A critique of the President’s financial regulation reforms

Posted by Richard A. Posner, Circuit Judge, U.S. Court of Appeals for the Seventh Circuit; University of Chicago Law School, on Thursday July 23, 2009 at 10:09 am
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Editor’s Note: This post is the first part of a two-part series by Richard A. Posner, and is based on a recent article in Lombard Street.

On June 17, the Treasury Department issued an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation. The Report (as I’ll call it) is a blueprint for reform of financial regulation, with the aim of preventing another financial crisis. In this first part of a two-part article, I discuss weaknesses in the overall approach that the Report takes to the problem of reform, as well as weaknesses in the Report’s proposals for limiting “systemic risk.” Part II (which will be published in August) will discuss the proposals concerning executive compensation and consumer and investor protection, and will also suggest some alternative proposals for regulatory reform.

The Report’s fundamental weaknesses are its prematurity, overambitiousness, reorganization mania, and FDR envy. Let me start with the last. It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Franklin D. Roosevelt’s initial months in office. Under Roosevelt, within what seemed the blink of an eye, the banking crisis was resolved, public-works agencies that hired millions of unemployed workers were created, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report cannot be implemented in months or years, or perhaps even in decades—as would be apparent had the Report addressed costs, staffing requirements, and milestones for determining progress toward program goals and had the Report attempted an overall assessment of feasibility.

The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don’t like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine; it is not necessary to find out what you’re allergic to. But generally, and in the case of the current economic crisis, unless the causes of a problem are understood, it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically, and are not obvious though they are treated as such in the Report. (Remember, the Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission’s investigation of an earlier unforeseen disaster.

The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly—a kind of collective madness—on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (duped into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out many potential causes that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge—$12 trillion—and the banks (a term I use broadly, to include other financial intermediaries as well) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitously.

Alan Greenspan has argued that because the Federal Reserve controls only short-term interest rates, and mortgage interest rates are long term, the pushing down and keeping down of the federal funds rate (the interest rate at which banks borrow from each other overnight in order to meet loan demands) could not have created the bubble. I disagree. Short-term and long-term interest rates are linked in a variety of ways, one of which is that many mortgages in the bubble era were “ARM” (AR = adjustable rate) mortgages. That is, the interest rate was adjusted from time to time, rather than being fixed, to track changes in prevailing interest rates, and usually the adjustment was based on current short-term rather than long-term interest rates. Another linkage is that banks tend to borrow short and lend long, and the difference between the short-term interest rate they pay and the long-term interest rate they charge generates a spread that includes profit. Competition limits profits and hence tends to push down the interest rates that banks charge when the interest rates they pay fall. In any event, when the Fed finally raised the federal funds rate, mortgage rates followed and the housing bubble collapsed.

The Report also does not mention as a causal factor in the crisis the Bush Administration’s large annual budget deficits, even though these deficits have made it difficult for the government to dig the economy out of its hole without setting the stage for a high rate of inflation, heavy taxes, devaluation of the dollar, or increased dependence on foreign lenders. The Federal Reserve may have to push up interest rates in order to head off these looming consequences, but if it does so this will retard the recovery.

There is no mention in the Report of the deregulation movement in banking, which enabled banks to make riskier loans than in the old days when regulation discouraged competition in banking. There is no mention of lax enforcement of existing regulations either. Regulatory errors are tepidly acknowledged but ascribed to defects in the regulatory structure—the sort of thing a government reorganization might repair — and of course the Report goes on to propose an ambitious reorganization. One gets the sense that the solution to the problem of financial collapse was chosen first, and the problem was then fitted to the solution.

The regulators were asleep at the switch. That is the elephant in the room that the Report ignores. When suddenly awakened last September by the financial crash, regulators reacted with spasmodic improvisations that sapped business and public confidence. The Report is scathing about the financial incontinence of bankers and consumers but complacent about regulatory failures, perhaps because authors of the Report were implicated in that failure and (a related point) because the failure was bipartisan; the deregulation of banking began in the Carter Administration. Since many of the Report’s authors are economists as well as officials, it is unsurprising that the Report also does not mention the complacency of and errors by the economics profession as causal factors in the crisis. The omission to mention budget deficits may reflect the fact that the current Administration’s programs will create additional huge deficits.

The emphasis the Report places on the folly of private-sector actors—investors, consumers, credit-rating agencies, and above all bankers—ignores the possibility that most of these actors were behaving rationally given the environment of dangerously low interest rates, complacency about asset-price recognition (the bubble that the regulators ignored), and light and lax regulation—an environment created by the government. Again, it is unsurprising, given where the Report is going, that it should depict the problem as having been created by private rather than public folly. Since the Report’s solutions will be a series of structural changes in government that will prevent regulators from repeating their mistakes, the logic here is that there is no need to dwell on those mistakes, which would only shake the readers’ confidence in the Report’s proposals, which depend on regulators’ being competent.

Now when I say that the Report places misplaced emphasis on the behavior of the market participants as distinct from the regulators, I mean misplaced on the basis of what we know, or at least of what I think I know. I may be wrong, but my point is that it is too early to draw firm enough conclusions about the causes of the crisis to base radical policy changes on those conclusions. Remember that economists are still debating the causes of the Great Depression and of its unusual severity relative to economic downturns before and since. This suggests that no account of the causes of our current depression is likely to be definitive, no matter how long we wait for the account. But the causal account in the Report is notably thin, one-sided, unsubstantiated, and implausible. And yet the validity of its proposals hinges on the accuracy of its causal account.

The Report is premature in a second sense, one illustrated by the proposals (discussed in greater detail in the second part of this two-part article) for limiting the provision of credit to high-risk borrowers. In an economic boom, thrift (restraint in consumption) reduces the amplitude of the business cycle by reducing consumption and increasing savings, savings that can be reallocated to consumption at the bottom of the cycle. Thus thrift makes the peak of the cycle lower and the trough higher. But in the trough of the cycle, thrift, by reducing consumption, retards economic recovery, because the less that people spend on consumption goods the less production there is and therefore the higher the unemployment rate, which by reducing incomes further depresses spending, which further depresses production, and so on. To tighten credit at the bottom of the cycle is therefore bad timing. And while the Report creates the impression that high-risk borrowers are feckless consumers unable to curb their greed for material goods, many high-risk borrowers are small businesses dependent on credit-card debt to finance their business.

Furthermore, throwing a raft of proposals at the banking industry while the industry is struggling to regain its footing is sure to distract the banks’ management, not to mention the Administration’s economic team. There is a danger, in short, of information overload. And some of the proposals are contradictory, which reinforces their effect in increasing the uncertainty of the economic environment. For example, the banks are instructed not to make unsafe loans, but the Community Reinvestment Act, which encourages lending to “underserved” individuals and communities, is to be vigorously enforced, even though many of the individuals intended to be protected by the Act are poor credit risks.

The proposals are presented as if their merit were self-evident and required no argument or evidence. A more thoughtful document would have discussed the objections to each proposal and explained why in the authors’ view the objections were not decisive. Consider the proposals for substantial reorganization of the regulatory structure. Government officials and politicians typically respond to a government failure (in this case the failure to prevent the economic crisis that has engulfed us) by proposing a reorganization, because reorganizations are relatively cheap, visible, and easily explained. More precisely, plans for reorganizations are cheap and visible, and plans are the easy part; it is at the stage of implementation that government falls down. But even when the plan leads to an actual reorganization, the reorganization usually fails, because of inertia, turf warfare, passive resistance, and lack of follow through, leaving in its wake more bureaucracy. One of the Report’s proposals is to create a powerful new agency for the protection of consumer borrowers, and this agency, if it is ever actually created, will overlap and scrap with the Securities Exchange Commission and the Commodity Futures Trading Commission. Another proposal, to create a National Bank Supervisor (NBS), will lead to conflict with the Comptroller of the Currency, who regulates national banks. (The Comptroller is to give up his “prudential responsibilities” to the NBS.) There is also a plan to create a council of regulators, the “Financial Services Oversight Council,” layered over the regulatory agencies themselves, and if the council is not merely a committee of kibitzers, it will complicate the regulatory process.

We have seen a similar process at work in the national intelligence field. After the security agencies failed to prevent the 9/11 attacks, the system was reorganized by the creation of the Department of Homeland Security, the Office of the Director of National Intelligence, the National Counterterrorism Center, the National Security Branch (in the FBI), and other entities. Many competent observers believe that the result, after several years, has been to create new layers of bureaucracy, turf wars, overstaffing, and confusion, rather than improved performance.

As I have said, the Report is highly critical of the competence of bankers, consumers, and other private persons, but uncritical concerning the capacities of regulators. Regulators’ failure to anticipate and head off the financial crisis is noted in passing but is assumed to be easily eliminated in the future by altering the regulatory structure. Politics, as an impediment to effective regulation, is not mentioned. The Report worries about actions by private persons that can precipitate an economic crisis, but not about actions (or inaction) by regulators. Its concern with market failures is not matched by a concern with regulatory failure. If brilliant bankers screw up, why not not-so-brilliant regulators? Don’t the enormous disparities in income between successful bankers and financial civil servants have implications for the competence of the latter? And isn’t there a revolving-door problem?

Congressman Barney Frank made a telling comment in an interview with Charlie Rose last fall. He said that the basic problem in the regulation of banking is that financial regulation lags financial innovation. This problem is compounded by the dependence of regulators on information supplied to them by the regulated firms, which have of course superior knowledge of their own businesses. As soon as the proposals in the Report are implemented (if they ever are), or even before, the banking industry will game them, looking for loopholes and openings for counter strategies, and as a result when the next financial crisis hits it won’t look like the current one and the regulators may be unprepared and ineffectual.

If one may judge from the current crisis, which is global, regulatory organization is uncorrelated with failures of financial regulation, for the nations’ regulatory structures are diverse, but none is pointed to as a model for the United States. So before adopting a new structure, why not try improving the performance of the existing one? I shall make some suggestions to this end in Part II in this series.

Finally, despite its length, the Report is lacking in detail. There is nothing about the cost of implementing the proposals, the staff required to man the new agencies and shoulder the new regulatory responsibilities that are to be imposed on the existing agencies, the time it will take for implementation, or the methods of determining the capital requirements of the banks and other financial institutions that are believed to create “systemic” risk (a concept I will examine in Part II). No evaluation of the feasibility of the package of proposals is possible without careful attention to impediments to implementation.

So there is a sense in which the 88-page Report is at once too short and too long: too long to be a statement of principles that would provide a basis for discussion, too short to enable an assessment of the desirability and feasibility of the specific proposals that the Report makes.

Probably the most important proposal in the Report gives the Federal Reserve responsibility for regulating financial companies that it deems pose “systemic risk.” The Federal Reserve and the Federal Deposit Insurance Corporation between them exercise comprehensive authority over commercial banks, particularly (in the case of the Federal Reserve) banks that belong to the Federal Reserve System (but I’ll ignore that detail). Runs on insured banks are rare, because depositors are insured; and while banks have uninsured creditors, the usual sequel to a bank failure is for the bank’s liabilities as well as assets to be assumed by another bank. Member banks of the Federal Reserve System can moreover protect themselves from insolvency caused by lack of liquidity (which might occur because the bank could not liquidate assets fast enough to meet withdrawal demands) by borrowing from the Federal Reserve itself, which by a mere computer keystroke can increase the cash balance in a bank’s account with the local federal reserve bank. (This is called “borrowing at the discount window,” an archaic phrase that confuses people about how the Federal Reserve System operates. There is no window and “discount” just means loan.) There is little concern that a string of commercial-bank failures would precipitate a recession or depression.

The crisis that engulfed the financial system last September primarily involved what is called the “shadow banking” system, which is to say the financial intermediaries that provide bank-like services (such as lending borrowed capital) but are not regulated as commercial banks. The shadow banking system provides in the aggregate more credit than commercial banks do. The shadow banks were heavily invested in securitized debt, particularly mortgage-backed securities, that soured when the housing bubble burst. Commercial banks, however, were also heavily invested in such debt.

An illustration of the perils of nonbank banking is provided by the commercial-paper market. Checkable money-market accounts are close substitutes for demand-deposit accounts in commercial banks, and they pay interest, which until 1986 commercial banks were not permitted to pay on demand deposits. To be able to pay interest, the money-market funds have to be able to earn interest with their depositors’ money, which they do by using those deposits to buy debt, such as commercial paper. The term refers to short-term unsecured promissory notes issued by companies that have sterling credit records, such as Proctor & Gamble, to finance their day-to-day operations. Sometimes these notes are issued directly to money-market funds, but more commonly they are issued to broker-dealers (firms that either broker, or deal in—that is, buy and sell—financial instruments), such as the ill-fated Lehman Brothers. The broker-dealers issue their own commercial paper to the money-market funds, and the cash they receive in return (that is, the money they borrow from the funds, the commercial paper being their promise to repay) is what they use to buy commercial paper from, which is to say lend to, nonfinancial companies such as Proctor & Gamble. Lehman thus was a dealer in commercial paper—an intermediary between nonfinancial issuers of commercial paper and money-market funds. Because it had a lot of risky investments (such as mortgage-backed securities) in other parts of its business, it defaulted on the commercial paper that it had issued to money-market funds, that is, failed to repay the money it had borrowed from them. This caused a run on those funds—because they were not insured—until the government stepped in and agreed to insure them. Since Lehman, broke, could no longer buy commercial paper, the nonfinancial issuers drew on the standby lines of credit that they had with banks; as a result the banks had less money to lend to the many firms that were clamoring for bank credit in the crisis atmosphere of last fall.

Lehman and the money-market funds were, for all practical purposes, acting as banks, which is to say lending borrowed capital, but their borrowed capital was not insured and they were not regulated by the banking authorities. The Report proposes that the Federal Reserve be authorized to designate a nonbank as a Tier 1 Financial Holding Company (FHC) and, having done so, to place restrictions on the bank’s capital structure, management, and operations (including its compensation practices, which I discuss in Part II) designed to prevent a repetition of the failure of Lehman Brothers and the near failure of other broker-dealers, such as Bear Stearns and Merrill Lynch. For example, the Fed could require a Tier 1 FHC to increase the amount of its capital or reduce its debt-equity ratio (leverage).

The basis for classifying a firm as a Tier 1 FHC would be that it poses a “systemic risk,” meaning that its failure, like that of Lehman Brothers, could endanger the financial system, or the larger economy. Usually this would be because of the firm’s web of direct and indirect relations with other participants in financial markets, such as, in Lehman’s case, the money-market funds, the nonfinancial issuers of commercial paper, and the banks that had issued standby letters of credit to those issuers.

Another example of the problem of systemic risk involves what is called “prime brokerage.” Some broker-dealers provide extensive financial services to other financial firms, such as hedge funds, notably by holding the hedge fund’s money, much as a broker-dealer holds an individual’s investment in a customer account, while the hedge fund is between investments and needs somewhere to park its money. When the broker-dealer, normally because of proprietary trading (that is, speculating, often with borrowed capital) or other risky activity, gets into financial trouble, the hedge fund will quickly withdraw its money from the broker-dealer, for like a person with a money-market account (before those accounts were insured), a hedge fund is merely an unsecured, uninsured creditor of the prime broker. A run by hedge funds seeking to withdraw their money before the prime broker declares bankruptcy can bring down the broker. And if, because of the broker’s insolvency, the hedge fund in turn gets into financial trouble, this will precipitate demands for redemption by the hedge fund’s investors, and thus another run, with the result that the hedge fund may collapse along with the prime broker.

The simplest solution would be to forbid broker-dealers to trade on their own account or engage in any other speculative or highly risky financial activities; and perhaps that is what the Federal Reserve will do to broker-dealers that it classifies as Tier 1 FHCs. Nor need it stop with broker-dealers, since other financial intermediaries that operate as critical nodes in the global finance network can also, if they collapse, carry much of the financial structure down with them.

The Report rejects the idea of specifying criteria for classifying a firm as a Tier 1 FHC, because it does not want to tie the Federal Reserve’s hands, or enable a firm to skirt classification by keeping just under whatever threshold in terms of assets or inter-connectedness with other financial intermediaries that Congress, or the Fed by regulation, might set. But by granting the Fed unchanneled discretion to subject firms to draconian restrictions, the proposal, if adopted, would endanger the Fed’s prized political independence. As long as it just manages the money supply and regulates commercial banks, which are the instruments by which it manages the money supply by adjusting short-term interest rates and thus the money supply by altering banks’ cash balances, it is engaged in a limited, technical activity that does not involve picking and choosing among individual firms outside the commercial-banking industry. But once it has a roaming jurisdiction to place the mark of Cain on whatever firm it deems a potential source of systemic risk, it is bound to be accused of playing favorites and invite political interference by an Administration and Congress.

The Report does not consider how the banking (including shadow banking) industry will try to game the Federal Reserve’s systemic-risk authority, but try it will. On the one hand, some banks may try to become Tier 1 FHCs on the ground that, since the Fed will not allow such a firm to fail, lest the potential systemic risk that by definition it is believed to pose becomes actual, it will be immune from bankruptcy and therefore able to borrow money at a lower interest rate than its competitors. But this seems unlikely, since recent experience teaches that when the government bails out a failing firm, it may impose conditions that wipe out not only shareholders and managers but also creditors, even secured creditors. Moreover, the Report recommends giving the Federal Reserve the power to “resolve” a failing Tier 1 FHC, a term that refers to the streamlined administrative bankruptcy procedure that bank regulatory authorities employ when a commercial bank or a thrift goes broke. As in conventional bankruptcy, the usual consequence is that the shareholders are wiped out and the creditors recover only a small fraction of their claims. And recalling creditors’ unhappy experience in the Chrysler and (in all likelihood, though it is still under way) General Motors bankruptcies, a firm classified as a Tier 1 FHC may find itself unable to borrow at attractive rates because lenders may fear that if it gets into trouble and has to be “resolved” it will be dealt with mercilessly by the bank regulators, as a macroeconomic culprit, and its creditors wiped out.

Not that it is certain that “resolution” or any other form of bankruptcy would be the fate of a Tier 1 FHC that got itself into deep financial trouble, as firms like Citigroup and Merrill Lynch did last September. The Fed might decide that the shock value of bankruptcy would be too unsettling for the economy, or that just the mechanics of taking over and running a giant financial institution would be too much for the Fed or other “resolver,” and so the institution should be bailed out with minimum harm to creditors, as was done last fall (except with respect to Lehman Brothers). Government has problems with precommitment; it cannot tie its hands the way a private firm, by signing a contract, can do; and it does not want to. So creditors can always hope that, when the chips are down, the government will balk at allowing Tier 1 FHCs to fail and be “resolved.”

Nevertheless, although Tier 1 FHCs might turn out in a crisis to benefit from their status, it seems equally and perhaps even more likely that firms that are candidates to be classified as Tier 1 FHCs will decide they’d be better off by spinning off enough of their operations to avoid the classification and so the restrictions that come with it. For example, a broker-dealer that, like Lehman, was both a dealer in commercial paper and a trader on its own account might be better off spinning off its trading operations, so that its shareholders would have shares in two companies, rather than continuing in its dual role and be subjected to restrictions that might make its trading unprofitable by preventing it from making attractive deals that were highly risky.

And the restrictions that the Fed could place on Tier 1 FHCs might make them noncompetitive with foreign banks regulated under looser standards. It is a terrible fate to be a regulated company forced to compete with a nonregulated, or less regulated, company. Candidates for Tier 1 FHC classification might take extraordinary steps to avoid being so classified.

Yet even if all firms that pose systemic risk decided to shrink, or to reduce their interactions with other financial firms, systemic risk would not be eliminated. For such risk is a property of the financial system rather than of individual firms. Systemic risk is correlated risk. If the entire banking industry were heavily invested in home mortgages, and a housing bubble caused a drastic fall in the value of those mortgages, it wouldn’t matter if the industry consisted of 10,000 banks of equal (and therefore equally small) size that had no dealings with other financial firms. The whole industry would be brought down.

We know from the events of last September that financial intermediaries can create “systemic risk,” but it does not follow that we need a new regulatory regime to deal with it. The crisis was the product of regulatory error and inattention. The Federal Reserve pushed interest rates too low earlier in this decade and missed the fact that as a result there was a housing bubble in which the banking (including the shadow-banking) industry was deeply invested. Despite warnings, the Federal Reserve failed to formulate a contingency plan to deal with a possible financial collapse, and failed even to inform itself about the structure and practices of the shadow-banking industry, as it could easily have done. It was no secret that Lehman Brothers occupied a key position (along with other broker-dealers, such as Merrill Lynch) in the commercial-paper market. Fed Chairman Ben Bernanke and then-Secretary of the Treasury Henry Paulson, Timothy Geithner’s predecessor, argued that the Federal Reserve could not have saved Lehman Brothers because a loan to the firm would not have been adequately collateralized. I find this hard to take seriously, as the Fed can (and could last September) lend to a nonbank in an emergency, provided the loan is secured to the Fed’s “satisfaction,” a criterion that gives the Fed broad discretion. However, statutory clarification of its authority to make any loans necessary to avoid financial calamity would be appropriate, if only to make it impossible for such an excuse for fatal inaction to be advanced in future crises.

There is a danger that the Fed will be distracted from its core function of managing the money supply if given the new responsibilities that the Report recommends it be given. The danger is acute because the Fed’s mismanagement of the money supply appears to have been a major cause of the financial crisis. One critic of the proposal to make the Federal Reserve the systemic-risk regulator has compared it to responding to an accident committed by one’s teenage son by giving him a more powerful car.

If, as I believe, the financial collapse is rooted in regulatory mistakes, expanding the responsibilities of the regulatory agency that made the most serious mistakes seems a perverse response. The problem was not lack of authority but lack of foresight and knowledge. And that problem, to the extent solvable, should be dealt with by enlarging the capability of the Federal Reserve, the Treasury Department, and perhaps other entities in the government to conduct financial intelligence gathering and analysis and to do contingency planning for responding to macroeconomic emergencies.


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