BANKTHINK

If Only the House Banking Committee Held a Hearing Like This

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Lawmaker: Mr. Bank Regulator, is it not so that banks and markets look at the perceived risk of default of any borrower, including the information contained in credit ratings, in order to set the interest rate, the amounts and all other terms of the credit?

Regulator: Yes, that is correct.

Lawmaker: Is it not so that currently the equity capital requirements for banks are based mostly on those same perceived risks, and that banks are required to hold less capital when the perceived risk is low than when it is high?

Regulator: Yes, those capital requirements are in fact the pillar, and the joy and pride, of us bank regulators.

Lawmaker: Is it no so that if you can earn a risk-adjusted margin on less equity, you make a greater return on equity?

Regulator: Yes, and of course the opposite is true too.

Lawmaker: So this signifies that bank lending that is perceived as safe produces a much higher risk-adjusted return on equity than lending that is perceived as risky?

Regulator: If you phrase it that way, yes.

Lawmaker: How would you phrase it?

Regulator: I'm not sure. I would have to come back on that.

Lawmaker: Now, if you provided banks with higher risk-adjusted returns on equity when lending to what was perceived as riskless, could you not have expected banks to lend too much to whatever was officially perceived as absolutely riskless?

Regulator: Yes, perhaps.

Lawmaker: And could you for the same reason not have expected the banks to lend too little to what was officially perceived as risky?

Regulator: Yes, perhaps.

Lawmaker: And so as a result we have a monstrous crisis threatening the West. A crisis that detonated because of obese bank exposure to what was perceived as not risky, like the triple-A rated securities backed with lousily underwritten subprime mortgages, or infallible sovereigns like Greece. And all aggravated by a truly anorexic exposure to what is perceived as risky, like small businesses and entrepreneurs, those who could help us to create the next generation of jobs. Would this be a fair description?

Regulator: Hmm, perhaps.

Lawmaker [imitating regulator]: Hmm … if we played on a golf club where they took away strokes from bad players like me and gave it to good players, like perhaps you are … that golf club would not last for long, since soon there would be no one left to play with the best player. Would you agree?

Regulator: Yes, absolutely… but I do not see the connection.

Lawmaker: Is it not so that there has never, ever been a major bank crisis that has resulted from excessive exposures to what was considered risky, and that these have always resulted from excessive exposures to what was perceived as not risky? If so, would that not suggest a need for higher capital requirements for banks when the perceived risk is low instead?

Regulator: Can I come back to you on that? I don't have the data available.

Lawmaker:  What, in your own words, is the purpose of bank regulations?

Regulator: To stop banks from failing and, if they fail, to assure that they have a sufficient buffer of capital so that taxpayers will not be left holding the bag for too much.

Lawmaker: Well clearly, if that was the purpose, your regulations did not work. But I was referring more to what banks are expected to do for society. Is there, for instance, any mission statement for banks that hints at helping a risk-adverse society with channeling capital to small businesses and entrepreneurs?

Regulator: Not really that I am aware of.    

Lawmaker: So you tell us you regulate banks without defining their complete purpose? Is that not a bit like regulating and supervising the construction of a road, without caring about from where it comes and to where it goes, or about who will travel on it?

Regulator: Yes, but that was sort of our job description.

Lawmaker: So if we now can so clearly connect these capital requirements for banks and the crisis, what are you proposing we use instead?

Regulator: We are not sure, but for the time being the use of capital requirements based on perceived risk remain firmly in place, for instance in Basel III.

Lawmaker: Sincerely, would you find it out of place if the current regulators, after this incredible failure, instead of rewriting regulations, were sent home and paraded down Fifth Avenue wearing dunce caps?

Regulator: Yes… Sir… we did nothing wrong… the whole world, even the Members of Congress could see what we were doing, it was all there on our websites.

Lawmaker: On second thought, tarring and feathering sounds much more appropriate. This hearing is adjourned. [Bangs gavel] Oh wait – one more thing: Occupy the Basel Committee and other bank regulators!

Per Kurowski was an executive director at the World Bank from 2002 to 2004. He writes the Subprime Regulations blog from Rockville, Md.  

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Comments (12)
The crises detonated because of massive OTC swaps that transfered the effects like lightning. We could have contained an "on balance sheet" event.
Posted by Old School Banker | Tuesday, July 10 2012 at 2:42PM ET
The flaw in this argument is the thesis that low bank capital requirements for mortgages caused banks to make mortgage loans excessively causing a bubble. In reality, the capital requirements in question apply only to depository banks and depository banks made relatively few mortgage loans in the last decade and did not cause the mortgage bubble.

The mortgage bubble was caused by independent mortgage brokers (like Countrywide) and syndicators that manipulated ratings with credit default swaps and the like, and rating agencies that allowed their ratings to be manipulated, in order to sell investments in mortgage pools. The problem was a progressive breakdown of underwriting standards as the world wide demand for CDOs grew.

I agree that extra weighting capital for subprime risks is of questionable benefit. Subprime risks should be directly managed with rates and loss reserves. Requiring more capital on top of rates and reserves can inflate capital ratios to the point where the institutions are not good investments and that does discourage subprime lending.
Posted by amuranaka | Tuesday, July 10 2012 at 4:08PM ET
There was a shift a few years back from the old rule of thumb....the average person should buy a house priced no more than 3 times annual salary, to the 'new' model ....the average person can buy a home priced up to 5 times annual salary. Because, as we ALL know, housing prices only go up!

Oh yea, there was this rule about "red lining" and being sure to lend to those less capable of paying the money back...because EVERYONE deserves the AMERICAN DREAM of home ownership....

But then, if a company makes a risky loan, NO PROBLEM! It can be bundled with other higher rated (triple A rated) mortgages in a big basket (with a fancy french name - tranche) and the rick can be averaged out over a large number of PRIME mortgages made with borrowers who have good credit and pose little risk...feel free to stop me anytime!

The problem is the reality of real estate on the ground. If one house is empty and the grass goes uncut, and the windows are broken and the bushes grow too large the effect is felt not just on that one homeowner but by every homeowner on the block, perhaps even a few blocks nearby. Then prices start to fall ....then people who used their homes as ATM machines find that they are underwater and the house is worth less than the loans...then someone gets sick or loses their job....and the bills don't get paid. And they think "why should I be paying more than this place is even worth?" ....but the bank and the investors who bought the mortgages from them? They already did this fancy maneuver called a CDS that makes money so long as the other guy holds up his side of the bargain..... and are making money on lending out more money that they don't have because they bet on the homeowner making their payments like they agreed so that investors and bankers can play the spread. Geez, now bankers (instead of being the sober and logical business people we think they are) are acting more and more like...investment bankers!

Then their counter party on the CDS calls the clearing house and they say..."We want our money" and the clearing house can't use the hedge the financial engineers designed because the counter party isn't getting their payments on time and ....The whole house of cards comes falling down. The banking system will be safe when banks stop using "risk models" and start lending money to the people in their communities who are working to create businesses and buy cars and homes that they can afford. But I don't blame bankers for the financial collapse of the west. I blame greed. Too little virtue and too many bad habits around money....it's not just the financial system...it's society as a whole.
Sorry, but I'm a philosopher.

There was no breakdown in underwriting standards as notioned above. There was a systemic breakdown in risk modelling and collateral management. There was no bubble, everyone said there was no bubble...there was just irrational exuberance...(?) It doesn't matter how much capital regulators require....it'll never be enough for a banking system that is corrupted by unflagging greed.
Posted by fractalshift | Tuesday, July 10 2012 at 5:31PM ET
It is simply amazing that people believe that regulators and regulation are:

1) To blame and
2) The answer

What is needed is more transparency. More market discipline. Board members and corporate governance that bites. Less government directed credit via subsidized leverage (e.g., g-fees of all GSEs). Lower levels of deposit insurance. Reform of money market funds. Higher levels of tangible capital. An bake sale for all the superfluous businesses that are not core retail or commercial banking activities (ie., a new Glass-Steagall). US bailing out of Basel completely, going its own way (which should be to create safety and soundness through market forces). More shareholder power, and less proxy power. And most important, a real recognition that our Western fiat currency, fractional banking system is built on the concept of debt and leverage. Not "safe" levels of debt and leverage (who defines "safe"?), but leverage that maximizes ROE based not on RISK but on GAAP numbers. RAROC, SVA, and Economic Profit are but windmills to joust at, and there are plenty of consultants and neophytes that want to pretend that Puff the Magic Capital Dragon will solve all these issues. If we can just refine the CCAR stress tests with a better pencil, all will be safe? While I applaud Tarullo's book "Banking on Basel" and the somewhat pedantic steps taken by the overly academic board, do we really expect lawyers and economists to create a safer system? Where is the "Invisible Hand"? Where is individual accountability? Where are structural reforms that allow competition rather than oligopolistic behavior, welfare loss, and perennial bad behavior? Can any of the above be reformed without campaign finance reform? DC is run by Wall Street, not the other way around. Until you "cork" the money by hard-cap limits on campaigns; until we don't see the Presidential election as entertainment akin to American Idol (I almost expect Ryan Seacrest to host a debate, or Obama play sax on Arsenio Hall....oops, wrong President); and until we have the collective will to break the "trusts" and go after the cancer by invasive procedures, we will continue to experience an annuity of volatility and contagion, with viral-like implications. The Dodd-Frank Act is weak and REGULATORS aren't to blame or the answer. They could all go home now and not much would change. It is our SYSTEM that is flawed and the philosophies and policies that got us here. Until we wake up to this fact, keep the seat-belt fastened.
Posted by Stentor | Tuesday, July 10 2012 at 8:47PM ET
gsutton@joneswaldo Allow me to explain.

In June 2004 Basel II, of which the USA was also a signatory, was approved.

Previously in April 2004, SEC had also handed it over to Basel... and you can read it here. http://subprimeregulations.blogspot.com/2009/12/day-sec-delegated-to-basel-committee.html

Now, Basel II, required only 1.6 percent of equity from the banks if they purchased or lent against the AAA rated mortgage backed securities... which implies an authorized leverage of bank equity of 62.5 to 1. This meant that if banks thought they could make one percent net margin dealing with these securities, then they could project a profit of 62.5 percent a year.

And of course they went berserk demanding these AAA rated mortgage backed securities. Only Europe about a trillion Euros, and Countrywide and some packagers looked to produce these as fast as possible. And, as normally happens, if the demand is too large for the supply of good originals, markets will find a way, and deliver fake ones, in this case what I have called Potemkin ratings.

If the capital requirements for the banks had been the same as when lending to a small business or entrepreneurs, there would never ever been buyers for all the MBS... and if you look at the statistics you will find how these really exploded after mid-2004 and if you want further proof then consider that most of the MBS packaged previously did not run into similar problems.

This was doomed to happen. In January 2003 after having seen what they were planning for in Basel II (I am not a bank regulator) I had a letter published in the Financial Times of London that ended with: "Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds"

But there was nothing I could do to stop it. Everyone thought that higher capital requirements for when risky and lower for when not risky, sounded so logical. They just did not want to listen to that what should matter for the regulators was not really the credit ratings of the borrowers, but how banks and bankers reacted to these credit ratings.
Posted by Per Kurowski | Tuesday, July 10 2012 at 11:51PM ET
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