suggests that new regulations should be comprehensive, contingent and cost-effective. Any regulatory regime has to be comprehensive, covering all actors and all instruments, so as to pre-empt the possibility of regulatory arbitrage. He feels that only those regulations which are contingent - exerts its biggest "force when the private sector is most likely to do itself harm, but impose fewer restrictions at other times" - can be cost-effective and less prone to being sabotaged politically or otherwise. Contingent capital, as opposed to explicit and permanent counter-cyclical capital, is both cheaper (since it is raised during normal times at the time of issue) and economically efficient deployment of resources. He writes,
"One version of contingent capital is for banks to issue debt which would automatically convert to equity (full paper here) when both of two conditions are met: first, the system is in crisis, either based on an assessment by regulators or based on objective indicators; and second, the bank’s capital ratio falls below a certain value. The first condition ensures that banks that do badly because of their idiosyncratic errors, rather than because the system is in trouble, don’t avoid the disciplinary effects of debt. The second condition rewards well-capitalised banks by allowing them to avoid the dilutive effect of the forced conversion (the number of shares the debt converts to will be set at a level so as to dilute the value of old equity substantially). It will also give banks that anticipate losses an incentive to raise new equity. A collateral benefit is that, anticipating forced conversion, banks will raise new capital expeditiously when they make losses, thus protecting taxpayers...
Another version of contingent capital is the requirement that systemically important, and leveraged, financial firms buy fully collateralised insurance policies (from unleveraged firms, foreigners, or the government) that will capitalise these institutions when the system is in trouble. Yet other versions would require banks to issue capital to top up losses based on public signal (as in case of margin calls)."
He also prefers more institutionalized mechanisms, instead of imposing strict limits on size and activities, to avoid the problems that arise when the "too big to fail" institutions end up on their death beds. He argues in favor of a "shelf-bankruptcy" plan that would require banks to "track, and document, their exposures much more carefully, probably through better use of technology. The mechanism would need to be stress-tested by regulators periodically and supported by legislation — such as one to facilitate an orderly transfer of the institution’s swap books to third parties."
Charles Goodhart raises doubts about collateralized insurance policies, especially in view of the recent crisis with AIG and others. He feels that private insurance is not a sensible mechanism "for dealing with tail risk whose probability is unknown" and that "disaster myopia will rule". Interestingly, he prefers public sector insurance, financed through a system of "counter-cyclical capital charges". He also feels that the "shelf-bankruptcy" plan would come up against the problems of managing the operations and activities of all subsidiaries of an institution, both domestic and foreign, and may therefore not be practical. Goodhart also fears that counter-cyclical capital charges are a better option than counter-cyclical capital requirements, since the latter would impose considerable costs in terms of the interest paid on that debt.
Hyun Song Shin argues in favor of a paradigm shift in the underlying principles behind any regulatory mechanism. He feels that any discretionary system that "relies on the regulator to take away the punch bowl at the height of the party", like the present one, cannot be effective. He therefore argues in favor of a more stringent rule-based regulatory architecture where the "rules are put in place at the outset, liberating the regulator to implement the consequences that flow from the rules".
Given the most recent experience, we have every reason to be skeptical of any arrangement that leaves it to the discretion of regulators and faith in market mechanisms to police and remedy market failures. Prof Shin argues against market-based counter-cyclical regulations and in favor of rule-based regulation precisely for the same reasons that Prof Rajan felt strict rule-based regulations were not likely to succeed - pressure by the private sector to circumvent or avoid them and the fading memory of past crises. He therefore argues that corrective interventions should kick in as soon as a market failure comes to light and capital targets should bind and restrain excesses when market-determined capital does not do so.
Prof Shin draws distinction between the conduct-of-business and consumer-protection regulators and a systemic regulator, and argues in favor of the Central Banks being given more powers to emerge as a macro-prudential systemic regulator. This would also require the Central Banks expanding their scope beyond the limited role of price stability to including financial market stability.
Mark Thoma makes several interesting points while disagreeing with the underlying premise of many of Prof Rajan's prescriptions. He feels that the climate exists now, and it will wane fast as the recovery sets in, for putting in place adequate regulatory mechanisms, and that we should bother about fine-tuning or minimizing (or even diluting) them as we go along. He feels that no regulatory arrangement (including capital requirements, private sector insurance etc) would have been adequate to tide over the magnitude of crisis we are going through, and therefore the objective should instead be to raise the average level of regulation, so as to prevent such full-blown crisis from developing. He also feels that the firm level contingency plans for orderly bankruptcy would come up against bad incentives, thereby leaving the arrangement doomed to fail. He rejects the arguments in favor of economies of scale or scope and efficiency in size, and is in favor of breaking up large too-big-to-fail firms and having in place regulatory features that prevent the emergence of such large financial institutions.
Brad De Long feels that traditional capital regulation requirements etc, cannot achieve the objective of containing systemic risks and preventing financial crises, since the the mood and temper of the market (and also of politicians, press and public), both during booms and busts, consistently runs contrary to the proper aims and objectives of regulators. He proposes that "all financial institutions' capital structures include provisions for the mandatory conversion of debt and other claims to equity on the regulator's option—when the regulator, ideally a global regulator, declares that a state of systemic risk exists". He also favors that "all financial professionals be compensated via long-run equity stakes (with attendant downside risks) — not options - so as to minimize incentive distortions in favor of short term bets.
The IMF (more details here) too feels the need for a rules-based regulatory arrangement to "help counter the tendency towards a build-up of excessive leverage, and the weakening of regulatory resolve, during the good times". Apart from counter-cyclical risk-based capital requirements, they advocate a bouquet of policies that will expand the perimeter to regulation to cover all instruments and institutions. They also argue in favor of "improvements in the quality and timeliness of information disseminated to investors, counterparties, and regulators", and better coordination both among national and international supervisory agencies to "ensure that the systemic risks posed by large, internationally active financial institutions are understood and can be dealt with, particularly when these institutions need to be resolved".
Eugene Ludwig suggests incorporating a wider range of capital requirement tools - appropriate loan loss reserving rules, prescriptions surrounding new products, checks on outsized growth, asset-to-stable-funding ratios, enhanced liquidity management rules generally, and model validation processes. He also stresses on the need for regulators to show the commitment to "take the punch bowl away as the party gets going".
Peter Wallison makes the important point that contingent capital, with equity conversion provision, while helping the ailing bank, weakens the creditors whose balance sheets immediately lose an asset. If the creditors are also banks, it disappears entirely, since equity can’t be counted as regulatory capital.
Surprisingly, Philip Augar is the only commentator in the Roundtable to question the model of integrated financial institutions that combine retail, commercial and investment banking functions, with all its attendant conflicts of interests and potential to trigger financial market crisis like the present one. He writes, "Financial institutions would have to choose whether to be investment banks that underwrite and trade securities or whether to be banks that take deposits from savers and lend to borrowers. Banks making loans would keep the risk on their balance sheets and would need to deal with investment banks on an arm's length basis if they wished to hedge risk or offer clients other services. Investment banks would become providers of liquidity. They would be able to trade for themselves as well as clients but would not be able to advise clients."