Why don’t we just admit that the current financial and regulatory system is dysfunctional?
We face two fundamental problems.
First, we need to clean the financial system — close weak banks more aggressively, encourage bankruptcies/foreclosures, and free good assets held by poorly financed owners. Small and medium sized businesses with quality projects are not getting loans. This problem will not be solved by tax breaks or targeting some incentives. We need structural change.
Second, the current regulatory system failed us. It needs to change. Our system is comprised of three federal agencies: the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, as well as 50 state banking departments! I am not even including the Office of Thrift Supervision and all of the Savings and Loan Institutions nor the National Credit Union Administration which supervises all the credit unions.
There are state chartered banks as well as national chartered banks. As a result of the historical maze of changing regulations, we have over 7,000 banks. There is no economic reason for 7,000 banks. It is inefficient both for the bank in providing the lowest cost and highest quality services to their customers. It is a nightmare to regulate.
What is most alarming is that none of our leaders have stepped up with bold proposals to revamp our financial and regulatory system.
To analyze these issues, let’s go back to the President’s speech of January 21, 2010 proposing two regulatory ideas.
The January 21, 2010 Speech
The President’s first proposal had to do with banks running speculative operations:
First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward.
I agree with the President on this one. I made this exact point in Davos in 2005. Indeed, I made the point directly to Senator Richard Shelby who, at the time, was the Chairman of the Senate Banking Committee.
Essentially, this means the partial repeal of the repeal of Glass-Steagall. It is partial because banks would still be able to trade risky assets for customers – but they would be prohibited from running their own proprietary trading operations. More on this later.
This proposal is now known as the Volcker rule (former Chairman of the Federal Reserve). The president said:
It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the Volcker Rule, after this tall guy behind me. Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers.
The second proposal was directed at non-banks:
There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today’s economy.
This one I do not like. Again, I will elaborate below.
It is worrisome that it took one year to come forward with such bare bones reforms. We need to push deeper.
U.S. Banking History 101
The Glass-Steagall Act of 1933 separated prohibited commercial banks from doing investment banking.
There was plenty of motivation. The U.S. economy had crashed into a Great Depression. Before the Act, many banks had practices that we would consider unethical today. For example, if the Investment Bank division held stock in a troubled company, the troubled company might get a cheap loan from the Commercial Bank division. In addition, stock that the Investment Bank held was often promoted to customers of the Commercial Bank.
All of this ended with Glass-Steagall.
By the way, the official name of the bill was The Banking Act of 1933 — and it did other important things, like establish the Federal Deposit Insurance Corporation.
In 1999, the key provisions of the Act (the separation of commercial and investment banking) were repealed by the Gramm-Leach-Bliley Act. A major proponent of the repeal was then Treasury Secretary Larry Summers. The repeal had broad bi-partisan support. The final bill passed the House (362-57) and Senate (90-8) and was signed by President Clinton.
The repeal opened aggressive expansion of commercial banks into much riskier investment strategies.
In some ways it put us back to pre-1933. Remember one of the complaints was that banks were making cheap loans to support companies that they were investing in. Fast forward to 2008. Banks were using customers’ deposits (cheap capital, and government guaranteed) to invest in their own highly speculative investments.
It is clear that we are not going back to pre-1999. Deputy Treasury Secretary Neal Wolin made said on January 25, 2009, that the new regulations are directed at the banks own prop desks. That is, banks will still be allowed to trade in risk securities for their own customers.
All FDIC-insured banks are quasi-government institutions. It does not make sense for banks to be making highly risky bets with capital that is made cheap courtesy of the U.S. taxpayer. In addition, it does not make sense for massive bonuses to be paid out when these institutions win their bets but when the bets go sour to rely on government subsidization (zero interest rates, guarantees) and bailouts.
However, it is but one piece of the problem.
Scope of Operations
The other issue is the “too big to fail”. The President proposed putting a cap on the size of financial institutions (non-banks). The idea being that no one firm should be so large to put the system at risk.
I don’t like this idea (at least applied to the current U.S. situation). Let me elaborate.
- If we measure a particular financial institution’s assets (or liabilities) relative to GDP, we really don’t have a size problem. In countries like the U.K., Beligium, Switzerland, you have individual banks that have liabilities that greatly exceed the country’s GDP. We don’t have anything like that.
- If you like the idea, where do you draw the line?
- Even if the idea is implemented, the problem is not one particular institution – the problem is with contagion. There is no difference between one big financial institution failing and a contagious reaction of many smaller banks failing. A cap on size does nothing to mitigate a systemic event.
- It will likely constrain the ability of our financial industry to compete globally.
The main problem is that it does not address the underlying issues. Lehman’s failure would not have been avoided with such a measure (Lehman was an investment bank). It wasn’t the size of Lehman that caused the problem.
Lehman failed because it took big risk. They were betting on heads and it turned out tails. Big risk means potentially huge rewards but also commensurate losses. They lost.
Lehman’s demise and the near demise of many other financial institutions might have been avoided if there was a different approach to regulation.
The immediate mess of the aftermath of Lehman was largely a result of the Chapter 11 procedures being ill-suited for financial institutions. That can be changed.
- Transfer all jurisdiction over banking to a single central authority. That is, only national banks should be chartered. This is the way banks operate in other developed countries. Currently, we have the OCC supervising about 3,000 banks and state banking departments responsible for over 5,000 banks.
- OCC and FDIC should be consolidated. The Federal Reserve should remain independent.
- Encourage consolidation of the many small banks (this is easy to do because many of them are insolvent but allowed by the FDIC to keep operating). There are many natural economies of scale that both reduce costs to customers, improve service and provide a natural hedging of risk for the bank (you do not want all your customers concentrated in one area of the country).
- Make banks fess up to the real value of their troubled loans. There are reports that FDIC staff have instructed many banks to restructure troubled loans into short-term interest-only loans. This is a terrible strategy. It assumes a robust recovery. However, the very fact that financial institutions are housing these assets that have little value – decreases the chances that they can make loans to quality borrowers. To be clear, these actions reduce the chance of a robust recovery. It simply delays the pain. Surely, we learned something from Japan’s disasterous strategy in the 1990s.
- Set up a Resolution Trust entity to house the troubled assets of failed financial institutions. I estimate that there are at least 1,000 institutions that should be closed. The financial system is not healthy until we greatly reduce the troubled loans on the balance sheets of our financial institutions. Again, we cannot continue to follow the Japanese playbook of the 1990s.
- Reserve requirements must be strongly procyclical. That is, in good times, banks must greatly add to their reserves. This provides a cushion in bad times. Our current system does not recognize this simple intuition.
- Investigate another layer of insurance called by Flannery “reverse convertible debentures” and Kashyap and Stein as “capital forbearance certificates”. Read about it here.
- Any financial institution that benefits from the explicit or implicit support of the U.S. taxpayer should be regulated. For example, AIG. The AIG disaster lead to a $162 billion bailout that cost each working American approximately $1,000.
- A new system of regulation should be streamlined (not redundant) and designed to achieve the objectives (reduce and control risk) and the lowest possible cost to the financial institution. The regulator should provide an atmosphere that encourages rather than stiffles innovation on the part of financial firms.So, I am not calling for more regulation — I am calling for less regulation but more effective regulation. It is reasonable that part of this regulation should include steps to protect consumers with common sense items such as no liar loans, no ninja loans, no prepayment penalties, transparent interest rate/fees for loans/cards, etc.
- Much of our problems are due to an explicit subsidization of the housing sector. This comes in many forms. Most Americans are so used to the deductability of mortgage interest that they don’t realize, in almost all other countries, there is no deduction. In addition, more than 90% of new mortgages are being underwritten by Federal agencies. Finally, the government has been active in the mortgage market in buying mortgage securities, thereby pushing interest rates lower. We need to re-examine all of these subsidies. The highest priority questions: (i) Should we abandon mortgage interest deductability? and (ii) Should the government be the insurer of almost all new mortgages issued?
Crisis and Leadership
A financial crisis and a recession exact a terrible human toll. It is not just about 10% of the labor force being out of a job. Millions more are not counted in the official numbers because they have given up looking for a job. Additional millions are living in fear they will soon lose their job.
I don’t think anyone doubts that a well functioning financial system is critical to the future growth prospects of our economy.
Right now, the system is broken.
In summary, we need a two pronged strategy. First, we need to cleanse the financial system. Given the current regulatory system, we need a new strategy that swiftly purges the weak financial institutions. Our current strategy of keeping zombie banks going damages the economy’s future growth and employment prospects. We need to send the message that the government is not the lender of last resort for too big to fail organizations. Second, we need a bold change in the way that we regulate our financial institutions.
Regulatory reform alone is not sufficient. The moral-hazard effects of government explicit and implicit bailouts will overwhelm the good effects of improved regulation. We need both cleansing and a fresh approach to regulation.
While a crisis has many downsides, it also provides an opportunity. It is one of the few times that bold, system-wide, changes can be implemented. The Banking Act of 1933 is a good example of bold legislation.
Am I naive?
Perhaps. However, someone needs to step up. We need more than cosmetic changes.