Model-Driven Regulation Fueled Bubble, Hobbles Recovery

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  • The Federal Housing Finance Agency acting director, Edward DeMarco, recently sent to Congress a strategic plan for the next phase of conservatorships of Fannie Mae and Freddie Mac. A new structure for housing finance requires congressional action, yet neither Congress nor the administration has come up with an acceptable plan in the three years since Fannie and Freddie were placed into conservatorship. It's far from clear that the DeMarco plan will get the job done.
    March 6

Five years since the beginning of what some label the "Great Recession," economic growth in the U.S. and Europe remains tepid to non-existent.  Central banks maintain close to 0% interest rates and pump trillions of dollars into the banking system with little or no positive effect on economic growth and job creation.

We search for the causes of our economic malaise in all the wrong places.  Government leaders would do well to look in the mirror.

We will not have solid and sustainable economic recovery unless it is led by the financial sector.  The financial sector will not be able to lead the recovery unless we implement sensible, effective, and efficient regulatory policies.  The confusion sowed by up to 20,000 pages of regulations mandated by the Dodd-Frank Act is precisely what we don't need.

The litany of problems in financial regulation is too long for this article.  So we will focus on just one – the risk-based capital models imposed under the Basel international accords.

The Federal Reserve was enamored with risk-based capital models since at least the 1960s.  It sounds good in theory – riskier categories of assets would have more capital allocated to them than less-risky categories.

The Federal Deposit Insurance Corp. refused to go down this path for several reasons.  Models are necessarily backward looking, not reliable predictors of future events, and introduce pro-cyclicality to bank regulation that results in more pronounced booms and busts. 

Regulators are not particularly qualified to assign risk weightings to various categories of assets.  Moreover, there is pressure for regulators to assign lower risk weightings to certain types of "socially desirable" lending.  Finally, bankers will often find ways to "game" the models.

The FDIC preferred to set a minimum capital level (in the 1980s it was 5% tangible equity to assets).  The examination process was used to require capital above the minimum through on-site evaluation of a bank's assets, liquidity, off-balance sheet exposures, interest rate and other operating risks, earnings, and management.

Two events conspired to change this system during the 1990s.  First, blame for the $150 billion cost to taxpayers of cleaning up the S&L mess was inappropriately placed solely on financial regulators and led to a more "rules based" approach toward bank regulation. 

Second, large banks were competing more globally for business and foreign banks were invading the U.S. market.  Large U.S. banks generally had higher capital requirements than their foreign counterparts and lobbied for a system to put large domestic and foreign banks on the same footing.

Conditions were right for the Basel I and then Basel II international capital accords (Basel II was a disaster so now we are on Basel III).  Basel brought international banks closer together on capital requirements, largely by bringing the top banks down rather than bringing the bottom banks up. 

As feared, governments used the models to steer credit to their favorite sectors.  A loan to Apple, Microsoft or a family drug store would carry a 100% risk weighting.   Sovereign debt – i.e., loans made to the governments writing the rules – was given a zero risk weighting.  Housing loans – another favorite of politicians – were given a 50% risk weight (25% if you securitized the loans and bought back the securities).  Not surprisingly, excessive real estate and sovereign lending followed.

Today the backward looking models are demanding substantially higher capital, encouraging banks to shrink their balance sheets and curtail lending.  Moreover, because the Basel models are applicable throughout the world, nearly every major country is simultaneously mired in same economic quicksand, and none can lead the way out.

Regulation of banks should always be counter-cyclical.  In good times, regulators should pressure banks to slow their growth, tighten their lending standards, and increase their capital and loss reserves.  In times of trouble, regulators should urge banks to continue lending to worthy customers even if capital and reserve ratios decline to some extent. 

The Basel capital accords are a serious policy mistake.  It's time to return to financial supervision that relies on good judgment and on-site examinations.  Models should be no more than a tool to assist management and regulators in the exercise of good judgment.  The current system of model-driven supervision helped create a huge worldwide bubble and is now seriously impeding economic recovery.

Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo & Company. William M. Isaac, former chairman of the Federal Deposit Insurance Corporation, is senior managing director and global head of financial institutions at FTI Consulting, chairman of Fifth Third Bancorporation, and author of Senseless Panic: How Washington Failed America. The views expressed are their own.

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