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Regulation and the Financial Crisis: Myths and Realities

Wednesday, September 9, 2009

Many regulatory policies were major contributors to the crisis. To proceed without examining past policies, particularly in the areas of housing and bank capital regulation, would preclude learning the lessons of history.

The role of regulatory policy in the financial crisis is sometimes presented in simplistic and misleading ways. This essay will address the following myths and misconceptions:

Myth 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry.

Myth 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities.

Myth 3: Policy makers relied too much on market discipline to regulate financial risk taking.

Myth 4: The financial crisis was primarily a short-term panic.

Myth 5: The only way to prevent this crisis would have been to have more vigorous regulation.

The rest of this essay spells out these misconceptions. In each case, there is a contrast between the myth and reality.

Myth 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry.

The decade leading to the financial crisis saw the development and growth of many innovations in the financial industry. These included collateralized debt obligations, credit-default swaps, special-purpose vehicles, and private-label mortgage securities. Without getting into the specifics of these innovations, their overall net result was to create what is now referred to as the “shadow banking system.” They allowed banks and other institutions to finance their mortgage security holdings with short-term debt. This meant that the financial institutions lacked the liquid reserves to withstand a change in market perceptions of the risk of such assets. It also meant that they lacked sufficient capital to cover losses when the housing market deteriorated.

Many regulatory policies were major contributors to the crisis.

The dramatic structural changes that took place in the financial industry were not noticed by the general public, and received little coverage even in the financial press. However, it is a myth that financial regulators were unaware of these developments.

The reality is that the policy community observed and approved of the innovations that restructured the financial system. For example, in a speech in 2006, Federal Reserve Board Chairman Ben Bernanke said,

the development of new technologies for buying and selling risks has allowed many banks to move away from the traditional book-and-hold lending practice in favor of a more active strategy that seeks the best mix of assets in light of the prevailing credit environment, market conditions, and business opportunities. Much more so than in the past, banks today are able to manage and control obligor and portfolio concentrations, maturities, and loan sizes, and to address and even eliminate problem assets before they create losses. Many banks also stress-test their portfolios on a business-line basis to help inform their overall risk management.

To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization. For example, trading in credit derivatives has grown rapidly over the last decade, reaching $18 trillion (in notional terms) in 2005. The notional value of trading in credit default swaps on many well-known corporate names now exceeds the value of trading in the primary debt securities of the same obligors.

Bernanke described these innovations as reflecting the cooperative efforts of bank supervisors and the regulated institutions. Similarly, the International Monetary Fund reported at around the same time that these developments had “helped to make the banking and overall financial system more resilient.”

The myth is that the regulators failed to focus on the systemic implications of financial innovation. The reality is that the regulators were keenly interested in systemic risk. However, like their counterparts in the financial industry, the regulators thought that the innovations had reduced systemic risk. The problem was not that regulators lacked a mandate to address systemic risk. What they lacked was judgment and insight.

Myth 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities.

The myth is that, as one prominent policy paper put it, “Market discipline broke down as investors relied excessively on credit rating agencies.” The reality is that it was regulatory policy, not markets, that drove the use of credit agency ratings. Bank regulators, especially with a rule that took effect on January 1, 2002, gave breaks on capital requirements to banks that held assets with AA and AAA ratings from credit rating agencies.

The problem was not that regulators lacked a mandate to address systemic risk. What they lacked was judgment and insight.

The market was not nearly as obsessed with ratings as were the regulators. Many rated securities were not even traded in the market. Instead, banks obtained ratings for the sole purpose of engaging in regulatory capital arbitrage, meaning that they were able to reduce capital requirements for a given risk.

The use of credit rating agencies for regulatory capital purposes was criticized at the time. Fannie Mae and Freddie Mac warned about regulatory capital arbitrage. A group of economists calling itself the Shadow Financial Regulatory Committee warned that ratings on non-traded securities would likely be inflated. Policy makers went ahead with their approach to risk-based capital regulation in spite of these objections.

Regulatory capital arbitrage was the motivating factor in most of the financial innovations that figured prominently in the financial crisis. For example, banks could use off-balance-sheet financing for mortgage securities in Special Purpose Vehicles (SPVs) and Structured Investment Vehicles (SIVs) to avoid capital requirements altogether. Credit default swaps on mortgage securities also served to transfer risk in ways that reduced capital requirements.

Myth 3: Policy makers relied too much on market discipline to regulate financial risk taking.

Many experts, including former Federal Reserve Board Chairman Alan Greenspan, have voiced the complaint that the market proved less rational than expected in its management of risk. The implication is that markets are too unreliable and that stronger regulation is the answer.

It is certainly true that some financial executives made serious miscalculations. They themselves greatly underestimated the risks of a housing market decline and overestimated the insulation from risk that could be obtained by using sophisticated financial models and structured finance.

However, the greater flaw was in the regulatory structure, and in particular the capital regulations for banks, investment banks, and the mortgage agencies Freddie Mac and Fannie Mae. There was an absence of market discipline at these firms in large part because such a large share of the risk that they took was borne by taxpayers rather than by shareholders and management.

There is a myth that financial firms were like teenagers who started a terrible fire because of a lack of adult supervision. In fact, Congress and regulators were doing the equivalent of handing out matches, gasoline, and newspapers.

The Shadow Financial Regulatory Committee criticized the capital “risk bucket” approach from the very beginning, when the 1988 Basel Accords were under discussion. The economists proposed instead that banks be required to issue unsecured debt, which would serve as a layer between the risks of their assets and the insured deposits. Recently, another group of economists reiterated support for such an approach.

Myth 4: The financial crisis was primarily a short-term panic.

The financial crisis has four components:

—Bad bets, meaning unwise decisions by developers to build too many homes, by consumers to purchase too many homes, by mortgage lenders to make unwise loans, and by financial institutions that incurred too much exposure to credit risk in housing.

—Excessive leverage, meaning that the debt-to-equity ratio was so high at some key firms, such as Freddie Mac, Fannie Mae, and Bear Stearns, that only a small drop in asset values could bankrupt the firms.

—Domino effects, meaning the ways at which problems at one firm could spill over to another firm.

—21st-century bank runs, in which institutions that were using mortgage securities as collateral for short-term borrowing from other firms found that their counter-parties were reluctant to extend their loans.

The first two components reflect fundamental problems that developed over a period of at least a decade. The last two components reflect a financial panic that emerged abruptly in 2008.

Too many policy makers are focused only on the financial panic. For example, when Bernanke, offering a retrospective on the crisis at a conference at Jackson Hole in August of 2009, used the word “panic” more than a dozen times, but the phrase “house prices” only twice and the phrase “mortgage defaults” just once.

The biggest myth is that regulation is a one-dimensional problem, in which the choice is either ‘more’ or ‘less.’

Such thinking leads policy makers to focus on tinkering with regulatory organization and regulatory powers rather than addressing deeper policy flaws. We need to be asking more fundamental questions about the costs and benefits of government support for securitization, about the aims of housing policy, and about how to reconcile the goal of providing government protection against financial risk with the need to ensure that this does not lead to unbridled risk-taking.

Myth 5: The only way to prevent this crisis would have been to have more vigorous regulation.

There is a myth that financial firms were like teenagers who started a terrible fire because of a lack of adult supervision. In fact, Congress and regulators were doing the equivalent of handing out matches, gasoline, and newspapers.

Housing policy was obsessed with increasing home purchases. This was pushed to the point where, given the lack of any down payment, the term “home ownership” is probably a misnomer. If the goal was home ownership, then the actual result was speculation and indebtedness.

The easiest way to have prevented the crisis would have been to discourage, rather than encourage, the trend toward ever lower down payments on home purchases. Maintaining a requirement for a reasonable down payment would have dampened the speculative mania that drove house prices to unsustainable levels. It would have reduced the number of mortgage defaults.

Another way to have prevented the crisis would have been to rely on something other than risk buckets and credit agency ratings to regulate bank capital. A better approach would have been to use stress tests, in which regulators would specify hypothetical scenarios for interest rates or home prices, with bank capital adequacy measured against such stress tests. Another approach, noted earlier, would have been to require financial firms to issue unsecured debt. Such debt would help insulate deposit insurance funds from fluctuations in asset prices. Moreover, if such debt is traded, then its price can be used as a market indicator of risk, giving regulators an early-warning system for problems.

Conclusion

The biggest myth is that regulation is a one-dimensional problem, in which the choice is either “more” or “less.” From this myth, the only reasonable inference following the financial crisis is that we need to move the dial from “less” to “more.”

The reality is that financial regulation is a complex problem. Indeed, many regulatory policies were major contributors to the crisis. To proceed ahead without examining or questioning past policies, particularly in the areas of housing and bank capital regulation, would preclude learning the lessons of history.

Arnold Kling was an economist on the staff of the board of governors of the Federal Reserve System and was a senior economist at Freddie Mac. He is a member of the Mercatus Center financial markets working group and co-hosts EconLog, a popular economics blog.

FURTHER READING: This essay offers a preview of Kling's study "Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008," which will be unveiled on September 15 at an event on Capitol Hill sponsored by the Mercatus Center. Kling's other articles for The American include “How to Fix Healthcare Delivery” and “The Problem with the Biggest Tax Break in America,” on reconceiving the concept of health insurance. He also wrote, “Would Keynes Have Supported The Stimulus Bill?

Image by Darren Wamboldt/Bergman Group.

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