Prudential Bank Regulation: What’s Broke and How to Fix It

Saturday, August 1, 2009
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Financial crises not only impose shortterm economic costs but also create enormous regulatory risks. The financial crisis that is currently gripping the global economy is already producing voluminous proposals for regulatory reform from all quarters. Previous financial crises—most obviously the Great Depression—brought significant financial regulatory changes in their wake, most of which were subsequently discredited by economists and economic historians as counterproductive.

Since the 1980s, the United States has been removing many of those regulatory missteps by allowing banks to pay market interest rates on deposits, operate across state lines, and offer a wide range of financial services and products to their customers, thus diversifying banks’ sources of income and improving their efficiency. It is worth remembering how long it took for unwise regulatory actions taken in the wake of the Depression to be reversed; indeed, some regulatory policies introduced during the Depression— most obviously, deposit insurance—will likely never be reversed. Ironically, financial economists and economic historians regard deposit insurance (and other safety-net policies) as the primary source of the unprecedented financial instability that has arisen worldwide over the past thirty years.

Will the current regulatory backlash in response to the financial crisis once again set back financial efficiency, or will it lead to the refinement and improvement of our financial regulatory structure? As of this writing, a mixed outcome seems likely. Some changes in the content of banking regulation are likely to be constructive. In other areas—the reform of the regulatory use of rating agency opinions and putting an end to the subsidizing of leverage in housing—the future is uncertain; counterproductive, knee-jerk reactions or preservation of the status quo, respectively, seem as likely as thoughtful reform. In some of the areas where reform would be desirable—most obviously, eliminating entry barriers in consumer banking—nothing is likely to occur. Finally, with respect to the implementation of supervision and regulation, major changes are afoot that will probably rearrange and consolidate financial oversight and extend the powers of the Federal Reserve Board into new areas.

Reconsidering the allocation of regulatory power will likely bring a mix of unpredictable outcomes. Unfortunately, one desirable change—removing the Fed from its current role as a microsupervisor and regulator of banks—is unlikely to occur.

Many commentators argue that the financial innovations associated with the securitization of subprime mortgages by banks and investment banks, and the repo finance (repurchase agreements) of investment banks, permitted subprime mortgage originators to sidestep commercial bank prudential regulation (of on-balance-sheet bank holdings of subprime mortgages and related instruments) so that they could assume more risk at lower cost by boosting leverage.

There is no doubt that, had more subprime loans been placed on the balance sheets of commercial banks, financial system leveraging would have been smaller. But that would not have prevented the crisis. Government policies that promoted risk-taking in housing finance, and regulatory standards for measuring risk when setting minimum capital requirements (for banks, investment banks, and their securitizations), were far more important in generating the hugely underestimated risks that brought down the U.S. financial system.

The subprime default risk was substantially underestimated during 2003–2007. Reasonable, forward-looking estimates of risk were ignored, and senior management structured compensation for asset managers to maximize incentives to undertake underestimated risks.

Those mistakes were not the result of random mass insanity; rather, they reflect a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. Risk-taking was driven by government policies.

Four crucial government errors


  1. Lax monetary policy, especially from 2002 to 2005, promoted easy credit and kept interest rates low for a protracted period. The history of postwar monetary policy has seen only two episodes in which the real federal funds rate remained negative for several consecutive years: the high-inflation episode of 1975–1978 (which was reversed by the rate hikes of 1979–1982) and the accommodative period of 2002–2005.

    The Federal Reserve deviated sharply from the “Taylor Rule” in setting interest rates during 2002–2005. (The Hoover Institution’s Bowen H. and Janice Arthur McCoy Senior Fellow, John B. Taylor, created the “Taylor Rule,” which stipulates the role the central bank should play. The rule recommends a relatively high interest rate—a “tight” monetary policy—when inflation is above its target or when output is above its full-employment level. The rule recommends a relatively low interest rate—“easy” monetary policy—to stimulate output.)

    What’s more, the federal funds rates remained substantially and persistently below levels that would have been consistent with that rule. Not only were short-term real rates held at persistent historic lows, but unusually high demand for longer-term Treasuries related to global imbalances flattened the Treasury yield curve during 2002–2005, resulting in extremely low interest rates across the yield curve. An accommodating monetary policy and a flat yield curve meant that credit was excessively available to support expansion in the housing market at abnormally low interest rates, which encouraged the overpricing of houses and subprime mortgages.
  2. Numerous housing policies promoted subprime risk-taking by financial institutions. Those policies included (a) political pressures from Congress on the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to promote “affordable housing” by investing in high-risk subprime mortgages, (b) lending subsidies for housing finance via the Federal Home Loan Bank System to its member institutions, (c) Federal Housing Administration (FHA) subsidization of high mortgage leverage and risk, (d) government and GSE mortgage foreclosure mitigation protocols that were developed in the late 1990s and early 2000s to reduce the costs to borrowers of failing to meet debt service requirements on mortgages, which further promoted risky mortgages, and—almost unbelievably—(e) 2006 legislation that encouraged ratings agencies to relax standards for subprime securitizations.

    All these policies encouraged the underestimation of subprime risk, but the behavior of members of Congress toward Fannie Mae and Freddie Mac, which encouraged reckless lending by the GSEs in the name of affordable housing, were arguably the most damaging actions leading up to the crisis. For Fannie and Freddie to maintain lucrative implicit (now explicit) government guarantees on their debts, they had to commit growing resources to risky subprime loans. Fannie and Freddie ended up holding $1.6 trillion in exposures to those toxic mortgages, half the total of non-FHA outstanding amounts of toxic mortgages.
  3. Government regulations limiting the concentration of stock ownership and the identity of who can buy controlling interests in banks have made effective corporate governance within large banks virtually impossible. Lax corporate governance allowed bank management to pursue investments that were unprofitable for stockholders in the long run but were very profitable to management in the short run, given the short time horizons of managerial compensation systems. When stockholder discipline is absent, managers can set up the management of risk to benefit themselves at the expense of stockholders.

    An asset bubble (like the subprime bubble of 2003–2007) offers an ideal opportunity for senior managers to establish compensation systems that reward subordinates based on total assets managed or total revenues collected, without regard to risk or future potential loss. The result is that subordinates have the incentive to expand portfolios rapidly during the bubble without regard to risk. Senior managers then reward themselves for having overseen “successful” expansion with large short-term bonuses and cashing out their stock options quickly so that a large portion of their money is invested elsewhere when the bubble bursts.
  4. The prudential regulation of commercial banks and investment banks has proven to be ineffective. That failure reflects (a) fundamental problems in measuring bank risk resulting from regulation’s ill-considered reliance on inaccurate rules of thumb, credit rating agencies’ assessments, and internal bank models to measure risk and (b) the too-big-to-fail problem, which makes it difficult to credibly enforce effective discipline on large, complex financial institutions (such as Citibank, Bear Stearns, AIG, and Lehman) even if regulators detect large losses or imprudently large risks.
It is worth remembering how long it took for the unwise regulatory actions taken in the wake of the Depression to be reversed.

The risk measurement problem has been the primary failure of banking regulation and a subject of constant academic criticism for more than two decades. Regulators use different means to assess risk, depending on the size of the bank. Under the simplest version of regulatory measurement of risk, subprime mortgages (like all mortgages) have a low asset risk weight (50 percent) relative to commercial loans, although they are riskier than those loans. More complex measurements of risk (applicable to larger U.S. banks) rely on the opinions of ratings agencies or the internal assessments of banks, neither of which is independent of bank management.

Rating agencies, after all, cater to buy-side market participants (i.e., banks, pensions, mutual funds, and insurance companies that maintained subprime-related asset exposures). When ratings are used for regulatory purposes, buy-side participants reward rating agencies for underestimating risk because that helps the buy-side clients reduce the costs associated with regulation. Many observers wrongly believe that the problem with rating agency inflation of securitized debts is that sellers (sponsors of securitizations) pay for the ratings; on the contrary, the problem is that the buyers of the debts want inflated ratings because of the regulatory benefits they receive from such ratings.

The too-big-to-fail problem involves the lack of credible regulatory discipline for large, complex banks. The prospect of their failing is considered so potentially disruptive that regulators have an incentive to avoid intervention. That ex post “forbearance” makes it hard to ensure compliance ex ante. The too-big-to-fail problem magnifies incentives to take excessive risks; banks that expect to be protected by deposit insurance, Fed lending, and Treasury-Fed bailouts and believe that they are beyond discipline will tend to take on excessive risk because taxpayers share the downside costs.

The too-big-to-fail problem was clearly visible in the behavior of large investment banks in 2008. After Bear Stearns was rescued in March, Lehman, Merrill Lynch, Morgan Stanley, and Goldman Sachs sat on their hands for six months awaiting further developments (i.e., either an improvement in the market environment or a handout from Uncle Sam). In particular, Lehman did little to raise capital or shore up its position. But when conditions deteriorated and the anticipated bailout failed to materialize for Lehman in September 2008 (showing that there were limits to Treasury-Fed generosity), the other major investment banks immediately were either acquired or transformed themselves into bank holding companies to increase their access to government support.

This review of government policy contributions to the financial crisis has not mentioned deregulation. During the 2008 election, many candidates (including Barack Obama) made vague claims that “deregulation” had caused the crisis. That claim makes no sense: involvement by banks and investment banks in subprime mortgages and mortgage securitization was in no way affected by banking deregulation. In fact, the deregulation of the past two decades (which consisted of the removal of branching restrictions and the expansion of permissible bank activities) facilitated adjustments to the subprime shock by making banks more diversified and by allowing troubled investment banks to become stabilized by becoming, or being acquired by, commercial banks. Since the election, President Obama and other erstwhile critics of deregulation have begun properly to focus on the various failures of regulation, rather than deregulation, as causes of the crisis.

The policy errors enumerated above were all subjects of substantial research before the financial crisis. It is not surprising, therefore, that credible solutions to those problems have been identified by financial economists who write about public policy. It is perhaps more surprising that the emerging academic consensus about reform is being embraced by Congress and the administration (at least so far). Even populist demagogues such as Representative Barney Frank and Senator Chris Dodd (who were egging on the pitchforks-and-torches crowd during the disgraceful AIG bonus hullabaloo) have shown some restraint in their regulatory reform advocacy.

Of course, the devil is in the details, and significant risks remain, including the possibility of counterproductive limits on compensation that could drive talent to less-regulated environments abroad, trading or reporting rules that would impose implicit taxes on the development of new derivative products, barriers to competition masquerading as “stabilizing” regulation, and the empowerment of politicized regulators who would in turn politicize credit flows and other financial decisions.

No credible voice within the administration or Congress is pushing to repeal the 1999 Gramm- Leach-Bliley Act, which allowed banks unfettered entry into investment banking, although some (notably, former Fed chairman Paul Volcker) have expressed the view that proprietary trading should be segregated from other aspects of banking. Representative Frank agreed with Federal Reserve chairman Ben Bernanke during his testimony before Frank’s House Committee on Financial Services on the appropriate regulatory approach toward the hedge fund industry. Bernanke argued that that approach should focus primarily on disclosure rather than regulatory control of hedge funds’ risk or capital structure (the approach favored in much of continental Europe).

The emerging consensus reflects, among other things, the Fed’s ability to take the intellectual lead, thanks to its substantial staff resources and experience. Few in Washington have the wherewithal to dispute the Fed’s knowledge and expertise on the technical matters of regulation. Having succeeded in elevating the discussion on regulatory reform, the Fed has given reformers (including myself) hope that this time government will not compound its errors too badly in its regulatory response to the financial crisis.

Sensible Banking Policy Reforms

  1. Limit incentives for large, complex institutions to take advantage of toobig- to-fail protection by (a) employing regulatory surcharges on complexity (e.g., requiring higher capital or liquidity by large, complex institutions) and (b) giving a financial regulator the authority to establish new procedures for intervening and resolving the problems of large, complex, distressed financial institutions (banks and nonbanks), rather than simply bailing them out.
  2. “Macro” prudent regulation (that is, the regulation and supervision of deposittaking institutions) is a relatively new idea that has been gaining support, including by Treasury secretary Timothy Geithner and many in Congress and the G20. A macro prudent regulator would vary capital and liquidity requirements over time in response to changes in macroeconomic and financial system circumstances. For example, during booms, minimum capital would be set higher, especially if a boom were occurring in which asset prices and credit were rising rapidly. Raising capital requirements on banks would discourage a protracted bubble from forming and create a larger equity cushion for banks if a bubble should burst.
  3. Replace housing leverage subsidies with subsidies that carry less risk to lowincome, first-time home buyers. Democrats in the House, Senate, and White House have not yet supported concrete measures that would reduce the vulnerability of housing finance going forward; many Democrats have, however, stopped claiming that Fannie and Freddie were mere victims of the crisis.
  4. Use regulatory surcharges (capital or liquidity requirements) to encourage clearing of over-the-counter (OTC) transactions through clearinghouses, thus simplifying and rendering transparent counterparty risk in the OTC market.
  5. Require timely disclosure of OTC positions to regulators and lagged public disclosure of net positions. This would help track systemwide risks by the macro prudent regulator and the market.
  6. An important area that has not been much discussed by policy makers is the need to reform the regulatory techniques for measuring risk. Secretary Geithner talks about the need for “capital, capital, capital,” but more capital alone is not an effective solution; financial institutions can raise asset risk to offset higher capital requirements using various means, some of which are hard to detect. There is no substitute for effective risk measurement; yet ideas for reforming risk measurement have been missing in congressional testimonies and speeches and G20 posturing, at least thus far.
  7. Avoid grade inflation in rating agencies’ opinions. Lots of bad ideas are surfacing about how to accomplish that goal, one of which is to require that the buy side pay for ratings rather than the sell side. As I argued elsewhere in this essay, this would not improve the reliability of ratings.
  8. Change corporate governance rules to encourage better discipline of bank management. Rather than deal with the symptoms of poor governance in banks (e.g., compensation structure), it would be better to improve the ability of stockholders to discipline management.