The Obama administration, in unveiling its financial regulatory reform proposals, identified three factors contributing to the financial crisis: ill-defined regulatory responsibility for systemic risks, inadequate supervision of large institutions and inadequate consumer protection.
Before passing judgment on the administration's reform proposals, we need a thorough debate on the causes of the crisis. We cannot treat the disease until we identify its source.
The seeds of the current crisis were sown in the aftermath of the banking and savings and loan crises of the 1980s. We misdiagnosed the causes of the S&L crisis, in particular, and put in place the wrong reforms.
The S&L crisis occurred primarily because we let inflation get out of control during the 1970s, requiring the Federal Reserve to raise interest rates to more than 21% to break inflation's back. This bankrupted the entire thrift industry, with its large portfolio of long-term, fixed-rate mortgages and government bonds, but neither the administration nor Congress wanted to confront that reality.
S&Ls were openly encouraged by the government to grow their way out of their problems. Since they had little or no private capital at stake, they took enormous risks and ultimately cost taxpayers $150 billion.
This caused a general loss of confidence in the regulatory system, which prompted a series of reactionary reforms that in turn led to today's crisis.
The truth is that S&L regulators handled the S&Ls exactly as directed by the administration and Congress.
Nonetheless, academics and others urged that banks and thrifts be subjected to more regulation by the markets and that regulators' discretion in dealing with banking problems be curtailed.
Congress responded by enacting "prompt corrective action," which requires that regulators take increasingly stringent actions as a bank's capital falls through various thresholds. This is a pro-cyclical measure, and it denies regulators the ability to help institutions get through tough times.
Congress imposed a highly pro-cyclical deposit insurance assessment system, which let banks pretty much escape paying FDIC premiums in good times when the deposit insurance fund was strong and forced them to replenish the fund in hard times when the premiums would diminish their earnings and capital and reduce their ability to lend.
We encouraged banks and thrifts to spread risks by instituting variable-rate mortgages, which passed the interest rate risk to consumers. Among other things, this obscures the risks and delays their recognition by banks and their examiners. When rates rise significantly, the risk of loss ultimately falls on the bank but not until the consumer runs out of options for staying current on the loan.
Securitization and derivatives markets grew like mushrooms as a way of further spreading and hedging risks. Accounting rules were interpreted to permit these transactions to be removed from bank and thrift balance sheets, which led to a false sense of complacency among bankers, regulators and investors about the risks. Never mind that few understood the risks or where they were landing.
The Securities and Exchange Commission and its sidekick, the Financial Accounting Standards Board, adopted mark-to-market accounting rules. Despite being warned by the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corp., the SEC and FASB gave no consideration to the pro-cyclical nature of these rules, which would record inflated earnings and capital when markets were booming and needlessly destroy bank earnings and capital when things went south.
The Federal Reserve and the Treasury added fuel by promoting highly complex mathematical models that few understood (the Basel capital regime) to determine bank capital requirements. The new rules leaned heavily on the judgments of the rating agencies, which was clearly problematic to say the very least.
The previous, and in my view much preferable, capital regime, before the Basel rules were adopted, set a significant floor on capital and allowed professional bank supervisors to require capital above the floor based upon on-site evaluations of risk. The Fed and Treasury contended that mathematical models would yield more objective results. Moreover, they argued, quite incredibly, that major U.S. banks had too much capital vis-à-vis their foreign counterparts and, therefore, large-bank capital ratios should be allowed to decline.
The Fed and Treasury ignored those who cautioned that the models necessarily look backward and are therefore highly pro-cyclical. The models do not require enough capital in good times and require too much capital in bad times.
The SEC misfired again in 1999 when it took an enforcement action against SunTrust Bank, alleging that it was managing earnings by creating excessive loan-loss reserves. Bank regulators expressed anger about the SEC's incursion onto their turf but fell into line with the SEC's approach, limiting banks' creation of reserves in good times and requiring excessive reserves in bad times.
Not done yet, the SEC adopted Basel-type capital rules for investment banks in 2004, allowing them to triple their leverage at the worst possible time in the business cycle. Adding insult to injury the SEC eliminated the Depression-era restrictions on short sellers in 2007, just when the markets were headed down.
I have written and spoken repeatedly against these policies over the past 20 years, including in congressional testimony on several occasions. I argued that we were taking the wrong lessons from the S&L crisis and that some day, when trouble hit again, we would deeply regret having installed these pro-cyclical policies.
Now the question is: Are we going to correct these policy mistakes or are we going to heap on more regulations and create greater moral hazards by permanently extending bank-type regulation and the bank safety net to large nonbank firms?
The administration's proposal heads pretty clearly toward heaping on more government without addressing the underlying problems.
The most important potential reform is creation of a Systemic Risk Council, but the administration's plan neuters it. The plan deprives the council of authority to overrule accounting and regulatory actions that would create systemic risks. It proposes a council that is too large (eight agencies represented) and too dependent on the Treasury's staff, with the secretary of the Treasury as its chairman. Who is going to challenge the boss, when he or she is trying to get the economy in shape for the next election?
If I could have just one reform in the upcoming legislative package, it would be a strong Systemic Risk Council, independent of any other agency (see related article advocating this reform, "Regulating Systemic Risk a Council Job," in the June 12 American Banker).
The council's chairman would be independent of any agency, would have considerable autonomy and would be appointed by the president and confirmed by the Senate to a six-year term. Its members would be the secretary of the Treasury, the Fed chairman, the FDIC chairman, the Comptroller of the Currency and the SEC chairman.
The council would have its own staff of experts (probably numbering in the hundreds) and would have access to all data and information the government has concerning the financial system, including examination data and classified materials.
Though it would not be a regulatory agency, the council would have the ability to overturn or request that Congress overturn any accounting or regulatory rule it believes would create a significant systemic risk.
The council would assume the SEC's responsibility for overseeing the FASB.
The administration's reform plan offers a number of proposals. Some are fine, and some are hard to figure, such as eliminating the thrift charter in the middle of a housing depression. Some, such as permanently expanding federal supervision and resolution authority to nonbanking companies, raise serious moral hazard issues that need to be thoroughly debated. Others, such as eliminating the industrial loan company charter, which played no role in the crisis, are simply puzzling, as is the failure to propose a resolution of the Fannie Mae and Freddie Mac problems at the heart of the crisis.
Though Congress may want to put more restrictions on the Fed's use of its lending and asset purchase authorities, I seriously question the wisdom and propriety of giving the Treasury the right to tell the Fed what it may or may not do. I believe firmly in a strong and independent central bank, which is one reason I oppose risking that independence by expanding the Fed's regulatory mandate, as the administration's plan would do.
Setting up a new agency to separate consumer protection from bank supervision seems a step backward. Enforcement on the consumer side would almost certainly be weakened due to the loss of surveillance by thousands of bank examiners.
Moreover, who would resolve disputes between prudential supervisors whose duty it is to enforce safety and soundness in banks and consumer compliance specialists who are charged with promoting the interests of consumers?
I urge Congress not to repeat the mistakes of last year by letting the administration rush it into adopting the wrong solutions to the wrong problems. The crisis has already happened — we cannot do much about it at this point.
We owe it to ourselves, future generations and the entire world to be thoughtful enough to identify the right problems and develop the right solutions.
At the very least it would seem appropriate to wait until the bipartisan Financial Crisis Commission President Obama signed into law reports its findings.
The ink from the president's signature on that law was barely dry when the administration rushed out its reform package. Taking another six months or a year to study and debate the reform package is far preferable to doing the wrong things quickly.