A Failure of Regulation.
How to reform Regulation to
avoid a relapse.
Chapter 1 – A
Failure of regulation
Much
has been said and written on the causes of the financial crisis of 2007/2009.
Fingers have been pointed at the lax
monetary policy operated by the Fed following the recovery from the bursting of
the tech bubble. Others have made a connection with the liquidity created by
the structural payments imbalances which forced surplus countries to dump their
excess savings on the US credit markets, forcing long term rates to lose their
linkages with the Fed’s traditional control over short term interest
rates.
Who
can forget the amazement of Alan Greenspan at seeing the Fed’s loss of influence
over the long term end of the interest rate curve, which amazement Greenspan had
described as ‘conundrum’?
Some
have blamed the crisis on the inability of banks to self regulate and their
indulging in excessive leverage to reap increased profits, leading to outrageous
executive bonuses.
Some
have blamed the lax control on the initiation of sub-prime mortgages and on the
distribution model for mortgage backed securities by major banks who had no
contact whatsoever with the mortgage borrowers underlying their CDO’s; such that
banks were totally blinded by their defective mathematical models on the true
credit worthiness (or lack of it) of the borrowers underpinning their exposure
to sub-prime mortgages.
Why not blame the
Rating Agencies who at the very least have to carry responsibility for stamping
high ratings too liberally on the Alt A super senior tranches of the CDO’s,
performing the financial equivalent of the miracle of Cana, transforming water (
probably dishwater) into fine wine?
Should we
exculpate the gullible mortgage borrowers who allowed themselves to be duped
into believing they can afford mortgages clearly beyond their ability to
service, purely on the utopian expectation that such mortgages can be
continually refinanced as their property undergoes an eternal increase in market
price?
A few have also
blamed the US Treasury for mishandling the problems of Lehman Brothers which was
the triggering event for the financial meltdown and the near complete seizure of
the credit markets in the last quarter of 2008 and the first quarter of 2009.
They argue, in my view rightly, that allowing Lehman to file for bankruptcy made
a dangerous situation tragic, and the extremes could have been avoided if Lehman
were nationalised and subjected to an orderly wind down.
These, and
others, are all valid contributory causes to the financial turmoil experienced
in 2008/2009. What is however underpinning most of these causes is a failure
of regulation.
If regulation
were effective banks would not have been allowed to over-leverage and take
extreme risks jeopardising their own existence. If regulation were effective
banks would not have turned their investment banking divisions into hedge funds
financed by ordinary deposits. If regulation were effective banks would not
have been allowed to warehouse enormous quantities of Alt A high rated sub-prime
CDO’s on their own balance sheet and would not have been allowed to take
substantial risks off balance sheet through SIV’s and such like investment
vehicles. If regulation were effective Banks would have had a much more
comfortable cushion of own capital to face the downturn and financial crisis
without the resulting loss of confidence.
So this financial
crisis has been a failure of regulation. This is not to say that Bank
Regulation, if properly dosed and rigorously applied, could have saved the
economy from the entire crisis. But even if a crisis would have occurred it
would have been an asset price crisis and not a credit crisis. It would have
hurt investors who invested their own money in over-priced assets but would not
have affected the strength of the banking system through clogging of the credit
mechanism and erosion of banks’ capital through market value losses on their
assets.
With proper
regulation the 2007/2009 crisis could have been an asset price property bubble
like the technology bubble of the year 2000 where the banking system remained
strong and capable of keeping the plumbing of the credit markets operating
efficiently to help pull the economy out of a mild recession or even prevent
such recession altogether.
So yes this
financial crisis was mostly a failure of bank regulation!
And if proof were
needed that this was so, one need look no further than the testimony given by
the ‘eminence gris’ of light touch regulation and self regulation, the longest
serving Chairman of The Federal Reserve, Alan Greenspan.
On the morning of
October 23, 2008, Greenspan, who had retired from the Fed for some 33 months
earlier, was back on Capitol Hill to give evidence before the House Committee on
Oversight and Government Reform, that was enquiring into what led to the
sub-prime crisis.
Chairman of the
Committee, Democratic Congressman Henry Waxman, asked:
“Dr Greenspan,
you were the longest serving Chairman of the Federal Reserve in history and
during this period of time you were, perhaps, the leading proponent of
deregulation of our financial markets.... You have been a staunch advocate for
letting markets regulate themselves. Let me give you a few of your past
statements :
“There’s is
nothing involved in federal regulation which makes it superior to market
regulation”
“There appears to
be no need for government regulation of off-exchange derivative
transactions”
“We do not
believe a public policy case exists to justify government
intervention”
My question for
you is simple. Were you wrong?”
Greenspan
replied:
“Partially. I
made a mistake in presuming that the self-interest of organizations were such
that they were best capable of protecting their own shareholders and their
equity in the firms. ..... The problem here is something which looked to be
very solid edifice, and, indeed, a critical pillar to market competition and
free markets, did break down. And I think that, as I said, shocked me. I
still do not fully understand why it happened and obviously, to the extent that
I figure out what happened and why, I will change my views.”
Greenspan, an
acolyte of the great libertarian philosopher and believer in free markets, Ayn
Rand, admits in Congress that he made a mistake! News rarely comes in crisper
formats.
He continued:
“ To exist you
need an ideology. The question is whether it is accurate or not. What I am
saying to you is yes, I found a flaw. I don’t know how significant or
permanent it is, but I have been pretty distressed by the fact..... I found a
flaw in the model that I perceived as the critical functioning structure that
defines how the world works, so to speak.”
Waxman retorted:
“You found a
flaw? In other words, you found that your view of the world, your ideology,
was not right. It was not working.”
Greenspan
replied:
”Precisely!
That’s precisely the reason I was shocked. Because I had been going for forty
years, or more, with very considerable evidence that it was working
exceptionally well.”
A greater
admission than that is almost impossible. The person who had persuaded
Congress that it was not necessary to regulate financial derivatives and that
the evolution of financial derivatives without any regulatory strings attached
was a blessing, as risk was spread thinly across a wide spectrum of investors,
ensuring that when the shock came no single institution would be brought down,
could not preview that the opacity of the system he allowed would on the
contrary threaten to bring down the whole system.
So let me repeat
in block capitals:
THE 2007/2009
FINANCIAL CRISIS WAS A GROSS FAILURE OF BANK REGULATION.
Chapter 2 – Self
regulation model was bound to fail
So Greenspan
admits he made a mistake in presuming that the self-interest of organizations
were such that they were best capable of protecting their own shareholders and
their equity in the firms.
But how could any
rational person make such mistake? Anybody with an average level of
intelligence can understand that in the game theory the prisoners will never go
for the optimum solution which would clearly result from their rational
collaboration if they were dealing with each other through open
communications. The market is much more complicated than the prisoners’
dilemma. Rather than just two players there are hundreds of players each
trying to outperform peers.
It would be
utopian to expect banks to behave collectively in a rational manner by uniformly
avoiding undue exposures to protect from systemic risk, as if banks had perfect
knowledge of each others’ strategies and a clear vision of the consequences
resulting from departure from such perfect collaboration.
Reality is
different. Banks operate in strong competition with each other and the
markets judge banks’ management by their quarterly results. If one bank
departs from perfect collective rationality and starts operating more
aggressively, taking on more leverage to achieve better short term results, it
will not be long before many of the other operators will be forced by market
expectations to adjust their strategies to compete as aggressively. Before you
know it risk has notched up a few steps across the whole financial
markets.
Greenspan
argument must have assumed that since banks’ management are themselves
substantial shareholders in the organisation they lead, mostly as a result of
having part of their remuneration packages paid in blocked shares or share
options, they would, in self-interest, steer clear from taking short term risks
that could prejudice the value of their long term investment in the equity of
their own firms.
Reality has
proven otherwise. The CEO’s of Bear Stearns and Lehman Brothers at the time of
their failure ( or in case of Bear Stearns near failure before it was saved by
JP Morgan Chase in a Fed/Treasury assisted takeover) had most of their personal
wealth locked up in equity holdings of the organisation they were leading.
But it is clear
that beyond a certain level of wealth, the motivation comes more from the honour
and satisfaction of winning ( or perception thereof) in the markets, rather than
in cautious capital preservation.
Especially when
banks reach a certain level of size which helps to solidify the perception of
being too big to fail, bank managements consider themselves protected enough on
the downside to take further risks to extend the upside.
Only proper and
effective regulation could force banks to avoid leverage and exposure which
could present risks to the whole system. In the absence of a situation where
banks are broken down into extremely small pieces, resulting no doubt in
substantial and very undesirable lack of efficiency in serving clients as they
need to be served in a global economy, regulation has to be pro-active enough to
bring into line, in a very timely manner, any bank that breaks away from the
long term collaborative maximum return option of the prisoners’ dilemma, in
order to secure for itself short term advantage over its competitors.
This is the
antithesis of the self-regulation so adored in the Greenspan era. It is
regulation which has to be dynamic and effective in the old traditional way
where a Regulator’s nod, wink or raised brows would be more important than the
written rule.
This is
particularly relevant in the area of risk management. History shows that
financial strategies that start as a risk management tool, end up being
themselves an instrument for leveraging risks. This is exactly the history of
how Credit Default Swaps (CDS) came into being. They were ‘invented’ by the
JP Morgan gang in order to reduce balance sheet credit risks of the Bank versus
major corporations. They finished up being copied and imitated by the whole
market that extended the concept to sub-prime mortgage area where statistical
evidence of past performance was much more thin than in case of corporate
defaults over the economic cycle. It is no coincidence that J P Morgan was one
of the banks least hit by the sub-prime crisis. As ‘inventors’ of the CDS they
had better appreciation than competitors of the inadequacy of their ‘invention’
in the mortgage field, especially as there was no historical data related to
property values in the context of a nation-wide property crash.
In the next
Chapter I will discuss what sort of regulation model is the most effective.
Given now that there is a wide consensus on the need of effective Regulation and
on the ineffectiveness of the self-regulation model, the next challenge is the
promulgation of a globally accepted and harmonised Bank Regulation model which
discourages or allows no space for regulatory arbitrage and which is dynamic and
effective to ensure that we do not face a recurrence of the financial crisis, at
least in our lifetime.
But before
leaving this Chapter, I would touch on the reconfirmation of Ben Bernanke as the
most important guardian of the international financial system in his capacity as
Chairman of the Federal Reserve Bank in the US.
Bernanke’s
reconfirmation process was hard work. Given that he was appointed by a
Republican President and was being put up for re-confirmation by a Democrat
President, one would have been forgiven for thinking that his re-confirmation
would have sailed plainly through the US Congress. It was not so. In the end
the 30% negative vote was the highest a Federal Reserve Chairman nominee ever
got and even some of those who in the end voted for Bernanke’s re-appointment
were quite critical in the appointment hearings. In the words of one
Republican Senator who voted for Bernanke’s re-appointment in spite of critical
posture during the hearings, he justified voting for Bernanke on the fear that
in case of failure, the President would nominate someone worse. The sort of
better the devil you know approach.
The reason for
this ambivalence versus Bernanke’s suitability for the job is not difficult to
understand. As a fire-fighter once the financial crisis started, Bernanke
performed admirably. With a deep knowledge of how the crisis of 1929 led to
the Great Depression of the thirties and fully understanding the policy errors
made by the Federal Reserve at the time which only compounded the risks of
depression, Bernanke was probably the best man to have in the position of
Chairman of the Federal Reserve during the crisis.
He was a
financial fire-fighter par excellence and performed admirably, often going to
the extreme edges of the legal limits of his authority to save the system from
imploding whilst the legislators were totally out of their depth in
understanding the seriousness of the crisis, let alone in providing timely legal
solutions for it.
As a
fire-preventer however Bernanke ‘s guilt for not preventing or previewing the
crisis could not be much less than that of Alan Greenspan. He was a member of
the Board of the Federal Reserve for most of the noughties prior to his
appointment as its Chairman In January 2006. And for the short period he was
not on the Federal Reserve Board he was the Chairman of President G W Bush’s
team of economic advisors with close linkages to the Treasury and the Fed.
There is no
evidence that Bernanke ever showed serious dissent with Greenspan’s decisions,
especially with his credo in the self-regulation model and on the excessively
lax monetary policy following the bursting of the tech bubble.
History shows
that Bernanke is a very efficient fire-fighter but if the crisis is behind us
who wants a fire-fighting expert to rebuild a shaken edifice? What was needed
was someone with a track record of capability to organise both effective legal
bank regulation manuals and,perhaps more importantly, someone who can use the
moral suasion authority of his position to budge the regulated entities to stay
on the straight and narrow.
If such person
does not exist, given that we have not experienced a similar financial crisis
since the thirties, than my hope is that the experience of 2007/2009 has been a
learning experience for Bernanke so that for the future he can be not only an
effective fire-fighter, but perhaps more importantly, an effective
fire-preventer.
Chapter 3 – An
effective Bank Regulation model
Unless we want
to roll back globalisation generally, effective bank regulation has to be
globally co-ordinated.
The confusion
resulting in the Copenhagen Summit on Global Warming held in December 2009 gives
a taste of the near impossibility of reaching agreement on globally harmonised
effective bank regulation which encompasses not only deposit taking banks, but
the whole shadow banking structure.
The world seems
caught in a living contradiction which unless resolved will lead from one
financial crisis to another. Without global harmonisation, bank regulation
would be ineffective. But global agreement on bank regulation is almost
unachievable given the varying circumstances in the different jurisdictions.
Just as an example: how can Canada be persuaded to breakdown or limit the
activities of its major banks when it has had no confidence crisis in its
banking sector?
It is quite
evident that globalised harmonisation of bank regulation is unlikely to be
reached if these regulations are modelled in quantities terms and are based on
the experience of jurisdictions whose banking systems went in distress during
the financial crisis.
It is more likely
that global agreement can be reached if the harmonisation of banking regulation
is defined in qualitative terms and in terms of general principles which are
universally applicable and could be readily adopted by most if not all major
jurisdictions.
A possible suite
of such generally defined and qualitative regulation for universal application
could include the following:
· All deposit
taking banks, non-deposit taking banks ( non-banks that fund their operations
through the capital or wholesale money markets), financial organisations who
fund themselves on the capital or wholesale money markets for the purpose of
performing bank-like operations (including hedge funds and private equity funds
that undertake leverage) have to be responsible to a single regulator defined in
their home jurisdiction who is to remain responsible for the global operations
of the licensed institution.
· All exposures of
the licensed institution are to be reported on balance sheet and off-balance
sheet exposures are to be prohibited. Contingent exposures are to be reported
upon as if they were real exposures and are to be calculated as real liabilities
for liquidity and capital adequacy purposes.
· Licensed
institutions have to keep a liquidity reserve equivalent to gross deposit
withdrawals and market funding redemptions for an average of ___ days as
experienced in the previous full financial year.
· Licensed
Institutions are to have net tangible pure capital which bears a reasonable
relationship to the size of its balance sheet and the risks posed by mismatches
of maturities between its assets and liabilities. The size of such reasonable
relationship is to be set by home country regulators in consultation with the
regulators of host countries where the bank is operating, if such is the
case.
· Capital which is
subject to regular fixed coupon payment will only qualify as net tangible pure
capital up to 50% of its gross value and only if it has no fixed date for
redemption or if it has provision for conversion into share capital if
circumstances so demand.
The question
remains as to how is it possible to have such a loosely worded set of objectives
turned into effective globally harmonised system of bank regulation.
I do not consider
the lose wording and the generic nature of the established principles as a
disadvantage for reaching the final objective. On the contrary I am very
sceptic of too specific numerically defined regulation and this for two
reasons.
Firstly because
gaining general acceptance for such detailed regulation is a very laborious long
term project which by the time it is brought to finality, even in the unlikely
event that it has not been watered down through compromises to gain wide
acceptance, it is generally poised to solve yesterday’s problems rather than
tomorrow’s challenges.
Secondly because
the financial industry is dynamic and any system of regulation defined in too
much detail cannot keep pace with the evolution and innovation of the financial
markets, especially given that in the past market operators have shown great
ingenuity to re-model their operations to work around detailed regulation and
still stay within the legal limits though not necessarily the spirit of the
regulations.
It would be
indeed a pity if after God only knows how long and laborious the exercise for
reaching consensus on globally well defined and numerically controlled
regulation, this would be rendered ineffective by the spirit of innovation of
the financial industry to circumvent such regulation.
For regulation to
be as dynamic as the industry it is seeking to regulate there must be a totally
new approach to it. The dynamics of regulation have to be re-jigged so that
the spirit of innovation is channelled to work in favour of strengthening of the
regulation and not against it.
For this purpose
Regulators of the various jurisdictions have to agree on what I consider a
simple method to give practical effect for the generally agreed principles to be
translated into effective regulation which prevents banking crisis rather than
cures it.
A leaf should be
taken from the practice in most successful commercial organisations when it
comes to Human Resource Management. Every year the organisation has to look at
its human resources and after defining which elements are the weakest, (social
considerations apart), will take steps to replace its weakest members by the
input of new blood. Failure to do so, and human nature being what it is,
will inevitably result that over time all human resources tend to lower their
performance and the weakest performance will tend to pull down to its level the
general performance of the whole organisation.
On the contrary
knowledge that the organisation operates a dynamic HR policy that each year cuts
out its weakest links will change the dynamics and stimulate the whole corpse to
perform better in order to distance themselves from the possibility of their
being the weakest link whose head would be next to go on the block.
This Q syndrome could be effectively applied by Bank Regulators for
the organisations that fall under their regulatory jurisdiction. Every year each
Regulator must look at the strength of the various licensed institutions and
rank them in a queue of performance on the basis of the qualitative objectives
agreed in the global system of general regulation.
Once the lowest ranking institution is identified, it will be given a
few months to correct its weakness or find a market solution through share
capital increase, trade sale or merger. Failing such a solution the
Regulator will invoke the Resolution Trust powers that it ( or a purposely
created organization) has to have to take over the institution and gradually
wind it down.
The process of resolution will respect the rights of depositors
under any State guarantee, force haircuts on bondholders in accordance with
their legal ranking rights. If bond holders are not paid in full and have to
suffer a haircut the shareholders have to be wiped out.
By adopting this system the market dynamics are changed with
management, bondholders and shareholders forced to keep a balance to achieve
market driven growth but staying on the right side of regulation to avoid being
the last in the qualitative queue.
It would be easier to reach a global agreement on this system rather
than on any system with quantitative controls which do not provide for the
different circumstances in different jurisdictions. The final qualitative
objectives proposed are applicable for all jurisdictions. Failure of the
weakest becomes an annual event and like recurring news it would stop being
shocking leading to loss of confidence and systemic risk. The too big to fail
concept would thus be buried once and for all.
Regulation can only be effective if it is as dynamic as the banking
and financial market that it is seeking to regulate. So specific limits and
other quantity criteria will unavoidably render regulation far less flexible
than the markets; in such circumstances the markets will take over forcing
regulators in Greenspan style to surrender and argue that the market can
regulate itself. The 2007/2009 crisis proves that the market cannot regulate
itself. On the other hand any stringent quantitative regulation, even if it
were possible on a global scale, would suffocate recovery and will limit long
term growth.
Critics of this proposed system of Regulation with whom I discussed
my ideas have expressed reservations on its applicability on the basis that
jurisdictions will use different criteria in their respective jurisdictions to
identify their weakest performers. I consider this flexibility in approach as
a strength not a weakness as it provides for the different realities in
different jurisdictions.
What is important for the system to work is not so much the accuracy
or uniformity in the process through which Regulators of the varying
jurisdictions reach their judgment to classify the financial institutions under
their regulatory purview, but the discipline it enforces on the market to adopt
better practices to distance themselves from the bottom rank. It also helps
to make orderly resolution of the weakest link in the financial system as a
regular annual affair, without major crisis and without propagation of moral
hazard in the too big to fail concept.
By continually weeding the system from its weakest performers the
financial markets are kept healthy and prudent, leading to crisis avoidance
rather than crisis resolution.
Alfred Mifsud
MALTA
2nd February 2010.
