Pro-Cyclicality: Bernanke and Dimon on Moderating the Credit Cycle

by: Tom Armistead

Jamie Dimon raised his profile by publicly questioning Fed Chairman Ben Bernanke on regulatory policy. Sadly, the choice of venue and the manner in which Dimon phrased his challenge obscured the common ground the two men may share, and contributed nothing to advancing the discussion that needs to occur. That would be about procyclicality, and specifically the degree to which that phenomenon mars the current regulatory regime.

From Dimon's shareholder letter (pdf), included in JP Morgan's (NYSE:JPM) 2010 Annual Report:

Critical accounting and capital rules need to be redesigned to ensure better transparency and less pro-cyclicality

If properly designed, countercyclical accounting and capital rules can serve as stabilizers in a turbulent economy. I will mention two issues that underscore the need for this approach, although there are many more.

First, loan loss reserving currently is highly pro-cyclical: When losses are at their lowest point, so are loan loss reserves and vice versa. There are many ways to fix this intelligently while adhering to rational accounting rules.

Second, capital rules even under Basel III require less capital in benign markets than in turbulent times. So at precisely the time when things can only get worse, we require the least amount of capital. This also is easy to fix.

And one additional observation from outside our industry: Federal, state and local governments need to change their accounting standards (as corporations did decades ago) to reflect obligations made today that don’t come due for many years. This one accounting issue allows governments to take on commitments today but not recognize them on financial statements as obligations or liabilities.

Bernanke, for his part, has outlined the importance of this consideration. From "Reducing Systemic Risk," delivered at Jackson Hole in August of 2008:

A systemwide focus for financial regulation would also increase attention to how the incentives and constraints created by regulations affect behavior, especially risk-taking, through the credit cycle. During a period of economic weakness, for example, a prudential supervisor concerned only with the safety and soundness of a particular institution will tend to push for very conservative lending policies. In contrast, the macroprudential supervisor would recognize that, for the system as a whole, excessively conservative lending policies could prove counterproductive if they contribute to a weaker economic and credit environment. Similarly, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously. I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs "through the cycle" to mitigate procyclicality. However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole.

More on the topic from Bernanke, in a speech entitled "Financial Reform to Address Systemic Risk," delivered 3/10/2009, at the height of the crisis:

Pro-cyclicality in the Regulatory System

It seems obvious that regulatory and supervisory policies should not themselves put unjustified pressure on financial institutions or inappropriately inhibit lending during economic downturns. However, there is some evidence that capital standards, accounting rules, and other regulations have made the financial sector excessively procyclical--that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes.

The Importance of the Issue

It's pretty clear that industry participants, regulators, rating agencies, the accounting profession and politicians all did their part to exacerbate the most severe credit cycle seen in several generations. Collectively they did an about face, from too lenient to too strict: they created the bubble, and then they created the Great Recession.

It's possible to attribute the growing wealth and income disparity in this country to the failure to stabilize the business cycle. The wealthy, after all, have the resources to withstand temporary declines in business activity. Indeed, given financial sophistication, or access to hedge funds or professional advisers with expertise to exploit the cycle, they may benefit from the turbulence.

The ordinary citizen, in contrast, loses his house due to unemployment, or is forced to liquidate his retirement savings at the market bottom. These are blows from which those who work, save and invest may never recover.

Do those who are making and influencing the decisions actually support the objective of financial stability? Or do they give it lip service, while fighting tooth and nail to avoid the types of prudential regulation that would prevent these wretched excesses?

Maybe Jamie Dimon should pick up the phone, give Bernanke a call, and try to translate what appears to be agreement on a theoretical level into something that could actually gain traction in the real world.

Pro-cyclicality in Fiscal and Monetary Policy

It's also clear that our politicians have developed fiscal policy in a way that is extremely pro-cyclical. During the prosperity of the post-Clinton years, tax reductions, an expensive Medicare Prescription Drug benefit, and two unfunded wars seemed entirely rational, and few questioned fiscal policy as it developed along those lines.

In the wake of the recession, as revenue plunged and expenditures grew, a band of hardy ideologues pushed a stringently pro-cyclical remedy for budget woes: the solution advocated is to immediately cut expenditures to the bone, thereby ensuring a double dip recession, if not a depression. Cooler heads prevailed, at least temporarily.

Monetary policy under Greenspan was excessively expansive. It was eased following the shock of 9/11, but was never tightened sufficiently to slow down the housing bubble and other financial excesses of the time.

Current monetary policy, nominally driven by the dual mandate, has dead-ended at a point where attempts to induce prosperity by quantitative easing have punished savers with low interest rates, flooded commodities markets with low cost speculative money, and done little to reduce unemployment. In point of fact, the blunt tool of monetary policy is much less effective than carefully targeted fiscal stimulus in reducing unemployment.

As an example, money which makes its way from the Fed to a TBTF bank to a hedge fund to the commodities market will not train an unemployed construction worker in the operation of CNC machinery, or any other skilled trade. It will not put him to work installing photovoltaic arrays, or manufacturing wind turbines. Instead, it will drive up the cost of oil, gasoline, or other inputs, slowing down the economy.

Monetary policy should be directed to insuring a stable medium of exchange and a rate of return in the form of interest sufficient to encourage and reward saving.

Prudential Regulation

Oversight of banks and other financial institutions became extraordinarily lax. The likes of WaMu, Countrywide, Lehman, Bear Stearns, and AIG operated unencumbered by any meaningful oversight from their regulators.

The investment banks, as a group, were regulated by the SEC as CSEs (consolidated supervised entities). What this meant, in practice, was that they used their own methods to assess the risk of their operations, and their capital requirements, reporting monthly to the SEC. This was intended to put them on a par with their global competitors, during a time of worldwide prosperity.

After the financial crisis, regulators over-reacted in the area of commercial real estate loans, so that many banks were prevented from rolling loans over as they expired. Eventually clarifying memos were required, to quash the newly zealous examiners. Banks, in the usual way, after shoveling money out the door to all takers, became unwilling to lend except to those who had no need of funding.

Entangled with Other Issues

It almost seems that capital requirements are being used to bludgeon institutions deemed too big to fail.

At the same time, the TBTF institutions have been intransigent in refusing to abandon or accept any restraint on the CDS and other derivatives that destabilize their balance sheets, and destroy transparency. You could study JPM's balance sheet for days, and not know anything more than you did at the outset of the study: the bank has huge derivative assets and liabilities, which they claim are approximately equal in size, with assets slightly larger than liabilities.

Politicians and regulators, having effectively caved on the CDS and derivatives issues, resort to demands for excessive capital, as if to discourage and tax the offending behavior. It would be far simpler, and more effective, to cut the whole derivatives mess down to a size that encompasses the legitimate needs of hedgers and those who possess an insurable interest in the referenced securities.

Hard to Make the Switch

As common sense as these ideas are, they are difficult to implement in practice. During a financial crisis, governments that have over-extended themselves do not have the resources to conduct counter-cyclical fiscal policies without backing themselves into a debt trap.

As prosperity returns, the idea of continuing austerity in order to accumulate a rainy day fund finds few adherents.

Indeed, a common pattern is that a period of fiscal restraint results in a change of control in Washington, with the new arrivals cutting taxes at precisely the point where the government is beginning to generate a surplus and could meaningfully reduce debt. Think Kennedy, Reagan and Bush.

Investment Implications

For many years, I was able to invest successfully by disregarding the macro environment. Fundamental analysis and a conscientious effort to buy low and sell high were sufficient. That changed with the financial crisis, and I now regard monitoring the macro environment as a key aspect of investing, spending about 25% of my investment time on the issues.

Several well known investment gurus have already drawn their conclusions: both George Soros and Carl Icahn have issued warnings to the effect that nothing is being done to stabilize the system.

Stocks and ETFs

At the level of specific equities, JP Morgan (JPM) and Wells Fargo (NYSE:WFC) appear to have been leaning against the wind at the height of the bubble, and would be my choice from among the big banks. Dimon seems philosophically attuned to a counter-cyclical approach and that may lead to more effective management, long term. WFC is a favorite of Warren Buffett who is seldom caught leaning the wrong way during any business or financial cycle.

Regional banks, to the extent they are less constrained by regulatory concerns about capital levels for systemically important institutions, may also be of interest here. I like Webster Financial (NYSE:WBS) and Sun Bancorp (NASDAQ:SNBC).

It should be noted the the much maligned bond and mortgage insurers had long-standing counter-cyclical plans in place, in the form of contingency reserves required by insurance statutes at the state level. These operated as intended, although some of the bond insurers got sucked too far into the structured finance situation, and those carefully accumulated reserves were vaporized by paying losses on CDOs of Synthetic ABS and similar concoctions. I like MBIA (NYSE:MBI), Assured Guaranty (NYSE:AGO) and Radian (NYSE:RDN), primarily on the basis of embedded value or potential wins in litigation.

But the concept of a contingency reserve, accumulated over time, could just as well be applied to banking. Build up the reserve in good times, and tap it in an emergency. Using the over-worked comparison to domestic finances, a rainy day fund is in order. For that matter, it could be applied to fiscal policy. A Federal government that has the resources to increase spending during a recession can do much to stabilize the economy and mitigate the severity of recessions.

Disclosure: I am long MBI, AGO, RDN, WBS.