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Making Financial Regulation Work: What Would Have Helped

This is part of a series on The Hearing called "Making Financial Regulation Work." This guest post is from economist Arnold Kling.

The financial crisis is often blamed on “an atmosphere of deregulation.” This strikes me as overly vague. What were the specific regulatory failures?

On close examination, a number of specific issues are not as important as they might appear. For example, adjustable-rate mortgages are risky, but adjustments in interest rates caused only a small portion of the problems in the mortgage market.

Starting in the 1960s, commercial banks and investment banks developed products and services that competed with one another, vitiating the 1930s Glass-Steagall attempt to separate the two types of institutions and culminating in a formal repeal of Glass-Steagall in 1999. However, it is hard to pin the decline in mortgage lending standards or the surge in leverage at banks on this development.

Another alleged regulatory failure concerns financial derivatives, and in particular credit default swaps. A credit-default swap is an insurance policy on a bond or mortgage security. CDS were traded over-the-counter, meaning that individual firms wrote contracts. With over-the-counter trading, AIG insurance wrote CDS to insure many mortgage securities, never dreaming that there would be enough mortgage defaults that they would have to pay claims. As the mortgage crisis unfolded, AIG's counterparties worried that AIG had not set aside enough reserves to pay its obligations, demanded that AIG put up short-term securities as collateral. These collateral calls were difficult for AIG to meet, and the government stepped in as a backstop.

During the Clinton administration, there were some who argued that CDS instead should have been traded on an organized exchange, and many policymakers have since come around to this view. I am not sure what difference it would have made. Had the same transactions taken place on an organized exchange, AIG would have been faced with margin calls from the exchange rather than collateral calls from its counterparties. If AIG had not been able to meet these margin calls, the exchange would have taken large losses and probably failed, creating a mess for policymakers. Moreover, even if an organized exchange would have done a better job of preventing or handling the AIG fiasco, this was only one part of the overall financial crisis. There still would have been catastrophic bank failures due to mortgage defaults.

I am also skeptical about the claim that we needed a “systemic risk regulator” to prevent the crisis. This would be true if most of the financial damage could not have been prevented by any individual regulator. However, the fact is that the Federal Reserve, which regulates most of the nation's largest banks, had enough power to prevent bank failures with better capital regulations. Preventing failure at Freddie Mac and Fannie Mae also did not require a systemic risk regulator—what was needed was tighter supervision by the Office of Federal Housing Enterprise Oversight, which regulates those institutions. That in turn would have required support from Congress, which generally was instead more prone to tampering with the regulator than with the housing enterprises it was supposed to regulate.

If you could turn back the clock and change regulations to prevent the financial crisis, the focus would be on two areas: mortgage underwriting standards and bank capital regulations. The housing bubble, culminating in a crash with severe mortgage defaults, was the trigger of the financial crisis. The crisis devastated the banking system because banks had found ways to accumulate tremendous amounts of mortgage credit risk without capital for protection.

If mortgage underwriting standards had not been dramatically weakened starting in the late 1990s, there would have been much less dangerous housing speculation, less fraud, and fewer poorly qualified borrowers with mortgages. But there was nobody in Washington who wanted to see mortgage underwriting standards made more rigorous. Tight underwriting standards were not in the interest of home builders, real estate agents, mortgage security traders, or anyone who wanted to see expanded homeownership.

In fact, there are some who argue that underwriting standards were driven downward because of the Community Reinvestment Act, which puts pressure on banks to lend to minority borrowers, as well as by “affordable-housing” quotas that were imposed on Freddie Mac and Fannie Mae. Even if those policies were not major contributors to the decline in mortgage quality, it is fair to say that no regulator who tried to push for tighter mortgage underwriting standards in 2004 or 2005 (when such a move would have been timely) would have survived the wrath of Congress.

In my view, the worst regulatory error was allowing bank capital regulations to be evaded. In the late 1980s, after many savings and loans had failed in the United States, international bank regulators developed the Basel capital accord. Although this was flawed in many respects, it did represent a formal requirement for banks to hold capital based on risk. Most assets required 8 percent capital. Some low-risk assets required 4 percent capital, and some government securities required even less.

Soon after the capital accords were rolled out, banks began to come up with ways to “game” the system. For mortgages, the two most important techniques were securitizing mortgages and creating off-balance-sheet vehicles. Securitization allowed banks to get large portions of their mortgage portfolios rated AAA, and these AAA ratings in turn lowered capital requirements, particularly after a revision to the capital requirements that was formalized on Jan. 1, 2002. The off-balance-sheet entities were an even bigger scam, because generally-accepted accounting principles (which the regulators copied) allowed the banks not to count the mortgage securities in these entities as assets at all.

All of this was done right under the nose of the regulators. An article in 2000 in the Journal of Banking and Finance,called “Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues,” was written by a Federal Reserve staffer. Although such scholarly articles always carry disclaimers that the contents do not represent the opinions of the Fed, it clearly showed an awareness of how banks were using techniques to evade capital requirements. The author rationalizes this in part by suggesting that without the ability to evade capital requirements, banks would have been less competitive in the market to finance mortgage loans or other low-risk assets.

In hindsight, the case for allowing regulatory capital arbitrage to take place was flimsy. At the time, a group of market-oriented economists known as the Shadow Regulatory Committee was arguing in the opposite direction. The Shadow Regulatory Committee warned specifically that basing capital requirements on credit-rating-agency classifications would lead to distorted rating estimates that would undermine risk controls.

I do not believe that regulatory capital arbitrage was tolerated out of an ideology of deregulation. It appears to have been tolerated because regulators felt that the Basel capital accords were making it too difficult for banks to finance mortgages in their portfolios. What seemed at the time to be a small regulatory adjustment turned out to be an enormous error.

Regulators constantly must make these sort of judgment calls. The fact that some seemingly minor mistakes can have catastrophic consequences does not bode well for the view that regulatory reform will be sufficient to prevent another financial crisis. Instead, I agree with those who would like somehow to have banks broken into smaller units and subject to market discipline (through subordinated debt, for example), so that regulators are under less pressure to get regulations right or to engage in bailouts when banks fail.

--Arnold Kling is an economist who worked at the Federal Reserve Board and at Freddie Mac. He regularly blogs at econlog.econlib.org .

By Terri Rupar  |  June 15, 2009; 12:12 PM ET
Categories:  Banking , Regulation  
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Comments

To Arnold Kling:

> AIG would have been faced with margin
> calls from the exchange rather than
> collateral calls from its counterparties.
> If AIG had not been able to meet these
> margin calls, the exchange would have
> taken large losses and probably failed,
> creating a mess for policymakers.

The International Bank of Settlements (Switzerland) has been quoted as saying that maybe $700T of CDSs are/(have been) floating around. Could you explain more clearly how an "exchange" would have changed the way CDSs were created, tracked, and what would have happened differently than what actually did happen when the "bottom" fell out?

Posted by: wmartin46 | June 15, 2009 5:57 PM | Report abuse

Kling: "... it is hard to pin the decline in mortgage lending standards or the surge in leverage at banks on this development."

I submit that the manner in which a realty bubble morphed into a SubPrime Mess, with the connivance of all the components in that chain, effectively substantiates that the above sentiment is wrong-headed.

There were, in fact, two failures:
* The first was the repeal of Glass-Steagal which reinforced a certain laxity in the federal watchdog agencies, foremost of which was the Fed under Greenspan, with his "markets are self-regulating" nonsense.
(Five global financial ruptures before our own SubPrime Mess, shows that markets are NOT self-regulating and that national supervisory agencies - with teeth - are a clear necessity.)
* The second was the profits feeding frenzy that induced both Private Finance and Semi-private Finance (Fannie; Freddie) agents to loosen creditworthiness criteria, which spawned the bad loans. This happened in the face of TILA (Truth In Lending Act) that should have prevented "teaser loans" and down-the-line "balloon payments". Some federal agency, responsible for supervising TILA, was asleep at the wheel.

The demise of Glass-Steagal paved the way for the consequences that we know all too well today. And, who is paying more the consequence of that inanity? Wall Street or Main Street?

Moreover, at about the same time as the demise of Glass-Steagal, here is the suggestion of the American Community Banker's Association to Congress when that body, in 1998, was considering reform of TILA:

"Addressing Abusive Practices Must Occur Separately From Streamlining and Simplifying Mortgage Disclosures

Abusive lending practices exist and are a threat to both unsophisticated borrowers and the general mortgage lending industry, but any proposed actions directed at curbing and eliminating these abuses must be explored separately from a discussion focused on streamlining and simplifying TILA and RESPA disclosures."

and,

"Conclusion

ACB supports and is committed to the simplification and streamlining of the disclosures provided to consumers under TILA and RESPA. We will continue to work with other groups, the regulators, and Congress to achieve meaningful reform. Education for and understanding by consumers about the mortgage process is in the best interests of all parties. We look forward to continuing our discussions with all concerned parties, as well as assisting the subcommittees in any way toward this end."

Yeah, right .... ten years later and how many American families are suffering because of our lack of foresightedness and unfounded trust in BigFinance?

Just when are we going to get Financial Regulation right? Meaning this: Any "financial engineering" must adhere to EXACTLY the same principle as engineering projects anywhere in the world. They must demonstrate clearly that they adhere to "fail-safe" guarantees.

Posted by: LafayetteBis | June 20, 2009 3:07 AM | Report abuse

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