Two unanswered questions since the beginning of the Great Financial Crisis are how much risk does society want banks to take and how does this compare to the actual amount of risk banks take.

The market is suppose to answer these questions.

In theory, investors are responsible for all losses on their investment exposures to banks.  This gives investors an incentive to assess the risk/reward of each bank and adjust their investment exposure to each bank based on this assessment.  This results in the maximum amount of risk investors are willing to have banks take given the potential for the investor to lose their investment.  If banks take on more risk, investors cut back their exposure (driving down share prices and driving up the cost of funds of the banks taking the additional risk).

Noticed how I said “in theory”.

Banks are opaque.  Investors cannot assess how risky they are.  Instead, investors rely on bank regulators who every year announce the results of stress tests and proclaim the banks can withstand financial armageddon.  By definition, reliance on the bank regulators proclamation banks are low risk results in investors taking on too much exposure to the banks.

Knowing they are misleading investors, bank regulators try to replace the market.  They do this by setting requirements for how much loss absorbing capacity each bank must have (loss absorbing capacity reflects how much capital a bank has plus a couple of regulatory fudges).

Is there any reason to think the bank regulators get this right?  No.

For starters, the bank regulators have no idea how much risk investors are willing to let banks take on when the investors are exposed to the loss of their investment.

So bank regulators are guessing.  One of the factors influencing their guess is when the bank regulator would feel comfortable having banks take losses during a financial crisis. For example, would the regulator feel comfortable a 50% reduction in loss absorption wouldn’t make a financial crisis worse.  Of course, this has nothing to do with what society thinks is the optimal amount of risk.

Making it even more difficult for the regulators to get it right is the bankers’ argument reducing risk too much hurts the economy.

As RBNZ’s Governor Adrian Orr observed,

We’re trying to calibrate it to society’s risk appetite rather than the risk appetite of a particular financial institution….

We know that society’s risk appetite is less than a bank’s risk appetite because banks get to privatise their earnings but get to socialise their losses. If they fail it’s us, it’s taxpayers, current and all future citizens, who have to pay for that bank failure. So we’re trying to get a better balance. More capital means a safer bank. It means a lower risk bank, which means that they will have a better credit rating themselves, and it means that society is in a better, safer and more efficient position.

Of course, rather than a regulatory suboptimal solution, the regulators could always let banks disclose their current exposure details and stop announcing the results of the annual stress tests. This would allow investors to assess the banks and exert discipline on the investors to do this assessment.  After all, once investors can assess the risk, they become responsible for losses on their investment exposures.