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In an article posted a couple of days ago, I began to discuss the changes in financial regulation that are likely to result from the crisis we are currently experiencing. (What follows is extremely wonkish, the squeamish are advised to leave the room.)

Major changes are on the way and there is a big debate over the nature of those changes. One major area of debate concerns the overall guiding philosophy of a reformed regulatory framework. There are two main tendencies here. One, which we can call the Too Big To Fail (TBTF) approach, is favored by the influential Group of 30 and its lead author, Paul Volcker. Mr. Volcker, as everyone knows, was the Chairman of the Federal Reserve Board before Alan Greenspan, and is presently (among other things) Chairman of the Board of Trustees of the G30 and senior economic adviser to the Obama administration. The “Volcker Report” contains many recommendations for what ails the world’s financial systems and one of these recommendations it to create a special regulator for financial institutions that represent a risk to the financial system as a whole. The other approach, which we can call the Orthodox Approach, relies on the kind of regulation in force before the “Great Deregulation” coupled with measures designed to limit the number of institutions that become so large and risky that they become risks to the whole financial system.

The results of this debate are important to investors in financial institutions because the new regulatory framework will determine what businesses banks, insurance companies, securities companies can enter into, and what kinds of restrictions will be put on these institutions and businesses. It will, in end, result in a playing field substantially different to the one we have now so investors should follow this debate closely.

Organizing a regulatory philosophy around the concept of TBTF raises a number of serious problems -- how to decide who is systemically important, the unfairness of the presumably lower cost of funding that these institutions would enjoy once they are declared to be TBTF, the fact that creating a box for them legitimizes their existence, etc.

I believe a simpler solution exists if we go back to first principles and concern ourselves more with the sanctity of bank deposits than with the size of institutions. Risks to depositors should be strictly limited, risks to investors less so. As I will try to explain in the paragraphs that follow, such a conventional system is simpler to operate and substantially reduces systemic risk, and does so more effectively than a regulatory framework that focuses directly on systemic risk.

The Problems of a TBTF Regulator

The perception that we need a systemic risk regulator is based on a misinterpretation of recent history. Wisdom that has almost become conventional goes something like this – financial institutions have grown very large and the markets have become very sophisticated in the instruments traded and the technology used to distribute them. The regulators have not been able to keep up with these processes and as a result, we have had a major failure of the world’s financial system and now find ourselves in the mother-of-all recessions. Since these institutions need to be large in order to be able to compete with the Deutsche Banks and Barclays Banks of the world, the best way to control them is to accept them, while placing them under the supervision of the systemic regulator to insure that they don’t fail and contaminate the rest of the system. It is a cold war kind of regulatory mentality with TBTF banks replacing nuclear warheads, and the systemic regulator replacing red telephones. Meanwhile the system retains its capacity for mutually assured destruction.

The trouble with this logic is that it presumes that the regulators were not able to keep up with what was going on in the large institutions because of the complexity of their activities. NOT TRUE. Rather, what happened was that a conscious decision was taken, or a series of conscious decisions, to abandon the regulatory principles and styles that had characterized the financial markets since the passage of the Glass-Steagall Act in 1933. These decisions begun to be taken when Alan Greenspan replaced Paul Volcker at the Fed, and gradually, through a combination of the passage of weaker laws and regulations, plus a much milder application of the regulatory apparatus and of the laws against outright fraud, the banks found themselves in a position where they could do much as they pleased, and nothing pleased them more than to push securities out the door until there was no one left to buy them. As someone at UBS famously said when asked to explain how they could of sold so many dubious bonds to the unsuspecting fund managers, “When the ducks quack, you gotta feed ‘em”. Thus, be suspicious of any call for a systemic regulator that requires it’s backer to invoke the argument that our previous regulatory framework failed. It did not, we simply abandoned it, something that will come to be regarded as a major foot-shooting exercise when the dust settles and the history of the Crash of 2008 is written.

Of course, dubious provenance is not a capital crime. The real problem is that a regulatory framework built around a systemic regulator poses a series of implementation problems that will cause it to fail, among which are the following,

Who Is Too Big to Fail?

How would you know who is too big to fail? Presumable, you design some kind of scoring system that combines measures of size and risk to identify institutions that might be TBTF. Then these institutions would be subject to a closer analysis to determine if they did indeed qualify to be handed over to the TBTF police. Sounds plausible but look at how one gets painted into a corner if you go down this rabbit hole.

First of all, such a system is very difficult to design. One must design a net that catches tuna but somehow releases the dolphins and sea turtles back to the sea. How do you measure size and risk precisely enough to ensure that all (or virtually all) of the institutions that are truly TBTF are identified? Leave too many out and the whole purpose of the exercise is frustrated -- you would have been better off staying with a more conventional regulatory structure. On the other hand, if the trap catches too many, you run the risk of stifling competition in the industry and losing more business to London or Frankfurt or, fore shame, even Toronto which has popped up recently as the new low-risk financial center. Do you use the same metrics for a commercial bank that you do for a securities company or a hedge fund. Obviously not, but how then would you calibrate the different measuring systems? There is no history for this kind of analysis, so there is little to go on. And the markets are so dynamic that whatever system you design would be obsolete more or less immediately. Clearly this is a nearly impossible task, so much so that it has within it the seeds of its own failure.

The Funding Advantage

Such a system might have perverse rewards for institutions that are caught in it. Once you are in the TBTF penalty box the market knows you aren’t going to disappear and they begin to shower you with cheap money. Remember Fannie and Freddy? You have a funding advantage over less risky institutions, an ironic result for a system that was designed to reduce risks. While you might be able to do things to reduce this advantage, like tax TBTF institutions at a higher rate or charge them for their incarceration, this does not solve the problem. As my mother used to say, two wrongs don’t make a right.

Another tactic that is being considered is to establish prudential rules and/or business restrictions that punish and discourage institutions from growing too large. You could have a higher level of capital for a large bank than a small one or you could prevent a bank that has gotten too large from trading certain kinds of instruments. However, once this restrictive framework is created, and its creators pat themselves on the back for a job well done, there will be pressure from many sides to weaken these regs as time goes on. Again Fannie and Freddy are called to mind. Rules will be weakened during times of financial calm when risks appear smaller. Eventually, all or most of the stakeholders in TBTF cabal will argue for weaker rules while more institutions are deemed to be TBTF. Soon the pain associated from heightened regulation will diminish to the point where it is overwhelmed by the funding advantage that joining the club brings with it. The financial institutions will soon want to achieve the designation of TBTF in order to lower their cost of capital. It will become a badge of honor to belong to this club, its members will be eating at Delmonicos, and they will be trading officials back and forth through the revolving door with the systemic regulator!

Build It and They Will Come

By overemphasizing systemic importance or TBTF you may actually increase the problem. Creating a systemic regulator acknowledges that some institutions are going to be TBTF and that others will join the club later on as the inertia of their growth carries them over the threshold. While no one would argue that you should ignore the tremendous risks such institutions represent to the system as a whole it is better to focus on preventing institutions from getting this big and risky, rather than on giving them a home once they do. By creating a box for them, you perversely create a constituency for them. The administrators of the systemic regulator are not going to want to throw a party that no one goes to. They are going to want to see their bureaucracy grow in budget and importance.

Back to the Future

A return to a more conventional approach that preserves some of the principles and features of the old Glass-Steagall model but does not endeavor to put the genie back in the bottle offers many advantages over the risky and untried system that relies on a systemic regulator. One of the main features of the GS framework was that it considered the public faith to be in play to a greater extent with bank depositors and with customers of life insurance companies than with the customers of securities companies (by securities companies I mean broker/dealers, investment funds, hedge funds, and other similar institutions). Meanwhile, investors in securities were explicitly accepting risk, in fact, risk sort of drove the whole system, so the public faith was not in play with these companies like it was with banks and life insurance companies. All these investors required was a level playing field – one where accounting rules could be counted on and where listed companies were prohibited from providing misleading information to the investing public.

Ah!, you will say, but this notion that investment banks and (non-life) insurance companies present less risk to the system went out the window when they got so big and had so many counterparties that their failure did cause systemic problems. Remember Lehman Brothers, Bear Sterns and AIG, you may be saying? But how did these institutions get so big and risky? They could only have gotten that way through the wholesale abandonment of normal regulatory common sense.

Consider these two sources of size that could have been easily controlled. Firstly, the proliferation of OTC-traded derivatives, of which credit default swaps are the poster child. There are still trillions of dollars of these guaranties out there and institutions now tottering on the brink are the guarantors of much of it. Here again we encounter a self-inflicted wound. The size of this market could have been kept to manageable proportions if the regulators had required trading in these instruments to occur only on regulated exchanges. The market would have had a well-financed exchange as the counterparty to all trades. The practice of netting of offsetting contracts would have substantially reduced the number of outstanding contracts, and margin calls would have taken poorly capitalized players out of the market before they can do much harm.

Another way investment banks got so big is by investing in securities originated by deposit-taking organizations. Since many of the kinds of risky assets that eventually found their way into the portfolios of investment banks, insurance companies and hedge funds either had their origin within the commercial banking system or otherwise relied on a commercial bank guaranty of one kind or another, regulating these institutions more rigorously to reduce the issuance of these instruments limits the leverage of the overall financial system and therefore makes it more difficult for institutions to become excessively large and systemically important.

Both of these factors contributed materially to the failure of the financial system we are now suffering through. However, neither require the presence of a Systemic Regulator to control, just a bit of old-fashioned regulation and supervision.

OK, But How Do You Implement Such a System?

Fair question. The framework that I am proposing requires some separation between different kinds of financial institutions. This separation is not as strict as under the old Glass-Steagall model, nor is it as loose as it is under present law, where with a few exceptions a single financial institution can take deposits, underwrite insurance, and trade stocks. On the business side, the model uses the concept of a bank holding company or, better, a financial holding company, at the top from which hang separate subsidiaries dedicated to commercial banking, securities business, and insurance companies. The commercial bank would be regulated more heavily, since it is part of the payments system and a repository for household’s savings. The life insurance company would also be subject to a strict regulation to protect financial unsophisticated customers while the securities companies and life and casualty insurance companies could be subject to a more lenient supervision. Lending from the bank to its sister companies would be limited through single borrower limits or related party lending limits, thereby ensuring that the non-banking subsidiaries could not contaminate the bank. Of course, who regulates the different kinds of financial institutions is important, but that is food for another article.

The holding company would be limited to just that, holding these separately incorporated operating companies,. It could not itself could not also be an operating company. And there would be the normal kind of limitations on how much the operating companies could lend to each other. In this way, economies of scale could be achieved by financial groups whose business model depended on scale, while others could specialize, by organizing themselves as independent banks, securities companies or insurance companies.

The present crisis presents an opportunity to design a financial sector with a much lower level of systemic risk. The deleveraging of the system and the elimination of a number of the worst offenders through bankruptcy or forced merger leaves fewer institutions that are too big to fail. This makes it easier to implement the kind of regulatory framework that I am proposing. Let’s not misinterpret this opportunity and jump to the conclusion that we need a systemic regulator. This would be a complex and risky step to take, especially when a much simpler way is available.

Source: The Debate over Banking Reform, Part 2