Sunday, June 21, 2009

Financial Regulation

Frank Rich, Simon Johnson, and many others, argues that the Obama plan for financial regulation is too tame. I think that the urge to regulate is occurring to quickly. The reason is that there is too much confusion out there on what caused the crisis. There is a great risk of putting a fence around the sheep that did not escape while the hogs run free.

For example, Rich blames Geithner and Summers for not resurrecting Glass-Steagall:
Suffice it to say that the Obama team has not resuscitated the Glass-Steagall Act, the New Deal reform that Summers helped dismantle in the Clinton years and that would have prevented the creation of banking behemoths that held the economy hostage.
Now one may think that eliminating Glass-Steagall was a bad idea, but it is hard to argue that it had any effect in causing this crisis. Bear Stearns and Lehman Brothers were not banks. Nor was AIG, of Fannie and Freddie for that matter. Had Glass-Steagall remained in force they still would have faced the same troubles. Moreover, hasn't anybody noticed that there are no investment banks left! One remedy that has been used in the crisis has been to turn investment banks into commercial banks.

Simon Johnson argues that the problem is that we have banks that are too large:
The issue was definitely not that banks and non-banks could fail in general. We're good at handling some kinds of financial failure. The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And--at least in the view of Treasury--these banks were so large that they couldn't be taken over in a normal FDIC-type receivership.
Well, we may have banks that are too large, but Canada's banks are much bigger relative to GDP and they have been relatively immune to the crisis. More important, how big is too big. Think about Bear Stearns. They were not large. No conceivable regulation could prevent banks from being larger than they were. How were they saved? Folded into JP Morgan, a much bigger bank. Lehman was bigger than Bear, but not very big in context. How would regulation prevent that kind of problem cropping up again? Paul Krugman makes a similar point here.

The most egregious error, however, seems to be the notion that securitization was problematic because the banks had no "skin in the game." Here the administration seems out of whack. According to the Washington Post, the plan requires that:
Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security...

Sales of asset-backed securities provided the bulk of funding for mortgages and other consumer lending during the economic boom, as investors spent trillions of dollars buying what was often advertised as a safe, more lucrative alternative to ordinary bonds. The process was lucrative for banks, which could quickly sell loans and use the money for new lending. It was lucrative for Wall Street, which collected fees on each transaction. And it was lucrative for investors, who made outsized profits.

But as borrowers began to default on the underlying loans, the value of the securities collapsed, and everything came tumbling down.

The administration concluded that securitization encouraged looser lending standards, because companies that sold loans to investors had little reason to care whether borrowers could repay those loans. Furthermore, employees were paid to make loans, but they were not penalized for defaults. And investors could not easily check the excesses because they lacked basic information about the contents of each security.

Hello! Hasn't anybody noted that the big problem was that the banks carried too much of this debt on their books? Banks did not eliminate all of securitizations from their books. They kept the super-senior debt on their books. This is what created the hole in their balance sheets. It was not the losses of buyers of CDO's that caused the crisis. That was a mess, and caused losses, but did not make this crisis so huge. The big problem is that Citibank, Merrill, and others kept too much super-senior debt on their books, and when prices fell their balance sheets imploded.

Why did banks do this? There are many answers, but the big one is inadequate calculation of risks. Super-senior debt was considered so secure that the returns that could be obtained from selling it was not worth the effort. The biggest problem with securitization was the way the risks were calculated. Risks that were not independent were treated as if they were.

We need to figure out how to change the incentives for institutions to do risk management correctly. That means more skin in the game perhaps, but of the executives, not of the balance sheet. But mostly we need more thought.

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