A major focus of
the Obama proposals to redesign the regulatory system is to bring all
the major financial institutions that were implicated in the current
financial crisis (or might be implicated in the next one) under
regulation. These include hedge funds, investment banks and mortgage
companies, which have been only loosely regulated.
The general
presumption seems to be that if all the major categories of firms are
regulated, with clear lines of regulatory responsibility, all should be
well. But will it?
There should be
some unease about this presumption, because major banks and thrifts
subject to extensive regulation were nonetheless caught up in the
crisis. The Citibank and Bank of America holding companies were
regulated by the Federal Reserve, the banks themselves were regulated by
the Comptroller of the Currency (OCC),and WAMU, Indy Mac and Countrywide
were regulated by the Office of Thrift Supervision (OTS).
The plan is to
shift major responsibility for regulating all systemically important
firms to the Federal Reserve, which is the most trusted of the agencies.
However, the major cause of regulatory failure during the period leading
up to the crisis was the same for the Fed as for OCC and OTS. They all
lacked a critical regulatory tool: the power to require a system of
mandatory transaction-based reserving.
Financial crises
arise out of the interaction of a major external event with a financial
system that happens to be extraordinarily vulnerable to that event. In
the saving and loan crisis of the 80s, the external event was an
explosion of interest rates sparked by efforts to contain inflation. The
vulnerability was the unbalanced portfolios of savings and loans, which
financed home loans carrying fixed rates for long terms, with short-term
deposits. Their interest cost on deposits rose sharply with rising
market interest rates, but their interest income on mortgages changed
very little. The circumstances generating the S&L crisis are very
unlikely ever to be repeated because systemic vulnerability to an
interest rate shock has been largely eliminated.
In the current
crisis, the external event was an unsustainable increase in housing
prices, termed a “bubble”. The vulnerability was the incentive created
by the bubble to generate income by ignoring the risks associated with
the inevitable collapse in prices. Here is a much-oversimplified
illustration for a firm I call “A”, which is a composite of many.
During the bubble
period, lender A could originate $1 billion of home loans every month on
which it made $75 million. Since it took 5 months to sell these loans, A
always had an unsold inventory of $5 billion. These highly profitable
loans maintained their value so long as home prices continued to rise.
The month that home prices dropped, however, the value of these loans
fell by 20%, A incurred a $1 billion loss on its inventory, and it shut
down. The loss was absorbed by its creditors.
Looking backwards,
during the 40 months A was operating, it generated $3 billion of
“income” for its owners and managers. I put the word “income” in quotes
because, while it constituted income in a legal sense, about a third of
it should have been allocated to a reserve for future losses. Had A done
that, it would have survived the shock of the house price decline. If
every firm had done the same, there would have been no crisis.
But the incentive
system is strongly biased against reserving.
For most firms, it makes more
financial sense to ignore the risk, pay out all the revenue as income as
it is received, and go broke when the bubble bursts. If it bursts after
a short period, reserving would cost them, and if it runs for a long
time, the firm can withdraw an obscene amount of money that, barring
fraud or other illegalities, the ultimate losers (including taxpayers)
can’t take away. Even our tax system discourages reserving, since the
amounts reserved would be taxed as income.
While the system is
no longer vulnerable to an interest rate shock, it will remain
vulnerable to bubbles in the housing market or elsewhere.
There is no plausible compensation system that would change this.
The search for one is a useless digression.
For the
reconstituted regulatory system to prevent bubble-generated financial
crises, it must have the authority and know-how to impose and enforce a
system of mandatory transaction-based reserving. In such systems,
varying amounts of what would otherwise constitute income, based on the
riskiness of individual transactions, must be allocated to a reserve
account that cannot be accessed except in
an emergency.
Such systems now
apply only to firms chartered as insurance companies, including mortgage
insurers, which are regulated at the state level. If a mortgage insurer
had insured the loans originated by A in my example, its risk would have
been very similar, but in contrast to A, it would have placed half of
every premium dollar it collected into a contingency reserve.
Most of the
knowledge and experience required to apply such systems to other
financial firms is currently in state regulatory agencies. This provides
an ironic perspective on the Obama plan proposal that the Federal
Government take over the regulation of insurance companies from the
states.