Will Bank Regulation Cause The Next Financial Crisis? Part II: Has It Done So Before?

Includes: BAC, C, GS, JPM, MS, WFC
by: Martin Lowy


Kurt Dew contends that bank regulation will cause the next financial crisis. i disagree.

I also find that bank regulation has not caused past U.S. financial crises.

Recessions + lending freely in booms + inadequate perceived capital = financial crises.

This is the second of three articles responding to Kurt Dew's contention that bank regulation will cause the next financial crisis. In Part I, I explored the historical meaning of financial crisis. In this article, I will discuss Dew's historical contentions. It is not that I think he is wrong about the history so much as I think he emphasized the wrong things.

Dew asserts that regulation has been an important cause of recent financial crises. By that, I would have assumed he meant primarily the GFC. He did, in an earlier post, describe the S&L failures. But by my definition, the failures of S&Ls did not provoke a financial crisis, since their failures did not include any panics and did not include any significant detrimental impact on the broader economy. The S&L debacle (which is the subject of my 1991 book High Rollers) was a slow-motion train wreck that took more than a decade to play out, ending not with a bang but with the whimper of the legislation called FIRREA in 1989 and the creation of the Resolution Trust Corporation to sell off the leftover bad assets. It cost something like $150 billion taxpayer dollars in 1990 money.

Was bank regulation an important cause of the GFC? My 2009 book Debt Spiral explores the causes of the Great Recession and the GFC. I would mostly stand behind my 2009 conclusions, although I would emphasize a great deal more the global financial and business conditions that pre-existed the boom of 2003-2006. Frankly, I do not see bank regulation as having been among the major causes. Weak bank regulation did make matters worse. For example, the exception to FIN 46 that allowed banks to guarantee SIV liabilities with out reflecting those liabilities on the bank's balance sheet did enable some of the worst lending in 2004-2007 and did impose costs on German banks and Citigroup. But most of the loose lending was done by bank-like entities that were outside the bank regulatory scheme, including mortgage banks and broker-dealers/investment banks that were under-regulated by the SEC. (That these entities were outside the bank regulatory net leads to charges about pushing activities outside that net, which are part of Dew's forecast and which I will deal with in the next article.)

But despite his statement that recent financial crises were created by bank regulation, it seems to me that Dew agrees that the most recent and most prominent crisis was not created by bank regulation. Here is what he said:

The 2007-2008 Crisis. This brings us to the last and most significant of the crises - the Crisis of 2007-2008. But except for the contribution of government housing policy to this crisis, there is no real sense in which the government can be held accountable, unless you hang the proliferation of financial derivatives on the government. Even if you blame government for the abuses that occurred in derivatives markets that added fuel to the fires that burned during the crisis, it was not government restrictions, but government permissiveness that was at fault.

At bottom the excesses that led to the Crisis of 2007-2008 do support the actions of Dodd Frank.

Curiously, after this (quite proper) admission, Dew turned to the Texas bank failures of the mid-1980s and the failure of Continental Illinois (and implicitly, Penn Square Bank in 1982) in 1984 due in part to the drop in oil prices. Regulation, Dew avers, made these institutions too similar and therefore left them all open to the same adverse economic events. He blames unit banking in Illinois and Texas that prevented them from diversifying geographically and forced them to rely on "hot" wholesale deposits. The Texas experience is a warning against forcing banks to be too similar, he suggests.

The Texas failures were not, by my definition, a financial crisis. Those failures would have caused a financial crisis had Texas been a sovereign nation with its own currency and banking system. But it was not. Therefore, the regional failures were dealt with by the FDIC in a costly but orderly manner. The see-through buildings in Dallas were completed in due course, and the banks from the north that took over continued lending in the Texas market. There were no lines at the closed banks and the Texas economy, already flat on its back was not made worse by a liquidity failure. And within a few years, the Texas economy was flourishing.

It is true that unit banks have (had) a hard time diversifying geographically. Like Continental Illinois, they can become the victims of adverse selection, as Penn Square Bank in Oklahoma foisted a boatload of bad oil and gas assets on its sophisticated Chicago partner, Continental. But diversification versus adverse selection has been a moot point in banking lore for the 50 years that I have been following it. Pick your poison.

The fact is that lenders like collateral. (Regulators do, too.) But what kinds of collateral are there in abundant supply? Most borrowers who contribute to the real economy lack financial instruments to pledge. Mature businesses have receivables and inventory to pledge (though keeping track of such moving targets requires special expertise), but that is not a very large asset category. Most business borrowers have real estate to pledge. Some of that real estate has plant and equipment on it, some of it is for construction, and some of it is for development of natural resources. Therefore collateral tends to be concentrated in real estate. (Large banks do lend a fair amount to financial borrowers against the security of financial instruments, but that is a relatively recent phenomenon and may not have much to do with the "real economy".)

I therefore conclude that bank regulation has not, historically, been the cause of financial crises in the U.S. Indeed, until the GFC, there haven't been any since the Depression.

That, of course, does not mean that regulation will not be the cause of the next one. The D-F law is different from previous bank regulatory laws. It therefore is logically possible that it could spawn the next financial crisis. That is what I will discuss in the third article of this series, as well as the potential impact on Wells Fargo (NYSE:WFC), JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Citi (NYSE:C), and BofA (NYSE:BAC), listed here in order of their stock price to book value: 1.4, 1, .9, .75, .6, and .6. The market does not have a lot of confidence in the group as a whole. Regulation does have something to do with that.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.