Financial innovation, regulation, and reform

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The subprime crisis reflected first and foremost the willingness of the managers of large financial institutions to take on risks by buying financial instruments that were improperly priced. These mistakes, however, were not the result of random mass insanity – they reflected a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market.

Four categories of government error were instrumental in producing the crisis.

• Lax Fed interest rate policy, especially from 2002 through 2005, promoted easy credit and kept interest rates very low for a protracted period.

Accommodative monetary policy and a flat yield curve meant that credit was excessively available to support expansion in the housing market at abnormally low interest rates. This encouraged the overpricing of houses.

•  Numerous government policies specifically promoted subprime risk-taking by financial institutions.

Those policies included: (a) political pressures from Congress on the government-sponsored enterprises (Fannie Mae and Freddie Mac) to promote “affordable housing” by investing in high-risk subprime mortgages, (b) lending subsidies policies via the Federal Home Loan Bank System to its member institutions that promoted high mortgage leverage and risk, (c) Federal Housing Administration subsidisation of high mortgage leverage and risk, (d) government and government-sponsored enterprises mortgage foreclosure-mitigation protocols developed to reduce the costs to borrowers of failing to meet debt service requirements on mortgages, and – almost unbelievably – (e) 2006 legislation that encouraged ratings agencies to relax their standards for measuring risk in subprime securitisations.

• Government regulations limiting who can buy stock in banks made effective corporate governance within large financial institutions virtually impossible.

This allowed bank management to pursue investments that were unprofitable for stockholders in the long run but very profitable to management in the short run, given the short time horizons of managerial compensation systems.

• Prudential regulation of commercial banks by the government has proven to be ineffective.

That failure reflects: (a) problems in measuring bank risk resulting from regulation’s ill-considered reliance on credit rating agencies' assessments and internal bank models to measure risk, and (b) the too-big-to-fail problem (Stern and Feldman 2004). The latter makes it difficult to credibly enforce effective discipline on large, complex banks – even if regulators detect that they have suffered large losses and have accumulated imprudently large risks.

Regulatory reform for a world populated by humans

I review six categories of policy reform that would address weaknesses of the policy environment that gave rise to the subprime crisis.

1) Making micro-prudential capital regulation smarter

• Finding ways to measure the value and the riskiness of different assets accurately, and
• Ensuring speedy intervention to prevent losses from growing once banks become severely undercapitalised.

If subprime risk had been correctly identified in 2005, the run-up in subprime lending in 2006 and 2007 could have been avoided.

The essence of the solution to this problem is to bring objective information from the market into the regulatory process, and to bring outside (market) sources of discipline in debt markets to bear in penalising bank risk-taking. These approaches have been tried with success outside the US, and they have often worked.

With respect to bringing market information to bear in measuring risk, one approach to measuring the risk of a loan is to use the interest rate paid on a loan as an index of its risk. Higher-risk loans tend to pay higher interest. Argentine bank capital standards introduced this approach successfully in the 1990s by setting capital requirements on loans using loan interest rates (Calomiris and Powell 2001). If that had been done with high-interest subprime loans, the capital requirements on those loans would have been much higher. Another complementary measure would be to use observed yields on uninsured debts of banks, or their credit default swaps, to inform supervisors about the overall risk of an institution.

Micro-prudential rules that rely on signals from the market will not work adequately during episodes when distortionary policies promote the systemic underestimation of risk in debt markets. Recognising that limitation to micro-prudential regulation is the primary motivation for adopting additional reforms, including a relatively new idea in financial regulation known as “macro”-prudential policy.

2) Macro-prudential regulation triggers

Macro-prudential regulation means making the key parameters of prudential regulation (capital requirements, liquidity requirements, and provisioning policies) vary according to macroeconomic circumstances. That variation takes two forms:

• Normal cyclical variation in minimum capital requirements as part of countercyclical economic policy, and
• Special triggering of increased prudential requirements during states of the world in which “asset bubbles” are probably occurring.

Before embracing that idea, however, advocates of macro-prudential regulation must be able to answer three questions.

1.      Why should prudential regulation, rather than monetary policy, be the tool used to lean against the wind during bubbles?

The Fed and other central banks already have their hands full using one tool (the short-term interest rate controlled by the central bank) to hit two targets (low inflation and full employment). Adding a third target to monetary policy (namely, identifying and deflating asset bubbles) would be undesirable because it would complicate matters and undermine the ability of central banks to use interest rates to meet the key goals of monetary policy. Furthermore, prudential regulation is ideally suited to addressing asset market bubbles, since loose credit supply has been so closely identified historically with the growth of asset bubbles.

2.      Is it feasible to reliably identify bubbles in real time and vary prudential requirements to respond to the bubble?

Borio and Drehmann (2008) develop a practical approach to identifying ex ante signals of bubbles that could be used by policy makers to vary prudential regulations in a timely way in reaction to the beginning of a bubble. They find that moments of high credit growth that coincide with unusually rapid stock market appreciation or unusually rapid house price appreciation are followed by unusually severe recessions. They show that a signalling model that identifies bubbles in this way (i.e., as moments in which both credit growth is rapid and one or both key asset price indicators is rising rapidly) would have allowed policy makers to prevent some of the worst boom-and-bust cycles in the recent experience of developed countries. They find that the signal-to-noise ratio of their model is high – adjustment of prudential rules in response to a signal indicating the presence of a bubble would miss few bubbles and would only rarely signal a bubble in the absence of one.

3.      What would be the economic costs associated with adopting macro-prudential triggers to combat asset bubbles?

Presumably, the main costs would result from false positives (i.e., the social costs associated with credit slowdowns and capital raising by banks during periods identified as bubbles that are in fact not bubbles). These costs, however, are likely to be small. If a bank believes that extraordinary growth is based in fundamentals rather than a bubble, then that bank can raise capital in support of continuing loan expansion (in fact, banks have done so during booms in the past). Most importantly, macro-prudential triggers would promote pro-cyclical equity ratios for banks, which would mitigate the agency and moral hazard problems that encourage banks to increase leverage during booms.

3) Pre-packaged “bridge bank” plans for large, complex banks

The too-big-to-fail problem can only be addressed adequately if regulators and bankers alike believe that regulators will be willing to intervene and resolve undercapitalised large, complex banks in a timely fashion.

The only way that prompt corrective action can be credibly applied to large, complex banks is if the social costs of intervening in those banks is considered sufficiently low at the time intervention is called for; otherwise, political and economic considerations will prevent intervention. To that end, commercial banks should be required to maintain updated and detailed plans for their own resolution, with specific pre-defined loss-sharing formulas that can be applied across subsidiaries within the institution operating across national borders. Those loss-sharing formulas must be pre-approved by the regulators in the countries where those subsidiaries operate. The existence of such a pre-packaged plan would make intervention and resolution credible.

The key error in US housing policy has been using leverage subsidies as the means to encourage homeownership. FHA guarantees, Federal Home Loan advances, and government guarantees of government-sponsored enterprises debts all operate via leverage. These subsidies are delivered in an inefficient and distorting manner.

The government-sponsored enterprises, which are now in conservatorship, should be wound down as soon as possible, and the FHA and Federal Home Loan Banks should be phased out. In their place, the US could establish an affordable housing program that assists first-time homeowners with their down payments (e.g., offering people with low income a lump sum subsidy to apply toward their down payments).

5) Improving bank stockholder discipline

Sweeping changes should be made to the regulation of bank stockholders. Current regulations almost guarantee that large banks will be owned by a fragmented group of shareholders who cannot rein in managers, thus encouraging managers to use the banks to feather their own nests. That agency problem not only produces significant waste within banks on an ongoing basis, it makes the allocation of capital in the economy inefficient. Banks are supposed to act as the brain of the economy, but they will not do so if their incentives are distorted by managers in pursuit of ends other than the maximisation of value for their shareholders.

A first-best solution would be outright repeal, or at least a significant relaxation, of the bank holding company act restrictions on ownership of banks, along with the removal of other restrictions that make it hard for stockholders to discipline managers. These reforms seem unlikely to be enacted at the present time. In the presence of continuing distortions relating to corporate governance, bank stockholders – who should be the first line of defence in the financial system against unwise risk taking by bank management – are unable to exert much of a role. That implies even more of a burden on regulators to implement reforms in micro-prudential regulation, macro-prudential regulation, and resolution policies that will limit the social costs associated with banking crises.

6) Transparency in derivatives transactions

Counterparty risk in transactions that do not involve a clearing house is borne bilaterally by contracting parties, and the true counterparty risk can be hard to measure.

How should prudential regulatory policy respond to this problem? There are two separate issues that must be addressed by regulators: encouraging clearing and encouraging disclosure. Policy reforms related to clearing mainly address the problem of counterparty risk opacity. Policy reforms related to disclosure mainly address the problem of monitoring and controlling the net risk positions of individual banks and the systemic consequences of those positions.

With respect to clearing, one option for dealing with systemic consequences of opacity in counterparty risk would be to require that all derivatives contracts be cleared through a clearing house and thereby eliminating the problem of measuring counterparty risk. The problem with requiring that all OTC transaction clear through a clearing house is that this may not be practical for the most customised OTC contracts. A better approach would be to attach a regulatory cost to OTC contracts that do not clear through the clearing house to encourage, but not require, clearing-house clearing.

With respect to disclosure, one option would be to require that all derivatives positions be publicly disclosed in a timely manner. Such a policy, however, would have undesirable consequences. Bankers that trade in derivatives believe that if they had to disclose their derivatives positions that could place them at a strategic disadvantage with respect to others in the market and believe that this might even reduce aggregate market liquidity. A better approach to enhancing disclosure, therefore, would be to require timely disclosure of positions to the regulator and public disclosures of net positions with a lag.

Preventing a repeat of the current financial crisis requires government to take a hard look in the mirror. The greatest threats to financial sector stability have to do with the ways that the rules of the game shaped by government policy promote the wilful undertaking of excessive, value-destroying risks.

Borio, Claudio and Mathias Drehmann (2008). “Towards an Operational Framework for Financial Stability: “Fuzzy” Measurement and its Consequences,” BIS Working Paper, November.

Calomiris, Charles W., and Andrew Powell (2001). “Can Emerging Market Bank Regulators Establish Credible Discipline: The Case of Argentina, 1992-99,” in Prudential Supervision: What Works and What Doesn’t, edited by Frederic S. Mishkin, 147-96.

Stern, Gary H., and Ron J. Feldman (2004). Too Big To Fail: The Hazards of Bank Bailouts, Washington, D.C.: Brookings Institution Press.