Washington failed us in four major ways concerning the financial crisis of 2008.
First, the wrong lessons were drawn from the banking and savings and loan crises of the 1980s. Second, government fiscal policies were irresponsible and monetary policies too accommodative over the past decade. Third, the government turned a blind eye toward excessive risk-taking during the 15 years between the two crises. Fourth, the government seriously mishandled the latest crisis, which led to a worldwide panic.
By focusing on the government's failures I do not intend to absolve the private sector. Greed, poorly structured compensation practices, excessive risk-taking, inadequate risk management systems and ineffective corporate governance all played significant roles leading up to the crisis.
Several major factors led to the banking and S&L crises of the 1980s. The government decided to fight the war in Vietnam and implement the Great Society programs without paying for them. These actions, coupled with lax monetary policies, unleashed inflation during the 1970s.
Financial institutions, still operating under the regulatory constraints imposed on them during the Great Depression, were not prepared to deal with what was to come. S&Ls were stuck in an unsustainable business model that required them to focus on long-term, fixed-rate real estate lending. Banks were tightly regulated in the services they could offer and the geographic areas they could serve, and the interest rates they could pay for deposits were set by law.
President Carter appointed Paul Volcker chairman of the Federal Reserve in 1979 with a mandate to get inflation under control. The Fed raised rates to an astonishing 21.5%. Inflation was brought under control but at great cost. A depression in the agricultural sector, a crash in the energy sector, a two-year recession with unemployment reaching 11%, and a collapse of the real estate sector ensued.
Nearly 3,000 banks and thrifts failed during the 1980s, including many of the largest in the country, without causing the public or the markets to lose confidence and panic.
The one major problem that I believe was not handled well was resolution of the S&L crisis. Rather than facing up to the S&L crisis in the mid-1980s, government leaders from both parties deferred action in the hope that given time the S&L industry could restructure itself and grow its way out of its problems.
Regulatory accounting principles were adopted to mask the problems and allow S&Ls to grow. S&Ls were granted authority to expand into businesses they did not have the capital or the management to support. By the time government leaders decided to confront the S&L problems in 1989, the cost of the cleanup had escalated to $150 billion.
Having spent a ton of taxpayer money to clean up the S&L mess, the politicians had to find someone to blame other than themselves. Greedy bankers and incompetent regulators were the easiest targets.
We moved to a regulatory regime that diminished the regulators' judgment and placed excessive reliance on markets and models to regulate financial institutions. Mark-to-market accounting was put into place over the objections of the Fed, the Federal Deposit Insurance Corp. and the Treasury Department, all of which argued that it would be highly procyclical, lead to excessive volatility in bank earnings and capital, and create severe credit contractions.
Prompt corrective action was enacted, which limited regulators' ability to work with troubled institutions they believed could be turned around.
Highly complex, unreliable and procyclical models were established to determine capital adequacy and loan-loss reserves. The FDIC's ability to respond to financial crises was curbed and politicized by requiring the Fed, the Treasury and the president to authorize the use of the FDIC's emergency authority.
In short, the political reaction to the crisis was to emasculate a bank regulatory regime that allowed us to get through a major recession and real estate crisis in the early 1970s, and an even more serious crisis in the 1980s without panic. We learned none of the lessons of the S&L crisis and instead implemented reforms that led directly to the recent crisis, making it much more difficult to manage.
Once the crisis hit in 2008, we lurched from failure to failure without a coherent plan and without sensitivity toward public psychology. One large firm was bailed out while the next was allowed to fail; back and forth, until no one could predict what would happen next.
Unable to handle the uncertainty the markets panicked, which in turn led the government to panic. The Bush administration proposed the Troubled Asset Relief Program to spend $700 billion to purchase toxic assets from Wall Street. The overheated rhetoric used by our political leadership to sell this ill-conceived program to a dubious public exacerbated the panic.
Congress enacted Tarp but it was never implemented. Instead of purchasing toxic assets, taxpayer money was used to recapitalize large banks, whether they needed it, or wanted it, or not. This caused a political fire storm. The FDIC could have implemented a capital infusion program for salvageable banks without legislation, had the Treasury and the president authorized it. Unfortunately that did not happen.
Proponents predicted that without Tarp the Dow Jones industrial average would fall by 1,000 points. Well, guess what? The Dow was at 10,800 when Tarp was enacted, and it fell to 8,500 during the month after enactment.
Tarp did not calm the markets, and the public stress tests made things much worse. Things were beginning to stabilize in the financial markets in February 2009 when the Treasury announced that the government would conduct stress tests on the 19 largest financial institutions. Chaos and uncertainty ensued as the media and markets fretted about which banks would flunk the tests and what would happen to them. The Dow fell another 2,000 points, to 6,500, and the bank stock index dropped by 50%.
Fed Chairman Ben Bernanke was forced to announce in late March that none of the 19 large institutions would be allowed to fail, no matter what the results of the stress tests were. Making the test results irrelevant calmed the markets. But the damage to the industry was enormous — both to the 19 institutions that were now deemed too big to fail and those that had to compete with them for funding.
Stress tests are an important tool for both bank regulators and bank management. We need to continue to improve them and run them annually. But they should be done privately as part of the bank examination process, and they should be kept free from politics.
Dodd-Frank would not have prevented the last crisis, and it will not prevent the next one. It represents a lost opportunity to make real reforms in the regulation of finance.
We have too many agencies regulating financial institutions. The regulatory system is too fragmented, complex and politicized. We need to consolidate agencies, make them more independent of the politics and strengthen the oversight of those agencies by an independent FDIC and an independent Systemic Risk Oversight Council. The system must have checks and balances.
Good bank regulation leans against the prevailing wind. Capital rules, loan-loss reserving methodologies and accounting rules must be revamped to rid them of procyclicality.
We need much better worldwide information systems. Even the best-conceived stress tests and regulatory system will fail us if they do not rely on good data.
We need to focus less on resolving failures and more on preventing them. The five largest companies control more than half our banking system. The economic impact of their failure would be devastating. So we need to figure out how to make them safer, less complex and easier to regulate while at the same time allowing them the flexibility to compete and serve our nation's needs.
The banking and S&L crises in the 1980s were driven by seriously flawed fiscal, monetary and regulatory policies. The same is true of the latest crisis.
I see nothing in the current political climate to suggest that we are not headed toward yet another crisis. Deficits are out of control with no end in sight, monetary policy is accommodating the deficits and our regulatory structure and policies remain seriously flawed.
