1. Bank Regulation Broke Down
All firms are bound to make mistakes and those mistakes will be bigger the bigger the firms involved. When big firms also happen to be financial institutions, especially banks, everyone in the economy will pay for their errors. That is because financial institutions are intricately connected with every aspect of the economy and they can and will bring an economy to a grinding halt if they cease to function. If banks and other intermediaries suffer badly enough, economic activity freezes and the entire economy suffers also. This is what economists call a “negative externality” and the Great Depression was a great example of what that means in practical terms. It is why banks have always been more heavily regulated than other firms, and why they should be treated the same today. Big banks present special problems and they require special handling.
Over the last decade, banking regulation has become, inadvertently, largely ineffective. Mostly, this has not been the fault of the Fed, the Comptroller of the Currency, or the other bank regulators. They were dealt a tough hand. Passage of the Graham-Leach-Bliley Act in 1999, allowed banks to become so big and complicated they became very difficult to manage, let alone regulate. Citigroup’s departing management has stated as much (e.g. “impossible to manage”). Overall, the bank regulators did an acceptable if not brilliant job given the circumstances.
What really caused the break-down of bank regulation was the incredible rise of “quasi-banks”, firms that don’t have bank in their title but collectivelyprovide banking services, compete with regular banks, and have taken over a large share of the market. In particular, large non-bank financial institutions – mortgage originators, insurance firms, investment banks, rating agencies etc. – collectively and massively invaded the turf of traditional banks. They invested in illiquid real estate through mortgage loans and transformed those loans through financial engineering into highly liquid and apparently safe securities, competing with bank deposits for funding. The quasi-banks were not banks traditionally defined, and were not subject to banking regulation. However, they performed banking activities, took huge risks, and have caused huge problems.
Fundamentally, the problems originated with there being too much money in the system, resulting in extremely low interest rates. Investors began searching for “riskless” investment opportunities with better yields; and naturally Wall Street was willing to provide these. It created new apparently-riskless securities with attractive returns, by transforming mortgage loans through financial engineering. Since meeting the demand for the apparently risk free securities involved generating mortgage loans, there was downward pressure on underwriting standards for mortgage loans – so as to maintain supply. Surely some investors were aware of this problem. If only their views were reflected in prices of mortgage backed assets, it would have made it costly for mortgage originators with weak underwriting standards to continue in business. However, there are several reasons why that just did not happen.
First, it is difficult to short sell mortgage backed assets. The short position holder will have to pay the coupons and other payments that a holder of a mortgage backed asset will receive during the duration of the short position, and it may take quite a long time before the short is proved right by the market. That means taking large short positions will require persons/institutions with very deep pockets to guard against interim adverse price movements, (and sufficient stature to withstand criticisms in the interim).
Second, even unsophisticated institutional investors could invest in a complex fixed income security provided the security was rated sufficiently highly by rating agencies. The incentive to invest in complex “highly rated” securities with higher yields without really understanding the risks involved was strong, especially during times when interest rates were low, and investors had to meet return-targets. Wall Street firms had the incentive to provide what those investors were looking for, and the rating agencies had very much the same incentives as the Wall Street firms. That led to insufficient scrutiny and inadequate understanding of the systematic risks involved before ratings were given. Note that rating agencies face precious little competition since there are only two major players.
Third, Wall Street firms and banks issued the CDOs through special purpose entities that were off balance sheet, so their exposure to large systematic shocks (like falling home prices, rise in mortgage rates at the time of reset, and consequent delinquencies) were hidden from the regulators and investors – , at least until the effects began to snowball. That facilitated banks and financial institutions taking on excessive socially unacceptable levels of leverage through the back door. Finally, elected government officials had little incentive to take any corrective action – not surprisingly, they wanted “easy” credit available to their constituents.
William McChesney Martin, the Fed chairman in the 1950s and 1960s, famously joked that the Fed’s job is “to take away the punch bowl just as the party gets going.” For some reason the Fed did not do that this time – more likely, the Fed could not do that this time since the punch was being supplied by money from foreign countries flowing into the US.
Falling housing prices in some regions and consequent increased delinquencies made investors suddenly realize that the CDOs, in spite of their high ratings, had substantial amounts of risk, and they started pulling back. The value of asset backed commercial paper declined by almost 300 billion dollars during the second half of 2007. Banks that provided backup financing for those asset-backed papers started facing liquidity pressures. That dried up credit for even customers with good credit leading to the liquidity crisis, affecting bond insurers, hedge funds (quants, especially) and others. The bailout of Bear Stearns and the Fed opening its lending facilities to investment banks, etc, followed in quick succession.
2. Banks and Quasi-banks Were “Too Big To Fail”
Why did investors not scrutinize and examine the risk in the investments they made? For example, if only the originators like Countrywide were paid over time so long as the mortgages stayed live, and were prohibited from borrowing against that flow (which is like executives with stock options cannot hedge by short selling their own stock,) may be, they would have had the incentive to do the due-diligence right. But then that would have reduced the amount of origination of mortgages; which was not in the interest of investment banks, since their fees depended on the flow of mortgage backed assets through their hands. Again, may be the investors should have insisted that the investment banks which originated the mortgage backed securities were paid a monthly fee for origination so long as the CDO tranches stayed alive, and were prevented from hedging that risk. None of these happened. Investors, because they were dealing with large financial institutions, assumed that they do not have to do the due diligence. Large financial institutions were just too big to fail!
Because of massive consolidation in the financial services industry, we have a number of financial intermediaries that have become very large and important relative to the size of the economy. When such large intermediaries get into difficulty, they are “too big to fail” (hereafter, TBTF). That means that if they get in trouble, they will be bailed out by government. For the government to do otherwise is to run the risk of causing domino effects, contagion, and a general meltdown of the financial system. Based on historical experience, this outcome is unavoidable. In the many banking crises around the world over last three decades (there have been about 100 of these) TBTF bailouts and attendant social costs have been present in almost every instance.
Many experts believe that TBTF policies actually generate a sort of pernicious feedback loop, indirectly causing the problems they are designed to contain. This is the so called “moral hazard” problem. Knowing they will be protected by government if things go badly, large banks are willing to take more risk than they otherwise would have done. To make matters worse, the special protection afforded by TBTF status is highly valuable. Recent research suggests that banking firms will pay huge acquisition premia just to get into the TBTF size range.
But note. Even if there were no feedback loop and no “moral hazard” problem, very large banking firms would still present a serious dilemma for policy-makers. Even the best of managers sometimes make fatal errors. When that occurs in a TBTF bank, it is costly not just to them but immensely costly to society.
The too big fail umbrella is actually much bigger than many realize. In 2006 it covered about 65% of intermediated financial assets in the United States, defining TBTF as the assets and guarantees of the 25 largest bank holding companies plus Fannie and Freddie. Our computation does not include the big investment banks and recent events have demonstrated that large these firms are TBTF. If we did it include them, the percentage would be greater than 65%.
Our proposed cures are two in number. Both are simple in principle but complex in detail. Therefore, we can only spell out the reform proposals in the broadest of terms. The first is to identify all firms that perform critical banking functions and then regulate them as banks. The second is to define a special TBTF designation. All banks or quasi-banks in this category will be subjected to exceptionally stringent requirements for disclosure, organizational structure, and capital.
The quasi-banks need to be identified and made fully subject to banking regulation, whatever their name or kind of charter. If it swims, flies and quacks, it should be deemed “duck” and dealt with as such. No exceptions. For two reasons this will be difficult to implement in practice. First, technology has blurred traditional business lines; for examples, eBay now provides payments services like a bank, and General Electric has become a huge lending institution. Second, financial firms are deft at end-running regulation and have a long history of doing that. However, it is essential that bank regulators focus on actual economic function, not name or charter. This regulation should be done by a single regulator to avoid games of playing off one regulator against another. (Others can debate whether that one regulator should be the Fed).
Once banks are formally and realistically redefined, they should be classified into two groups: those that are TBTF and those that are not. The Federal Reserve has done some work along these lines by defining and tracking a group of “Large Complex Banking Organizations”, there being about thirty of these at the present time. However, the Fed’s classification is rather vague and they do not concede that these firms are all TBTF. We would. Further, we would prefer a simple, objective, and easily understandable rule that defined TBTF. “If your assets, plus the assets you guarantee, exceed (say, $100 billion) you are TBTF”. Banking firms in the TBTF category would then be treated much more stringently than others and their capital requirements would be an order of magnitude higher. For the first time, there would be a real cost to banks that get into the TBTF size range. At present, there are only benefits. Spelling out the details of all this can be left for later. For now, current events and historical experience teach a clear lesson. These giant banking firms pose special risks and potentially large costs for the economy.
Boyd, John H, Sungkyu Kwak and Bruce D. Smith, “The Real Output Losses Associated with Modern Banking Crises; Or, the Good, the Bad and the Ugly,” Journal of Money, Credit and Banking, December 2005, 37(6): 977-999.
Brewer III, Elijah and Julapa A. Jagtiani, “How Much Would Banks Be Willing to Pay to Become ‘Too-Big-To-Fail’ and To Capture Other Benefits?” working paper, Federal Reserve Bank of Kansas City RWP07-05, July, 2007 (visit site, accessed November 14, 2008).
DeFerrari, Lisa and David E. Palmer, “Supervision of Large Complex Banking Organizations,” Federal Reserve Bulletin, February, 2001 (visit site, accessed November 14, 2008).