The financial system now is safer than it was before the financial crisis in 2008 and that is almost entirely a result of better-capitalized banks, argued John Cochrane, Senior Fellow of Hoover Institution at Stanford University. In order to prevent a financial crisis, one needs to understand bank runs. Importantly as he stressed at a SAFE Policy Lecture on 28 March at the House of Finance, runs are always a result of problems of short-term debt.
Not better-designed risk regulation but more capital is the medicine for a potentially unstable banking sector: “With enough capital, we can end private financial crises forever”, Cochrane stated. He questioned the idea that the financial system needs the threat of runs to discipline banks.
He proposes a two-pillar system where risky or illiquid assets are not backed by short-term debt. In this model, banks that hold short-term debt would be entirely ensured by government bonds. The two activities would be separated under bankruptcy, which would put an end to financial runs. Cochrane admitted that the proposed approach relies on the availability of risk-free sovereign debt, which is a realistic assumption for the United States, but less so for the European Monetary Union.
Short-term debt as a risk
Cochrane is pessimistic about the current regulatory approach as faith in it lessens. He considers most of it to be nearly useless because it focuses on what sparks a crisis, instead of resolving the issue of gas in the room. That is the problem of short-term debt. The attempt to fix all possible causes is hopeless, Cochrane said. More capital reduces the likelihood of a bank run preventing a financial crisis, he explained. He also noted that, compared to the 1930s, short-term debt plays a less important role in modern economies: “Today we do not need fixed value for liquidity anymore.”
The banking industry warns that increasing equity means higher costs and that would result in higher mortgage rates. According to Cochrane, this is not necessarily true. He showed that after the financial crises, when capital requirements were raised, there was no significant increase in costs and mortgage rates in the US.
For Cochrane, threats for a new crisis are sovereign debt, cyber-attacks, and geopolitical risks. In all cases, more capital would help. Pointing to the example of the Greek sovereign debt crisis, he made clear that a system built on default-free sovereign debt could not insulate a crisis like capital could.