Financial Regulation: What Can We, Or Congress, Do?

By Simon Johnson

At a hearing of the House Financial Services Committee yesterday, Barney Frank nicely summarized where we are with regard to re-regulation of our largest financial institutions: some of them are definitely “too big to fail”, with the potential to present the authorities with what Larry Summers calls the “collapse or bailout” choice, but what exactly should be done about it?

On a five-person panel, I had the middle seat (as usual) and found myself agreeing with points made both to my left and to my right. Alice Rivlin is correct that we need to control leverage as well as increase capital requirements, and the Fed’s tools vis-à-vis leverage need modernization – your grandparents’ margin requirements would not suffice. Peter Wallison, a member of the new financial crisis investigation commission, stresses that capital requirements should be higher for larger banks. Paul Mahoney wants to change the bankruptcy code, to make it easier for courts to handle large financial firms in quick time; recent CIT Group events suggest this is a good idea.

And Mark Zandi was persuasive on the point that households had no idea what they were signing up to with option ARMs – even he has trouble with those spreadsheets. Effective consumer protection – including a new consumer safety commission – would definitely contribute to financial system stability.

What will Barney Frank and his committee do? There will be no “Tier 1 Holding Company” category of firms, if Frank has anything to do with it; this is too much like creating an implicit government guarantee. Frank is clearly drawn towards higher capital requirements or more insurance payments from firms that pose more system risk. I suggested total assets of 1% of GDP as a threshold, but we agree this should be essentially a progressive drag on profits – creating the strong market-based incentive for the biggest firms to downsize.

Other than that, watch this space.

My written testimony submitted to the committee is below.

Main Points

1) The U.S. economic system has evolved relatively effective ways of handling the insolvency of nonfinancial firms (through bankruptcy) and small or medium-sized financial institutions with retail deposits (through a FDIC-run intervention process). These kinds of corporate failures inflict limited costs on the real economy, and even a string of problems in such firms does not generally jeopardize the entire financial system.

2) We do not yet have a similarly effective way to deal with the insolvency of large financial institutions (e.g., any bank with assets over $500bn, which is roughly 3 percent of GDP). When one of these firms gets into trouble, the authorities face an unpalatable choice of “bailout or collapse.” If the problems spread to more than one firm, the balance of responsible official thinking shifts towards: “bailout, at any cost”.

3) The collapse of a single large bank, insurance company, or other financial intermediary can have serious negative consequences for the U.S. economy. Even worse, it can trigger further bank failures both within the United States and in other countries – and failures elsewhere in the world can quickly create further problems that impact our financial system and those of our major trading partners.

4) As a result, we currently face a high degree of systemic risk, both within the United States and across the global financial system. This risk is high in historical terms for the US, higher than experienced in most countries previously, and probably unprecedented in its global dimensions.

5) Short-term measures taken by the US government since fall 2008 (and particularly under the Obama administration) have helped stabilized financial markets – primarily by providing unprecedented levels of direct and indirect support to large banks. But these same measures have not removed the longer-run causes of systemic instability. In fact, as a result of supporting leading institutions on terms that are generous to top bank executives (few have been fired or faced other adverse consequences), systemic risk has likely been exacerbated.

6) Some of our largest financial firms have actually become bigger relative to the system and stronger politically as a result of the crisis. Executives of the surviving large firms have every reason to believe they are “too big to fail.” They have no incentive to help bring system risk down to acceptable levels.

7) Specifically, the surviving large U.S. financial firms and their foreign competitors have a strong incentive to resume “pay-for-performance” incentive systems – they compete by attracting “talent,” and if any one firm brings its compensation under control, it will lose skilled employees. But these firms – and their regulators – have also demonstrated they cannot prevent such incentives from becoming “pay-for-disguised-risk-taking” on a massive scale.

8) The potential for unacceptable systemic risk remains deeply engrained in the culture and organizational structure of Big Finance. Over the past 30 years, this sector has benefited from a process of “cultural capture,” through which regulators, politicians, and independent analysts became convinced this sector had great and stabilizing technical expertise. This belief system is increasingly disputed, but still remains substantially in place – big banks are, amazingly, still presumed by officials to have the expertise necessary to manage their own risks, to prevent system failure, and to guide public policy.

9) There are four potential ways to reduce system risk going forward

1. Change our regulations so as to reduce ex ante risk-taking, e.g., by more effectively controlling the extent of leverage in the financial system or by more tightly regulating derivatives transactions.
2. Change the allocation of regulatory authority within the financial system, so that the relative powers of the Federal Reserve, Treasury, FDIC and various other regulators are adjusted.
3. Make it easier for the authorities to close down failing large financial companies using a revised “resolution authority.”
4. Change the size structure of the financial system, so that there are no financial institutions that are “too big to fail”.

10) All of these approaches have some appeal and it makes sense to proceed on a broad front – because it is hard to know what will gain more traction in practice.

11) The growing complexity of global financial markets means that even sophisticated financial sector executives do not necessarily understand the full nature of the risks they are taking on.

12) There is no ideal – or even proven – regulatory structure that will work inside the U.S. political system. Relative to the alternatives, strengthening the FDIC makes sense. For certain levels of potential bailout (e.g., as with CIT Group recently), the FDIC has an effective veto power over providing some forms of government support. This has proved a helpful check on the discretion of the Federal Reserve and the Treasury recently, but it would be a mistake to assume this will be the case indefinitely.

13) While an extended “resolution authority” could be helpful, it is not a panacea. As markets evolve, new forms of interconnections evolve – and we have learned that not even managers of the best run banks understand how that affects the transmission of shocks. Furthermore, as banks become more global, an effective resolution authority would need to span all major countries in comprehensive detail. We are many years away from such an arrangement.

14) The stakes are very high – the country’s fiscal position has been significantly worsened by the current crisis, and our debt/GDP ratio is on track to roughly double.

15) As a result, it makes sense also to consider measures that will reduce the size of the largest financial institutions. The recent experience of CIT Group suggests that a total asset size under $100bn may provide a rough threshold, at least on an interim basis, below which the government can allow bankruptcy and/or renegotiation with private creditors to proceed.

16) Market-based pressure for size reduction can come through a variety of measures, including higher payments to the FDIC (or equivalent government insurance agency) from institutions that pose greater system risk, higher capital requirements for bigger firms, and differential caps on compensation based on the cost of implied government assistance in the event of a failure – think of this as pre-payment for failure.

17) Breaking up our largest banks is entirely plausible in economic terms. This action would affect less than a dozen entities, could be spread out over a number of years, and would likely increase (rather than reduce) the availability of low-cost financial intermediation services.

18) The political battle to set in place such anti-size measures would be epic. But as in previous financial reform episodes in the United States (e.g., under Teddy Roosevelt at the start of the 20^th century or under FDR during the 1930s), over a 3-5 year period even the most powerful financial interests can be brought under control.

19) If we are able to make our largest financial firms smaller, there will still be potential concerns about connected failures or domino effects. Much tougher implementation of “safety and soundness” regulation is the only way to deal with this. In that context, stronger consumer protection – through a new agency focused on the safety of financial products – would definitely help (as well as being a good thing for its own sake).

The remainder of this testimony (see this pdf) provides further background regarding how systemic risk developed to its current high levels in the U.S., and suggests why we need new limits on financial institutions whose management regards them as “too big to fail”.

Comments

[Jordan Lindsey:]

I don't buy the ignorance case at all. They knew very well they could not afford the house just as much as the bank lending them the money knew.

The borrower borrowed and the lender lent because they both speculative the home price would continue to rise and they both would make money on it.

Let markets be markets and forget "too big to fail". Intervention causes larger problems down the road.

Jul 22 11:57 AM

[john s. gordon:]

let 'too big to fail' become 'too big therefore we'll carve it up into smaller entities'.
> jack

Jul 22 12:06 PM

[CautiousInv...:]

I don't think it is a coincidence that shortly after, in historical terms, the repeal of Glass Steagall and the decision by banking authorities, early on in the Bush administration, to allow five institutions to increase their leverage from 12:1 up to 30:1 (Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs) that we experienced a financial meltdown.

That other factors contributed cannot be argued but I believe the two factors identified above played an important role. With this in mind, it would seem logical that we (1) reinstate Glass Steagall, (2) increase the capital requirements of all banks, effectively reducing financial leverage (3) dismember banks seen to be too big to fail and/or (4) penalize banks seen to be TBTF through higher capital requirements and higher FDIC premiums. I'm agreeing with much of what the author has laid out.

With respec to systemic risk, perhaps we should borrow certain statistical tools from the realm of trading and use them in the world of banking by better understanding the correlation of bank assets, which is likely to be high, and regulating them accordingly. Under this thinking perhaps such tools as VAR could be used as a tool in determining appropriate capital levels.

Lastly, we have to contain the pathological political influence of the commercial and investment banking oligarchs. In addition to supporting repeal of Glass Steagall, then Secretary of the Treasury Summers in commenting on derivatives said these “are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws.”

And, in the summer of 1997, Greenspan in testifying on derivatives demanded that the Financial Accounting Standards Board weaken the new rule, which would have forced companies to book changes in the market value of their derivatives contracts. "Greenspan said the new rule “may discourage prudent risk-management activities,” would create “volatility” in bank capital levels and give an inaccurate picture of banks’ financial conditions."

There needs to be more distance between the govenors and the goverened; and there needs to be more distance between the regulator and the regulated.

Jul 22 12:27 PM

[Mill Rat:]

I agree with the above comments from "Cautious Investor" and John Gordon.

Without detracting from those comments, I would also add that some of the factors described above were also exacerbated by the false sense of security provided by inadequately-supported Credit Default Swaps (such as those sold by AIG).

One consequence of CDS's is that they added yet another 'degree of separation' (beyond the 2 or 3 'degrees of separation' already coming from Collateralized Mortgage Obligations') between the person making loan approval decisions and the entities which were intended to bear the ultimate risk for those decisions.

I don't yet have a firm opinion on the best way to regulate the use of CDS's, but it would be another worthy topic for discussion.

For starters...At this link is a proposal by Shah Gilani, a former hedge-fund manager, who writes for the web site, "Money Morning".
www.moneymorning.com/2.../

I do like the idea of restricting the purchase of CDS protection to only those entities who actually hold the underlying bond or loan.

It has also occurred to me that we could impose a Federal sales tax upon the sale of CDS protection. This could, in part, re-capture the value of the "negative externalities" (i.e. "bailouts") whose burden has been placed upon the American taxpayer. Futhermore, it seems that the prices of CDS protection were found to be poorly correlated to the actual risk of the underlying bond or loan. (Regarding this last point about pricing, I am basing it merely on anecdotal reports. So, if you have data which refutes or supports this last point, please feel free to share it.)

Bryan Kay

Jul 22 05:56 PM

[derryl:]

I think Simon's recommendations are excellent and most or all of them are probably doable, too. I agree with Simon and commenters that banking functions should be isolated from investment banking and insurance functions.

"Banks", or depository institutions, are the only kinds of institutions with the legal right to create money. Banks call it "deposit creation" because every time a bank makes a loan the funds are deposited into the customer's account, then probably transferred by check to someone else who deposits it in his bank account, etc. So the loan funds end up adding to the total amount of money on deposit in the banking system. This is what 'fractional reserve banking" is all about--deposit creation.

Once the money is out there and the borrower is making his payments the originating bank has done its job. Now investment banks can induce an owner of some of that money to invest with them. All that can be lost in this transaction is the investor's own money. No bank is at risk because even if the investor loses his money it's a zero sum game where somebody else gains that money. Investment banks should ONLY be able to play with money that is owned by investors, and should never be able to create their own gambling money.

CDS is insurance and should be treated as such. It has nothing to do with banking and should be isolated from banking. If traders of debt want to insure themselves against default let them buy the insurance, but the realistic cost of insurance will likely be higher than the interest being paid on the debt underlying the trade, so the trade in debt will collapse down to a level that doesn't create systemic risk. If debt traders and their insurers go broke so what? The money doesn't evaporate in a bank "writedown" of debts. The money simply changes hands from the loser to the winner.

I also like the idea of consumer financial protection. I think 10-20% down minimum, of your own savings, should be required for mortgages. We're also bailing out car companies so 0 down 0 interest in-house car loans should also be banned. Really, all this does for car companies is sell forward future purchases. The sale they make today on cheap financing is a sale they would have made in 3 years on regular financing, but in no case do they get both sales.

Again, the principle is that if only your own money is at risk then do whatever you like with it. But if you're too big to fail or if you have been authorized to create money then your customers and the taxpayers who are backstopping your gambles should have realistic protection against being sold debt they can't afford and will end up defaulting on.

Jul 22 11:32 PM

[John Lounsbury:]

Jordan Lindsey - - -

I can only talk anecdotally. From the late 90s right up to late 2007, I kept getting requests from clients, their family members and referrals. I can only guess the number because many received undocumented free advice, but I probably talked to somewhere between 50 and 100 people over that time period. The question was: Which mortgage should I take, the variable rate mortage (say initial rate 3.5%), 15-year fixed (say 5%), or 30-year fixed (say 5.5%). Most of these people had no idea of the risk exposures existing in the variable rate contract. By and large, these were very well educated people, involved in professional careers of various sorts, that one would expect to have an above average financial awareness. They were, by and large, oblivious.

Added to the naivite regarding financing matters, most of the mortgage originators were recommending the variable rate mortgages, pointing out the much lower initial monthly payments. I assume they (the originators) were more knowledgable than the clients and made the recommendations based on commission schedules.

So, Jordan, I think you are imputing too much financial intelligence to the average home buyer - mortgage applicant. From personal experience I can testify that there were at least some "babes in the woods".

Jul 23 12:14 PM

[Kinabalu:]

"2) We do not yet have a similarly effective way to deal with the insolvency of large financial institutions"

FDIC's Sheila Bair is scheduled to testify before the Senate Banking Committee this morning, and will ask lawmakers to impose fees on the country's biggest financial firms. This is a singular development. For the past 20 years the FDIC has been pushing bank mergers with the view that larger banks were less likely to fail. I doubt she will start her testimony with a 'mea culpa' but at least it's a recognition of a failed strategy.

Jul 23 01:28 PM

[Kinabalu:]

I don't believe that banking authorities had any legal ability to restrict the leverage ratios of the companies you name. Those are all investment banks not traditional depositary banking insitutions. The repeal of Glass Steagall allowed bank holding companies to own subsidiaries in fields other than banking such as insurance and investment banking, but the regulatory authority over bank holding companies is limited to making sure the holding company is a source of strength for the subsidiary bank. Any subsidiary banks those companies owned were so much smaller than the parent company that it was easy to meet that test. There was certainly no active decision by banking authorities to allow leverage increases of the extent you allege.


On Jul 22 12:27 PM CautiousInvestor wrote:

> I don't think it is a coincidence that shortly after, in historical
> terms, the repeal of Glass Steagall and the decision by banking authorities,
> early on in the Bush administration, to allow five institutions to
> increase their leverage from 12:1 up to 30:1 (Bear Stearns, Lehman,
> Merrill Lynch, JPMorgan, and Goldman Sachs) that we experienced a
> financial meltdown...

Jul 23 01:48 PM

[msgtb:]

Glass Steagall was repealed during the Clinton Administration on the recommendation of Lawrence Summers. Does the name Lawrence Summers sound familiar, he is currently giving President Obama counsel on the economy. This is truly outrageous. He should be held responsible for this crisis not given a position in the administration.

Good luck and good trading

Dave

Jul 23 05:24 PM

[Tony L.:]

I find it interesting to see that people always look for complicated solutions to what should be a very simple one....

If there was no Federal Reserve back stopping these banks and the ponzi scheme fractional reserve banking system there would be no problem in the first place.

Jul 23 11:22 PM

[RiskAverseA...:]

We DO SO "have a similarly effective way to deal with the insolvency of large financial institutions (e.g., any bank with assets over $500bn, which is roughly 3 percent of GDP)."

This, of course, involves an HONEST accounting of the true extent of insolvency besetting our securities-based financial system, the POLITICAL WILL to cancel fraudulent contracts, reorganization in bankruptcy of the entire global financial system, and finally, reassertion of NATIONAL INTEREST by venturing to honor principles put forward in the Preamble to the U.S. Constitution via reconstitution of Alexander Hamilton's Bank of the United States.

You see, not even the British Empire was "too big to fail."

And this thought, my friend, touches upon the REAL issue here. How so? Just look where most OTC derivatives originate! CLEARLY, the backers of her majesty's Empire have entered through the back door...

Jul 24 12:30 PM

[Moon Kil Woong:]

There is an ideal effective and proven way of managing financial firms to prevent over leverage and systemic failure. It worked for us since the Great Depression. It's called Glass Stegall. This downturn has just gone to show that there is clear message about it, "Love it or suffer the consequences."

Jul 25 10:59 AM

[dcb:]

I know you don't bother to read your comment stream which is a mistake.
Nice post, but where is the petition I can sign saying I support your proposals!!!

Jul 25 08:24 PM