Now that the Dodd-Frank financial-reform bill has become law, the real battle begins. Despite the laws 2,000 pagesor possibly because of themthere is much ambiguity about what its eventual impact will be. The Wall Street Reform and Consumer Protection Act, as the law is officially known, grants the Federal Reserve enormous regulatory power. The Fed can now unilaterally decide that any financial institution is systemically importantmeaning that its failure could destabilize the financial system itselfand impose any sort of regulation on it, such as requiring that it hold more equity capital, limiting the amount of short-term debt it can issue, forcing it to write up a living will, and so on.
Unfortunately, the law does not adequately define what systemically important means. The largest banks can, in theory, be exempted from the classification (though this is unlikely), while the smallest hedge fundsshould many of them pursue similar strategies, meaning that they might all fail simultaneouslycan fall under it. The lack of a clear criterion will likely make the designation difficult to appeal; its really up to the Fed to decide. For many institutions, the systemically important label could amount to a regulatory death sentence, without a fair trial.
Some might argue that giving the Federal Reserve this loosely defined power is a necessary evil. The 2008 financial crisis exposed the financial systems endemic risks, they claim; inadequate regulation could lead to more instability and further taxpayer-financed bailouts. Yet should we subject the entire financial system to heavy regulation and bureaucratic (if not political) arbitrariness, seeking to avoid a repeat of the financial crisis?
There is a better alternative. The Federal Reserve can announce the minimum conditions that firms must meet to avoid being designated as systemically important. Each firm can then decide whether to meet those conditions or face federal regulation. And basic principles of economics can tell us what these minimum conditions should be. For a financial firm to cause a systemic shock, two conditions are necessary. First, the firm must be at risk of defaulting and harming the value of financial claims held by depositors and other financial institutionsthat is, it has systemic claims against it.
Second, it must be sufficiently large or sufficiently interconnected that the losses caused by a default spread through the entire economic system. While the second condition is difficult to assess, the first is not. Fortunately, as long as we can prevent a financial institution from becoming at risk of defaulting on its systemic claims, we dont need to get the second definition right. With an early-warning system in place and enough equity and long-term debt (which is better able than the short-term kind to absorb losses) in its capital structure to act as a buffer and absorb losses without jeopardizing systemic claims, even the largest financial institution will be safeand thus unimportant systemically.
But how do we create an effective early-warning system? And who should determine the appropriate amount of long-term debt and capital? And how do we ensure that clever financial engineering doesnt sabotage any such requirement? The answer is to delegate these tasks to the market. The yield of risky debt exceeds the yield of Treasury bonds with the same maturity because the market requires compensation for the expected loss in case of default. Therefore, the difference in the yield reflects market perception of the probability of default. (This market estimate is reliable only if the creditors dont expect to be bailed out. The Dodd-Frank bill allows for the long-term debt of systemically important financial institutions to receive a haircut in case of default. It would be better, however, if the Fed announced in advance that it would impose a haircut as a matter of policy.)
With a potential haircut firmly in place for systemically important institutions, the Fed can then announce in advance a level of bond yield spread above Treasuries that it considers low enough for an institution to be considered nonsystemically important. Lets assume, for instance, that this threshold is set at half a percentage point (50 basis points). This yield spread implies that, under reasonable assumptions about losses on default, the market attributes a 1 percent chance to that event. Even if unlikely, though, the possibility of a default could still be devastating to the financial system if it imposes heavy losses on systemic obligations. For this reason, along with the early-warning system, large financial institutions should have a large cushion of long-term debt (say, 20 percent of assets). With this cushion in place, even in the rare event of a default, only the long-term debt would suffer a loss; the systemic obligations would be protected. Thus, the demise of an institution meeting these specifications would not have any impact on the system as a whole. As long as a financial institution satisfies these strict criteria, therefore, it should not be considered systemically important.
In practice, the market for long-term bonds is segmented because of different maturities and covenants. Thus, a better indicator than the yield on long-term debt is the cost of insuring the long-term debt against default. The price of a credit default swap (CDS), expressed in percentage points per year, represents the cost of that insurance. The 50-basis-point yield spread equates to a CDS price below 50 basis points. Therefore, we propose that the Fed enforce a rule of the form: For a financial institution not to be considered systemically important, it must have at least 20 percent of its capital in junior long-term debt and a CDS price on this debt below 50 basis points. The moment that either of these two conditions is violated, the institution will be deemed systemically important and subject to all other conditions required by the Fed.
Such a rule would have no cost in terms of the financial systems stability. If financial institutions follow the rule, they pose no threat. If they dont follow the rule, they become subject to the same requirements that they would have had to satisfy under a straight application of the Dodd-Frank bill. The rule would give financial institutions the option between two regimes, letting them select the least costly one. More important, it would spare the most vibrant financial institutions from the rigidities and bureaucratization that a strict application of the Dodd-Frank bill would entail.
Oliver Hart is a professor of economics at Harvard University. Luigi Zingales is a professor at the University of Chicago Booth School of Business and a contributing editor of City Journal.