01 July 2009

Leverage Regulation Works

Was the Financial Crisis proof that regulation is incapable of preventing economic harm? No. It proved the opposite.

Commercial banking and thrift and credit union regulation didn't fail. Yes, a few dozen of these institutions, only a handful big and none "too big to fail" collapsed. Yes, a few dozen more have had bailout funds more or less forced upon them -- including a handful of "too big to fail institutions" some of whom probably needed the funds. But, these industries, because of FDIC type reserve requirements in the case of banks and thrifts, and the incentives created by depositor ownership in the case of credit unions and also downside risk concerns in the case of regional family owned banks, were not rocked to the core.

In contrast, non-bank lenders who are subject only to imperfect SEC/CFTC/FTC disclosure regulation and unregulated private transaction financial players regulated only by contract law and 10b-5 anti-fraud rules, utterly collapsed. Not a single free standing major investment bank survived as a free standing investment bank. Something like 95% of subprime lenders went out of business and both subprime lending and Alt-A lending virtually ceased to exist. Even sound mortgage backed securities were tainted by complex ones. Credit default swaps, supported by chains of CDS "reinsurers" defaulted, and far more would have defaulted if AIG, near the top of the reinsurance pyramid, had not been bailed out and nationalized. The money market came to the brink of a run that would have ruined it.

In short, 99% of reserve requirement regulated financial institutions are still here, while probably a majority of all non-bank, non-government sponsored, non-mutual financial institutions have collapsed or survived solely by dint of government assistance.

The financial crisis has shown that regulation works and that failure to regulate fails. History shows the same thing. The percentage of commercial banks failing in any given two decade period pre-FDIC frequently hit more than 50%. The percentage of commercial banks failing in any given two decade period post-FDIC approached 1%.

The FDIC works like title insurance. It micromanages what it insures in the ways that matter in advance, so that it doesn't have to clean up afterwards. The micromanagement isn't comprehensive: the FDIC basically micromanages only a couple things that matter to its insurance obligation -- reserve requirements (and there only at the bottom line level) and permitted transactions/investments (commercial banks can't go bet depositors money on the stock market no matter how sure a thing it seems to be).

But, mere transparency isn't sufficient, and transparancy also isn't necessary if substantive regulation is sufficient (banks make very little substantive disclosure of particular transactions which come under the rubric of banking privacy, despite the fact that they have the theoretical capacity to hide immense risk as they did in the mortgage backed security industry). Empirically, the SEC/Truth-In-Lending "disclosure is enough" formula of regulation simply does not work, standing alone. You either need to regulate the variables that can make a government feel it would need to do a bailout (mostly leverage), or you need to create better incentives (a la credit unions, mutual insurance companies and non-profit lenders; the Department of Education, Small Business Administration, FHA and VA didn't indulge in risky, poorly documented lending and loan guarantee underwriting in their respective subfields, for example).

When banks do get into trouble, the FDIC has another tool that has saved taxpayers (in the short term) and FDIC premium payers (i.e. banks) in the long term, huge sums of money, while protecting the vast majority of uninsured deposits as well. It has the power to make pre-bankruptcy loans that have the priority over other creditors of post-bankruptcy debtor-in-possession lending, and the ability to quickly sell the assets of troubled institutions free and clear of creditor claims without a full fledged bankruptcy (a bit like the Chrysler sale to Fiat), in a way that stiffs shareholders and some long term creditors, but protects trade creditors and depositors.

The Fed didn't have these powers in the Lehman case, perceived, not necessarily rightly as a key domino that collapsed, and these FDIC powers are the ones the Obama Plan obliquely mentions and delegated to regulatory wonks and Congressional staff to implment in detail, when it talks about given the Fed power to intervene pre-bankruptcy in non-bank situations.

Regulating leverage, either directly, like the FDIC and the Fed do with commercial banks and thrifts, or indirectly, though improved incentives that better align the incentives of people who use other people's money with the incentives of those who are providing it, is a key element of any regulatory program to make our economy more robust.

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