Three years after the onset of the worst financial crisis in more than half a century, the debate over how to make the banking system more secure is far from over. Should there be more regulation; should capital and equity requirements be raised; there’s even disagreement about what constitutes financial instability.

In keeping with what Stanford President John Hennessy called the university’s primary mission “to further the public good,” the Stanford Graduate School of Business and the Stanford Law School convened the Stanford Finance Forum on June 3. Led by business school finance professor Darrell Duffie, the event gathered regulators, financial executives, and academics to discuss the future of the banking system, and the need to establish acceptable levels of capital and liquidity. The forum was sponsored by The Clearing House banking association.

“The liquidity crisis caught everyone by surprise,” Hennessy said in his introductory remarks to an audience of 140 at the business school’s Knight center. “We [Stanford and other universities] are the longest-term investors. Many in the university convinced themselves that the liquidity crisis had no effect on them.” But the crisis forced universities across the country to face sharp drops in funding or the value of endowments. New tools, he said, will be needed to avert another crisis.

The all-day event made news when keynote speaker Eric Rosengren, president and CEO of the Federal Reserve Bank of Boston, said U.S. money-market mutual funds may be vulnerable to Europe’s debt crisis. Those funds “have sizeable exposures to European banks, by virtue of holding the banks’ short-term debt,” he said.

While there was general agreement that banks and other institutions need to hold higher levels of capital and liquidity, the day’s sharpest disagreements focused on a proposal by three members of the Graduate School of Business faculty and a coauthor to raise the percentage of equity financing by financial institutions well above levels suggested by the Basel Accords.

First published in 2010, the proposal is controversial, with many bankers and some regulators arguing that equity financing is too expensive, would lower the return on equity to unacceptable levels, and would result in banks lending much less - contentions the four researchers reject.

“Quite simply, bank equity is not expensive from a social perspective, and high leverage is not required in order for banks to perform all their socially valuable functions, including lending, taking deposits, and issuing money-like securities,” professors Anat R. Admati, Peter M. DeMarzo, and Paul C. Pfleiderer wrote in a paper presented at the forum. (A fourth coauthor, Martin F. Hellwig of the Max Planck Institute, was not present.)

The Basel Accords, a nonbinding but influential international agreement, allows the equity of banks to be as low as 3% of their total, non-risk weighted assets, a level that is “dangerously low,” says Admati, who maintains that a safe range would be at least 10% to 15%. Equity capital represents the share of the firm’s total value held by shareholders in the form of common stock, not money set aside as a reserve.

That proposal led to the sharpest exchange of the day when Adam Gilbert, a managing director of JP Morgan Chase, said it would cost his bank hundreds of billions of dollars and challenged Admati to meet with Chase’s CEO and convince him. When she accepted the tongue-in-cheek offer, Gilbert replied: “I guarantee you - that meeting will not go well.”

If we learned anything from the recent crash, it’s that “liquidity and funding are the keys to life,” David Viniar, the chief financial officer of Goldman Sachs, told the forum during another presentation. “Excess liquidity is the ultimate defense.” Since the crisis, Goldman has pumped up its average reserves of liquid assets to over $113 billion a quarter and now stands at about $164 billion, he said. Viniar noted that adequate capital is not the same as liquidity - adequate levels of both are needed.

It’s clear, he said, that capital requirements were too low before the crash and needed to be raised, but if they are too high, it will raise the cost of doing business to unacceptable levels.

David Miles, a member of the Bank of England’s monetary policy committee, presented a very different point of view, arguing that the risks of allowing reserves that are too low is much higher than the risks to business of overshooting the mark. A systemic financial crisis could permanently reduce a Western nation’s GDP by some 2.5%, he said.

“Be skeptical of the argument that equity is very expensive,” he said. Like Admati and her colleagues, Miles believes the targets set by the Basel Accords are much too low. The most recent set of Basel agreements, known as Basel III, call for a 7% ratio of equity to risk-weighted assets (a somewhat different measure than that used by the Stanford researchers), while Miles thinks 16% to 20% would be a more suitable range. “The game isn’t to make banks so watertight [that a crisis] can’t happen; instead, the goal is to reduce the probability by a few percentage points,” he said.

Basel was also criticized by Adrian Blundell-Wignall, of the Organization for Economic Development and Cooperation, who said that financial markets have become very concentrated, a condition that leads to inefficient pricing. But the Basel Accords make no mention of the dangers of concentration, he said.

In sounding the alarm about the vulnerability of U.S. money market funds to the European debt crisis, the Fed’s Rosengren said that concerns about the stability of the funds have not been adequately addressed by Congress or regulators, despite the passage of the Dodd-Frank financial reform law.

While being careful to say that he wasn’t predicting a bad outcome for the funds, Rosengren noted that the bankruptcy of Lehman Brothers precipitated heavy withdraws from so-called prime money market funds — those which purchase a wide variety of debt instruments, rather than just government securities or tax exempt securities. “I believe we all do well to recognize and address this vulnerability,” he said.

A solution could include a requirement that funds set aside a certain level of capital as a cushion or allowing the net asset value of the funds to float. But whatever solution is developed, it must address the need of investors to access their cash quickly, he said.

Borrowing a term often used in nearby Silicon Valley, Kevin Warsh, a former governor of the Federal Reserve, said “the business of banking is at an inflection point. Will the borders between the very large banks, the regional banks, and the community banks be porous? And are banks or financial services companies now at the center of the financial universe?” he asked.

Whatever the answer to those questions, Warsh said he believes regulatory forum is necessary, but warned that regulation is too important to leave to the regulators. “If the regulators are the only ones setting the rules,” he said, the system will not work. Earlier, Rafael Repullo of Spain’s Centro de Estudios Monetarios y Financieros had concurred, recommending that the Basel Committee involve academics in their discussions of bank capital and liquidity regulations.

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