Bank Regulation

This article by Mark Perry seems right to me -- the lightest touch (and probably the most effective) approach to bank regulation is to return to a regime that puts its major emphasis on capital requirements.

We can talk all day about causes of the recent financial crisis, but in my mind the root cause was taking real property with a volatile underlying value (e.g. homes) and leveraging the absolute crap out of it.   In the initial transaction, home buyers were allowed to come to the table with less and less equity, until deals were being cut with more than 100% debt.  This stupidity was a true public-private partnership, as the government kicked off the party and encouraged its growth via various community development policies as well as policies atFannie and Freddie, but private originators as well as home buyers eagerly jumped into the fray.

This debt backed by property that was already too highly leveraged was thrown into portfolios that were themselves highly leveraged, and then further leveraged again through CDS's and other derivatives.  And then the CDS's were put into leveraged portfolios.  I would love to figure out the effective leverage in the AIG portfolio.  For ever $1 million in real property that secured the mortgages they insured, how much equity did they have?  A thousand bucks?  Less?

These investors felt protected by diversification that didn't really exist.  The felt safe with AAA ratings from agencies who really didn't understand the risks any better than anyone else did.  They relaxed assuming everything was watched by government regulators who were in way over their heads.  But more than anything, they felt protected by history.  The system of putting mortgage risks into tranches, such that the top tranches could only be affected by default rates consider then to be wildly improbable, had never to that point failed to deliver its promise.   Default rates had always stayed withing expected norms.

And this is the most dangerous risk -- the risk that something will happen that has never happened before.  Default rates that seemed impossible suddenly became reality.  Tranches that were untouchable suddenly were losing large chunks of their value.  Sure, there were warning signs, but at the end of the day what happened was that events occurred that were worse than people had thought was the worst case scenario  (there is a whole body of interesting behavioral study on how humans tend to overestimate their understanding and underestimate the width of a probability distribution).

As new financial products are created and the economy evolves and the government pursues new forms of interventions in commerce, new failures can occur that have never happened before.  And never has there been invented a micro-regulatory approach that guards against new-type failures (they don't even do a very good job against old-style failures).  Capital requirements are the one approach that guard against catastrophic failures even for unanticipated risks.

It can be argued that this will raise the cost of capital, at it is true interest rates at any one point of time would have to go up.  But one can argue that the low interest rates of the 2000's greatly understated the true cost of capital, and that those additional costs were paid in a sort of balloon payment at the end of the decade.

I am still thinking this through -- I don't think any regular reader would be mistake me for someone who favors regulation in general, but I am coming around to some extent on the notion that banks are different.  I would ideally like to see a self-policing market where companies that choose to cut equity too fine just go bankrupt.  But the reality of the political-financial complex today is that this never happens -- costs of large failures are socialized, and executives who made bad choices get fat gold parachutes and Treasury jobs.

Postscript:  I have arguments all the time about whether the financial melt down was mainly caused by government or private action.  Was it a public or private failure.?  My answer is yes.

One thing that those of us who promote private action over public can never repeat enough is this:  Our support for private action does not mean that private actors don't screw up, that there are not bad outcomes, that people don't make bad decisions, etc.  They do.  Lots of them.  When these constitute outright fraud, there should be prosecution.  For the rest of the cases, though, libertarians believe that in a free society there are automatic corrections and sources of accountability.

Make a bad product - people stop buying it.  Sign a union contract with wages that are too high - you go bankrupt.  Treat your workers shabbily - and the best of them go work for someone else.  Take on too much risk - you will fail and lose all your capital.

The problem with our financial sector is not that it is not regulated -- it is the most regulated sector of the economy.   The problem is that, as always happens, there has been substantial regulatory capture.  There has been an implicit deal cut by large financial institutions - regulate me, but in return protect me.  In a sense, as is typical in a corporate state, large corporations and government have become partners.

As a result, many of the typical checks and balances on private action in a free economy have been disrupted.  In effect, certain institutions became too big to fail, and costs of failure and risk taking were socialized.

That is why the answer is not one or the other.  Certainly the massive failures were driven by the actions of private actors.  But they were driven in part by incentives put in place by the government, and their stupid behavior was not checked because traditional private avenues of accountability had been neutered by the government.    This is why the recent financial crisis will always remain a sort of political Rorschach test, where folks of wildly different political philosophies can all find justification for their position.


  1. NL:

    Investors should be able to go with a bank that has a pretty risky portfolio. The risky investments are limited by the extent to which one can convince others to risk their money or credit on his investment. People will make mistakes fairly often, but that's always going to be the case in life. As long as those mistakes are not borne by the public treasury, then the major remaining purpose of a capital reserve rule is just to protect investors from their own poor decisions. And of course, we don't really know what risk-benefit tradeoff is optimal.

    The larger problem is setting a rule standardizes everybody and halts experimentation. If the limit is too restrictive, we've decided that the entire economy must sacrifice growth for stability. If the limit is too loose, banks will likely move themselves to that bad standard and we've therefore made the entire economy more susceptible to a large recession.

    There's of course, as always, the knowledge problem. Is there one ideal capital reserve standard for all investors and all investments? Do rich investors get to gamble on lower reserves? Do younger investors have to be as risk-averse as older investors? The government is either going to set one standard (or a small number of standards), and thus force a singular standard on a host of investments where it's suboptimal, or is going to have to manage an ever-increasing army of analysts to decide how to continually modify a large number of reserve ratios in response to changing market conditions.

    The best solution is to let the banks worry about employing all these analysts to decide on market ratios. Not only will that mean more than one team will be available to research and analyze the proper ratios (where government would have just the one decision maker) but it also aligns incentives. Companies want to find the right limit, so they want to find the best rate using the best analysts. Government incentives would only be to restrict the ratio to avoid an embarrassing recession or loosen the ratio to reward favored business connections.

    The solution to a lack of perfect knowledge of risk is not to centralize all risk decisions. It's to align incentives by making investors sufficiently fear the risks to seriously analyze them. Independent oversight has a place, obviously, but the government has incentives at least as poor as independent agencies. And when the government's wrong about something, they drag everybody else with them (similar to a population's lack of a genetic diversity leading to severe vulnerability to disease). Better that some investors get it wrong making their own choices than all of them get it wrong following a government dictate.

  2. Captain Obviousness:

    I don't think you've ever written a post on whether fractional reserve lending per se is fraud. I'm not sure "fraud" is the right word if all depositors are in fact aware that the bank will lend out some multiple of its actual deposits, but to me it is very unseemly. It essentially allows private banks to have the power to create money out of thin air. Theoretically they can't create too much money or there will be a run on the bank, but in modern reality big banks have the federal government/FDIC to make sure there is never a bank run. That is a ridiculous perversion of a free banking system. In my opinion we need to either completely abolish the FDIC and explicitly state that the government will never backstop a failing bank, or we need to make fractional reserve lending completely illegal. The combination of implicit federal bailouts and fractional reserve lending creates a financial system with insanely perverse incentives.

  3. NL:

    PS: Obviously a reserve ratio is better than a whole host of micromanaging regulations, though. It'd be an acceptable transitional policy, or at least a decent compromise versus the status quo. But I don't think it's an ideal policy.

  4. perlhaqr:

    I am still thinking this through — I don’t think any regular reader would be mistake me for someone who favors regulation in general, but I am coming around to some extent on the notion that banks are different. I would ideally like to see a self-policing market where companies that choose to cut equity too fine just go bankrupt. But the reality of the political-financial complex today is that this never happens — costs of large failures are socialized, and executives who made bad choices get fat gold parachutes and Treasury jobs.

    In programming, this would be referred to as patching over a bug. If you've got a program that's generating faulty results, the correct solution isn't to write another program that makes that fault less noticeable to the end user (although this happens all the time) but instead to go in and fix the bug that's causing the faulty results in the first place.

    Further regulating banks (or any other private institution) to try and stave off these failures because the failures get socialized and the Execs get fat paychecks isn't the right answer, the right answer is to stop socializing private failure costs and rewarding Execs for destroying companies.

    IMO, of course.

  5. John Moore:

    One issue that seems to call for some sort of systemic change is that of agency problems in the private sector. A huge amount of capital is managed by people who are not the owners - such as mutual fund managers and pension fund managers. These people often have incentives contrary to their fiduciary duties - their incentives are for short term gains that look good, while their investors often want long term steady growth. This leads to the managers of capital putting inappropriate incentives on the managers of companies whose stock they hold.

    The net result: absurd overpayment of many executives, companies operated to generate short term gains at the expense of financial health, etc.

    In the banking sector the same thing existed. Mortgage brokers were incentivized to sign up anyone they could, because they got paid the same whether the borrower was able to repay or not. Banks which resold the loans were in the same position. Ratings agencies were being paid by those whose instruments they rated - putting them also in a conflict of interest.

    Although the government did plenty to get things rolling the wrong way, and keep them going, everything above is a result, as far as I can tell, of deficiencies in the free enterprise system.

    Solutions? That's tough. I think it might be appropriate to limit the maximum size of financial institutions, both because of the "too big to fail" problem and the oligopolistic effects of a few huge companies. Who knows.

  6. Matt:

    Fiat money. Fractional-reserve banking.

    Everything else is just a symptom.

  7. Mesa Econoguy:

    Coyote nails it right here:

    The problem with our financial sector is not that it is not regulated — it is the most regulated sector of the economy. The problem is that, as always happens, there has been substantial regulatory capture.

    As a result, many of the typical checks and balances on private action in a free economy have been disrupted.
    The normal feedback mechanisms and signals are so distorted and out-of-whack, it is comical trying to get a firm handle on financial system status right now.

    Signed, I work in the business.

  8. Dr. T:

    "Was it a public or private failure?"

    Physicians, when completing death certificates, record the immediate cause of death, and, when applicable, any factors that contributed. The "death" of our booming 2007 economy would be characterized as:

    Immediate Cause: Fear that financial institutions that owned mortgage-based securities would fail.

    Due to (or as a consequence of): Paulson and Bernanke creating a panic and claiming that financial institutions would collapse without massive support from government.

    Due to (or as a consequence of): Heavy federal involvement with and interference in the home financing market.

    Due to (or as a consequence of): Pandering politicians scoring points with voters sympathetic to the belief that home ownership should be universal.

    Due to (or as a consequence of): Idealistic but ignorant people who don't understand economics, simplify issues, and vote for pandering politicians

    Due to (or as a consequence of): Widespread prosperity in the USA that allows ignorant people to survive and vote.

    Due to (or as a consequence of): The brilliant and hardworking people who, over past few centuries, invented, improved, and built things that increased productivity. (There wouldn't have been a booming economy to collapse without these people.)

  9. me:

    Well said. I said it once, I'll repeat it again: Warren for president. Soon. Please?

  10. Bob Smith:

    "Do rich investors get to gamble on lower reserves"

    That's effectively what accredited investor and anti-advertising regulations (Regulation D et al) do: prevent "not rich" investors from participating in private equity. Heck, if you're not accredited you couldn't participate (due to the legal risk sponsors take even in those narrow circumstances where accepting unaccredited investors is permissible) even if there were reserve requirements. Not only does that stop the middle class from obtaining the benefits of such investments, but it keeps all those billions of dollars in middle-class investments in the fee-earning hands of a very regulatory-captured industry: stock brokerages.

  11. John VI:

    One other point you missed. Being so overly regulated by government, the bank and financial sector became beholden to the politicians that wrote the rules( see blackmailed ). When a group of social scientists created a lovely chart out of thin air claiming that banks were "racist" because they didnt lend money to people that wouldnt pay it back, they went to the government to "fix" the problem. And now we have a bunch of loans made to people that wont pay it back... imagine that...

    You yourself champion the cause of bad incentives all the time in your articles. Put a government agency in charge of any company or resources and thier incentives are best met by driving it into the ground, destroying it completely. And here we have politicians with thier hands on the gun pointed at bankers licences heads, and voila... we have bad decisions by bankers that oddly enough dramatically boost the odds of said politician being re-elected.

    Banks may be guilty of bad decisions, but if I was a banker, and the regulator in charge of my career and future tells me to loan money to people that cant pay it back, I do it. And then I put a great deal of effort into finding a way to spin that KNOWN liabilty off onto someone else, preferably back to the government.

    Gee...l bad loans ---> 2 derivaties --->3 sold to gov pension plans and fannie/freddy ---> 4 hmmmm

  12. Mike S:

    As is the case in every other industry, all the regulations are merely barriers to entry into the banking market, rather than any control or guarantee of quality or success.

    The way to "solve" banking is to:

    - Abolish fractional reserve banking. Allow the banks to only loan money that has been specifically deposited for that purpose. Depositors will research banks that loan according to their risk tolerance to trust with their deposits. Responsible banks will prosper, and banks doing that wacky derivative lending will quickly go belly up and disappear.

    - Abolish the FDIC. FDIC is paid by responsible banks to insure the losses of irresponsible banks, inciting moral hazard. It rewards risky business, which is more profitable but would break a lender without the FDIC safety-net.

    - Prohibit bail-outs. Banks will have to behave responsibly or go out of business.

    Step 2 would be to abolish the Fed and replace so-called Federal Reserve Notes with gold and silver, and bank notes, thus eliminating inflation. People could simply save, and their savings would increase in value without needing to earn interest.

    Problem solved!

  13. Henry Bowman:

    I think what Coyote is attempting to do is to modify our current system with a simple rule to minimize financial armageddon. Personally I would love to see the monetary system in the U.S. completely divorced from the government, as other commenters have suggested. In the short run, certainly, this simply is not going to happen. A return to reserve requirements of 12:1 or so would go a long way to stabilizing the current system, which appears to have been designed by the banksters for their profit. I think that, prior to the current crisis, financial institutions were leveraging at a rate of about 30:1, which seems absurdly high.

    We might consider a redesign akin to that of the Canadian banking and mortgage system. Home mortgage rates in Canada are comparable to the U.S., but the mortgage system is far more robust. It seems well worth pointing out that no Canadian banks have failed during the current downturn, so one might conclude that they are doing something right. It's also worth noting that no Canadian banks failed during the Great Depression, in stark contrast to the U.S.

    I have read a great deal on the perils of fractional reserve banking, and I am unconvinced that it is inherently evil, as some seem to think. It is certainly not fraud, simply because everyone knows what is being done with their money. Without fractional reserve banking, interest rates charged to borrowers would have to be exceedingly high (probably greater than 15%) in order for financial institutions to make any profit.This would have severe consequences for the generation of long-term capital. That said, one can make a good case that the use of fractional-reserve banking will necessarily contribute to a boom-bust cycle, with the amplitudes of the excursions closely related to the amount of leveraging permitted, as well as the interest rate.

  14. Henry Bowman:

    Sorry about the excessive use of bold in the last comment; somehow, the terminating tag was not correct, and there is no way to edit a comment on this blog.

  15. IgotBupkis, President, United Anarchist Society:

    > but private originators as well as home buyers eagerly jumped into the fray.

    Indeed, it's been my position all along that it was 60% Dems, 25% GOP, 10% private investment firms, and 5% individual greed at fault. You cannot absolve the idiots who bought houses at 100% looking to "flip" them in 12 months.

    I cannot recall the number of times I heard, here in Florida, "Real Estate never goes down!" (Yeah? Really? Were you around in the 1970s in the post-Disney land bust? No? Then STFU and go look at news articles about land/home prices in the mid-to-late-70s, you ignorant fool, and stop parroting BS you know nothing about)

    It took idiots in Congress (& Admin -- both Clinton AND Bush!) to make the scenario happen, but when the opportunity came to make stupid "me-too!" pile-ons, both companies and people hopped on with both feet.

    The companies that weathered it well (and are the ones who bought the other ones) are the well-managed ones who didn't go stupid.

  16. Smock Puppet:

    > Sorry about the excessive use of bold in the last comment;

    No excuses, Henry!! We sentence you to 3543 lashes with a wet noodle!!

    (What? Oh, come on!)

    Ok, *I* sentence you to ....

    (What? Oh, come on!)

    OK, OK -- geez: Adjudication withheld.

    But you should realize, sir, that This Is Going On Your Permanent Record.


  17. Pat:

    Warren... have you read "Jimmy Stewart Is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking" by Laurence Kotlikoff? I liked his solutions and I'd be curious to know what you thought. Here's the Amazon link:

  18. Ted Rado:

    Everything the Feds touch turns to poopoo. It would be much better to minimize government involvement in everything. The idea that a bunch of politicians and nitwits can run anything better than competitive free enterprise is insane. The Soviets tried it with complete lack of success.

    The small depositor has been protected since the depression. If a bank or other large investors want to gamble with their investments, let them do it with their own dime. I live within my means and make my own investment decisions. If a stock I buy goes south, that's my problem. The same should hold for banks. If one of them occasionally fails, so be it. It will make the others more careful. Adding more regs and government agencies does nothing other tht waste more money. Idiots and crooks will figure out a way to screw up regardless. The taxpayer should not be made to pick up the pieces. A recession caused by bank failures would probably be better than the mess we are now in.

  19. markm:

    "I cannot recall the number of times I heard, here in Florida, “Real Estate never goes down!” (Yeah? Really? Were you around in the 1970s in the post-Disney land bust? No? Then STFU and go look at news articles about land/home prices in the mid-to-late-70s, you ignorant fool, and stop parroting BS you know nothing about)"

    IMHO, boom-bubble-bust cycles prove that the only people who remember history are those who lived through it - and economic history will be repeated as soon as a sufficient number of people who went through the last bust have retired. The last bust was unusual only in two respects:

    1. The government went berserk with bailouts and other attempts to halt the workings of a free market. Bailouts have happened before, but never on such a scale. The last time so much of the economy was directly affected by governmental reaction to a market drop was the 1930's - when interventions by Hoover and then FDR turned a cyclical stock market crash into a decade-long depression.

    2. It was AFAIK the first time mortgage-backed securities were central to a bubble and bust. In the past, 20% down payments and stern credit-worthiness requirements restrained housing bubbles from going so high in the first place, and limited how much the bank was apt to lose when things went bad. Those protections were gone this time, and on top of that there were new securities that divorced the payoff/risk of holding mortgages from the gritty details of actually holding paper on houses.

  20. AUM Financial Advisors:

    Thanks for vital detailed description on the topic and I do believe mutual funds portfolio needs to be thoroughly checked for the feasibility of each of the schemes in your portfolio and analysis of your both return & risk parameter.