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Is a ‘Systemic Risk Regulator’ Possible?

Tuesday, May 12, 2009

Political reaction to financial crises is usually accompanied by what proves to be greatly overstated expectations about its future effectiveness.

Financial cycles have related political cycles. In the wake of every bust, with its crisis, its overoptimism turned to overpessimism, and its inevitable scandals, comes the political overreaction.

There is an overpowering desire by politicians to show that they can do something—increase regulation, create new regulatory bodies, reorganize existing ones. The urge to reorganize is natural, in companies as well as governments, and “a wonderful method it can be for creating the illusion of progress,” as the quote spuriously attributed to an ancient Roman goes.

A reorganization may be a good idea. But as pointed out by financial historian Bernard Shull, these political reactions are usually accompanied by what proves to be greatly overstated expectations about their future effectiveness.

A favorite case cited by Shull is the conclusion by the comptroller of the currency in 1914 about the future results of newly created Federal Reserve System: “Financial or commercial crises seem to be mathematically impossible.”

Needless to say, they were not. Indeed, it turned out that the Fed could aggravate and even create financial problems.

Everybody, no matter how intelligent and diligent, no matter how many economists and computers are employed, makes mistakes when it comes to predicting (let alone controlling!) the future.

Financial crises keep happening. My banking career started during the credit crunch of 1969, which was followed shortly afterward by the failure of the Penn Central railroad (doubtless a “systemically important” railroad) and panic in the commercial paper market. Skipping ahead a few crises, we find the financial crisis of 1989–1991, with the final collapse of the regulated savings and loans, a terrific commercial real estate bust, and severe insolvency problems for regulated commercial banks, of which more than 1,400 failed in the decade ending in 1991.

Here’s a familiar-sounding headline: “Banks Entering Era of Painful Change—More Bailouts, Bankruptcies, Layoffs Likely.” The date? July 22, 1991.

Do the following lines sound familiar? “Today Citicorp is a more humble place. Its image has been badly tarnished by increasing loan losses, particularly the more risky kinds of loans.” “Citicorp—banking’s stumbling giant.” “Citicorp is more likely to find itself the butt of jokes these days.” They are all from 1991–1992.

Major regulatory reforms and reorganization marked the time, including three acts of Congress: the Financial Institutions Reform, Recovery and Enforcement Act of 1989; the FDIC Improvement Act of 1991; and the Housing and Community Development Act of 1992. Such actions would insure, the then-secretary of the Treasury said, “This will never happen again.”

But it did happen again.

Today once again we hear high ranking government officials saying, “We must make sure this never happens again.”

Alas, there are few new ideas in finance.

Short-Term Funding and Leverage

Some people call a financial bust a “Minsky Moment,” after the economist Hyman P. Minsky, the theoretician of the intrinsic growth of excessive risk in financial markets, which he called “financial fragility.” Does changing boxes on the regulatory organization chart alter Minsky’s financial fragility?

I do not think so. This is because Minsky’s theory reflects human nature. As he observed, when everybody makes money for an extended period, “Short term financing of long positions becomes a normal way of life.” How true. In other words, there is an overconfident build up of leverage by the use of short-term debt supplied by complacent lenders and investors.

In a financial panic, such as in 2007–2008, these complacent lenders suddenly realize they are, contrary to their intentions, seriously at risk. When formerly prominent names like Lehman Brothers fail, everyone necessarily thinks: What other financial firms might collapse? How do I know who is solvent and who is broke? I don’t!

As a result, the short-term lenders all become conservative at once and withdraw. They seek the greatest safety of Treasury bills, even for no yield. There is a discontinuous drop in the ability of leveraged firms to roll over the short-term borrowing which had up to then seemed “a normal way of life.” As described by David Ricardo two centuries ago, “On extraordinary occasions, a general panic may seize the country, when every one becomes desirous of possessing himself of the precious metals [now: cash and Treasury bills]—against such panic banks have no security on any system.”

I favor a philosopher, but not a philosopher-king.

From this recurring experience, we can see that liquidity is not a substance, but a metaphor. It is the group belief in the reliability of prices and the solvency of counterparties. When belief turns to disbelief, liquidity vanishes—we call that the “panic.”

As Minsky taught, when markets are stable, everybody comes to think leverage is safe. But a highly levered financial system—one with assets of 10, 15, 20, let alone 25 or more, times equity—will always bust from time to time. Running the system at high leverage means you will periodically have crashes.

How low would leverage have to go to have a financial system with no busts? I do not know, but maybe leverage of no more than 4 or 5 times? That would be 20 percent to 25 percent capital ratios, as opposed to 6 percent or 7 percent. Since that will not happen, Minsky’s financial fragility thesis is safe, any movement in the regulatory boxes notwithstanding.

A Systemic Risk Regulator?

Let us address one currently popular regulatory reorganization proposal: to create a “systemic risk regulator.” This term means a super regulator of the largest or “systemically important” firms, across all financial industries, that is responsible for controlling the risks of the financial system as a whole. About this we may ask two questions:

—Should there be one?

—Should it be the Fed?

As to the first question: No.

Forecasting the financial future correctly, much less controlling it, is a literally impossible task. This is because of the exceptionally complex and rapid recursiveness of financial markets and the resultant Uncertainty. This “Uncertainty,” with a capital “U,” means, remembering the classic definition of Frank Knight, that you not only do not know the odds of events, but you cannot know the odds.

The transcendent mathematical genius, Isaac Newton, having first made a lot and then lost even more of his own money in the collapse of the South Sea Bubble, wrote in disgust, “I can calculate the motions of the heavenly bodies, but not the madness of people.” You can apply math to finance, but that does not make it science.

If the politicians set up a systemic risk regulator anyway, should it be the Fed? No. Such an assignment would make the Fed too conflicted, when combined with its role as monetary manager. Besides, why would we reward with even more power that same Fed whose monetary policy stoked the housing excesses in the first place?

As Senator Jim Bunning (R-Kentucky) said to Fed Chairman Ben Bernanke at a congressional hearing, “You are thinking of becoming the overseer of systemic risk, but in my view you are the systemic risk.” There is a lot of truth in that.

A Systemic Risk Advisor

Although I oppose a systemic risk regulator, I do favor creating a new box on the government’s organization chart for a very senior systemic risk advisory function. This advisory body should have a heavyweight board and a small staff of top talent, and be free to speak its mind to Congress, the administration, and private financial actors. In other words, I favor a philosopher, but not a philosopher-king.

Deliberations should reflect that risk-taking is essential, and the failure of individual firms is not only necessary, but in the systemic sense, desirable.

What should our philosopher look for? First of all, this should be a Minskian philosopher, intent on understanding the build-up of leverage, hidden as well as stated, and of short-term funding of long positions being considered increasingly “normal,” on an international basis. The deliberations, deeply informed by the financial travails of the past decades and centuries, should reflect the reality that losses often turn out to be vastly greater than anyone thought possible—yet also that risk-taking is essential, and the failure of individual firms is not only necessary, but in the systemic sense, desirable.

Our philosopher should apply Gould’s Principle, which is to look for concentrated points of vulnerability to system failure. If you allow such points to develop, sooner or later they are likely to fail. Good examples of such concentrated points of possible failure, which indeed failed, are the government-mandated use of credit rating agencies, with their mistaken ratings of mortgage securities; Fannie Mae and Freddie Mac, which under government sponsorship made the housing and mortgage bubble much worse; and the dependence of credit default swap counterparties on AAA-rated American International Group. Would a systemic risk advisor have caught such concentrated vulnerabilities? Perhaps.

I think the systemic risk advisor is distinctly worth a try. But let’s not get overoptimistic. It is in vain to think that it or anybody can or could foresee all future problems or prevent all future bubbles and busts. Everybody, no matter how intelligent and diligent, no matter how many economists and computers are employed, makes mistakes when it comes to predicting (let alone controlling!) the future.

Because uncertainty is fundamental, Minskian mistakes will continue to be made by entrepreneurs, bankers, borrowers, central bankers, government agencies, politicians, and by the interaction of all of the above, whatever is done with the regulatory organization charts.

Knight wrote: “If the law of the change is known … no [economic] profits can arise.” Likewise: “If the law of change is known, no financial crises can arise.” But the law of change is never known.

So change reflecting uncertainty goes on, bringing both Minsky’s fragility periodically, and Adam Smith’s “progress of opulence” on the trend.

In conclusion, a witty observation by Professor George Kaufman: “Everybody knows Santayana’s line that those who fail to study the past are condemned to repeat it. When it comes to financial history, those who do study it are condemned to recognize the patterns they see developing, and then repeat them anyway!”

Alex J. Pollock is a resident fellow at the American Enterprise Institute. Previously he spent 35 years in banking, including 12 years as president and chief executive officer of the Federal Home Loan Bank of Chicago.

FURTHER READING: Also in The American, Pollock wrote “A Theory of Two Big Balance Sheets,” explaining the recent period of bubbles, busts, and bailouts, “Did They Really Believe House Prices Could Not Go Down?,” and “Your Guide to the Housing Crisis.”

Image by Darren Wamboldt/Bergman Group.

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