Free Our Markets

by Howard Baetjer Jr

  Accordingly, banks wish to hold some capital in addition to the amounts required by regulation. That additional capital is a cushion they can use to avoid the legal penalties of falling below the regulatory floors. Regulatory capital arbitrage based on the Basel rules and the Recourse Rule gave them a way to plump this cushion at low cost.

  To see how, let’s continue our example from above. Suppose to begin with, as before, that your Bank X has $8 million in capital and $100 million in assets, all business loans. This is Strategy A.1 from Table 12.1, repeated for comparison purposes in Table 12.2. Because the Basel rules assign a 100 percent risk weight to business loans, your risk-weighted capital ratio is 8 percent ($8 million ÷ $100 million).

  That regulatory capital ratio is perilously low: you have no usable capital to protect yourself from consequences with your regulators if you should make even small losses on your loans. So suppose your executive committee decides it must raise that ratio. Suppose (to pick a number that will be useful for comparison purposes shortly) your executive committee decides you must raise your capital ratio by a tenth, from its current 8.0 percent to 8.8 percent.

  What would you have to do to achieve that goal if you engage in no regulatory capital arbitrage, but stay invested entirely in business loans? You would have to reduce the dollar amount of the loans you make to $91 million, as shown in Table 12.2 Strategy D: Increase Capital Ratio by Reducing Assets. That change would have the unpleasant consequence of reducing your expected income from $7 million to $6.37 million. So you explore another option.

  Doing some regulatory capital arbitrage (Strategy E) will let you raise your capital ratio the same amount—to 8.8 percent—while reducing your potential income less and letting you maintain the dollar amount of your interest-earning assets. You can switch out of some of your business loans and into mortgage-backed securities, and thereby take advantage of the lower risk weight the Basel rules and the Recourse Rule assign them. Table 12.2 shows Strategy E: Increase Capital Ratio by Regulatory Capital Arbitrage. Shifting the composition of Bank X’s assets from all business loans to a mixed portfolio, as shown, does not expand your balance sheet but does increase your bank’s capital ratio as desired, while reducing your expected income from $7 million, not to $6.37 million, but only to $6.78 million.

  This regulatory arbitrage lets you achieve the same increase in your usable capital cushion while investing in (what were generally considered) very safe assets, and give up less than half the income you would have had to give up if you had stayed entirely in business loans. The example illustrates why even many banks that did not increase their leverage to expand their balance sheets nevertheless altered their balance sheets to include mortgage-backed securities.

  I have chosen the proportions of MBSs in the mixed portfolio of Strategy E to match the proportions of these different kinds of securities that U.S. commercial banks actually did hold in 2008. In aggregate, they held 7.7 percent of their assets in MBSs issued by Fannie Mae and Freddie Mac (and Ginnie Mae, a smaller player whose securities were always explicitly guaranteed by the government) and 3.5 percent in MBSs issued by private-sector securitizers.

  Table 12.2 Increasing Usable Capital with Regulatory Capital Arbitrage

  That 3.5 percent of assets may not seem large, but remember, it is an aggregate figure, an average. For every bank that held no private-label MBSs there was one that held 7 percent of its assets in them. When the housing boom went bust, the solvency of banks that held a lot of MBSs immediately came into question, because no one could readily tell which MBSs were based on a lot of shaky mortgages, or which banks owned those that did. Banks themselves could not tell for sure the value of the MBSs they owned without laboriously examining all the different mortgages in the securitized pool. In that tense time of sudden uncertainty, banks hoarded cash just in case, lending fell off, and the wheels of commerce slowed.

  I call the reader’s attention here, in passing, to two other government interventions that interacted with the Basel rules in important and damaging ways. We won’t discuss these at length lest this long account run longer still.

  One of these two other interventions is the legal oligopoly granted to the “Nationally Recognized Statistical Ratings Organizations”: Standard and Poor’s, Moody’s, and Fitch. The law privileges these three agencies alone to qualify a mortgage-backed security with a AAA or AA rating for the favorable 20 percent risk weight under the Recourse Rule. The other intervention is “mark-to-market” accounting, which requires banks to assign values to their assets (e.g. mortgage-backed securities) in a particular manner when they do their capital ratio computations.

  In a free market there would be no legal oligopoly for Standard and Poor’s, Moody’s, and Fitch, but free competition in the rating of securities; and banks would be free to do their accounting in any non-fraudulent manner they chose and to discover the most useful ways to do so. The completely unforeseen, damaging interaction of these two interventions with the Basel rules is fascinating. I recommend that those interested read Chapter 3 of Engineering the Financial Crisis, by Jeffrey Friedman and Wladimir Kraus.

  From Housing Bust to Financial Crisis

  In the absence of governmental restrictions, banks would seek the best balance they could achieve between the risks and rewards of various asset classes—residential and commercial mortgages, business loans, credit card loans, auto loans, mortgage-backed securities, other asset-backed securities, student loans, and so on—and decide for themselves how to diversify their portfolios and how much capital to maintain. Under the Basel rules, however, whether motivated to increase their leverage aggressively (as some did) or to broaden their usable capital cushions conservatively (as most did), banks had an incentive to load up on mortgage-backed securities. In consequence of this government intervention in banking, banks invested in these at three times the rate of non-bank investors. The securities included the “private-label” MBSs which had no guarantee, as well as the “agency” MBSs which did.

  Banks’ overinvestment in MBSs helped cause the financial mess in two ways.

  First, banks’ eagerness for mortgage-based assets fueled the housing boom: With such a lively market for their product, banks and mortgage originators sought out house buyers, offering attractive rates and conditions. With mortgages easy to obtain, lots of buyers entered the housing market, bid up prices, and fueled the boom.

  Second, when housing prices started downward, increasing numbers of mortgages began to go into default, and the value of MBSs became questionable, the solvency of American commercial banks holding these MBSs became questionable also.

  That is why, when mortgages started to default in record numbers, the problems in the housing sector spilled over into the financial sector: Wrong-headed government regulation had induced too many banks to invest in too many securities backed by shaky mortgages. The losses on those mortgage-backed securities reduced banks’ capital; banks’ solvency came into question; lenders everywhere got cautious, not knowing which banks were sound and which were shaky; lending dried up; and the financial crisis began.

  There is a painful irony here: capital adequacy regulations imposed to keep banks sound made them unsound instead.

  The Knowledge Problem of Centralized Bank Regulation

  The lesson to draw from this is not that we need better bank capital regulation by government. Regulators probably are and have been doing the best they can. The lesson to draw is that we need regulation by market forces instead. Why? Because top-down regulators in the Basel Committee on Banking Supervision, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the Office of the Comptroller of the Currency—these are the U.S. bureaucracies that apply the Basel rules to American banks and issued the Recourse Rule—face the knowledge problem of central planning. These individuals, no matter how well-meaning and well-educated, cannot know all they would need to know to regulate well. The banks did not get into trouble with mortgage-backe
d securities because they were hiding from regulators or because the regulators were not paying attention. The regulators supported regulatory capital arbitrage. But they, like most bankers and economists, did not foresee where it would lead. Government regulation of bank capital is a classic case of the knowledge problem and the corresponding need to allow the Profit-and-Loss Guidance Principle to regulate bank activity.

  In his illuminating paper on the policies that produced the crisis, economist Arnold Kling writes, “The phenomenon of regulatory capital arbitrage was well understood by the Federal Reserve Board.” Kling quotes a paper by a Fed researcher from the year 2000 whose “tone … was generally sympathetic to the phenomenon.” Here are some illustrative passages, quoted in Kling’s paper:

  In recent years, securitization and other financial innovations have provided unprecedented opportunities for banks to reduce substantially their regulatory measures of risk, with little or no corresponding reduction in the overall economic risks—a process termed “regulatory capital arbitrage” (RCA).

  … Ultimately, RCA is driven by large divergences that frequently arise between underlying economic risks and the notions and measures of risk embodied in regulatory capital ratios.… Efforts to stem RCA … for example, by limiting banks’ use of securitization … would be counterproductive…. In some circumstances, RCA is an important safety-valve that permits banks to compete effectively (with nonbanks) in low-risk businesses they would otherwise be forced to exit owing to unreasonably high regulatory capital requirements.

  That is from a Fed researcher. Kling shows that the International Monetary Fund held similar views (note that 2006 was the year in which more subprime and otherwise shaky loans were made and securitized than in any other year):

  [T]he annual report of the International Monetary Fund in 2006 stated that financial innovation “has helped to make the banking and overall financial system more resilient.”

  Federal Reserve Chairman Ben Bernanke agreed also. Here are some remarks of his from June, 2006, again quoted in Kling’s paper (my emphasis):

  The evolution of risk management as a discipline has thus been driven by market forces on the one hand and developments in banking supervision on the other, each side operating with the other in complementary and mutually reinforcing ways. Banks and other market participants have made many of the key innovations in risk measurement and risk management, but supervisors have often helped to adapt and disseminate best practices to a broader array of financial institutions.

  … The interaction between the private and public sectors in the development of risk-management techniques has been particularly extensive in the field of bank capital regulation, especially for the banking organizations that are the largest, most complex, and most internationally active.

  ... To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization.

  Kling concludes,

  Thus, regulators were well aware of the innovations in credit risk management. However, they viewed these developments with sympathy and approval.

  The regulators were overseeing a system that was broken and headed for big trouble, and they didn’t know. They did not comprehend the damaging ways in which financial innovations were interacting with the vast web of financial regulations. They thought everything was in pretty good shape. They were wrong. They didn’t know enough. The regulators were not asleep at the switch; they did not lack sufficient authority; they just were not supermen; they were not able to foresee all the ramifications and interactions of all the many regulations. They were fallible. They are human.

  The Basel bank capital regulations were but a minor cause of the housing boom and bust. In their absence, there might still have been a housing boom and bust, but it would have been smaller and less destructive: without banks’ hungry demand for AAA-rated mortgage-backed securities, banks and other mortgage originators would have had less money with which to originate mortgages, and the pressure in the boom would have been lower.

  But the Basel regulations were a major cause of the financial mess that followed the bust, because in the absence of the Basel rules, banks and other financial institutions would not have held so many toxic mortgage-backed assets when borrowers started to default. Accordingly, banks would not have gotten into so much trouble when mortgages started to go bad. There might still have been a (milder) housing boom and bust, but there would have been no financial crisis to follow it.

  Intervention #7 – Deposit Insurance with Taxpayers’ Money

  Why have the Basel rules at all? Why shouldn’t banks be free to try out various combinations and amounts of capital as they see fit as long as they are honest with their depositors about what they are doing? Why not let profit and loss shape what bankers do?

  That’s the way it should be, and would be in a truly free market.

  In our present mixed economy, however, bank capital restrictions and other government regulations on banking are considered to be necessary to reduce the bad effects of a prior government intervention: insurance of bank deposits. Because it is the reason for bank capital regulation, government-provided deposit insurance is itself, indirectly, a major cause of the financial mess. In this case, as in many others, the ill effects of one intervention lead politicians to intervene further, the ill effects of the second intervention lead them to intervene in still a third way, and so on. One of the goals of this book is to show that the more sensible response to most problems is not to intervene further but to identify and repeal the interventions that cause the problems in the first place.

  The Federal Deposit Insurance Corporation (FDIC) was instituted by the Banking Act of 1933 (the Glass-Steagall Act). At the outset, the maximum deposit insured by the FDIC was quite small, only $2,500: the government promised that if a bank became unable to pay back its depositors in full, the government would make up the shortfall up to $2,500. By 2008, the limit was up to $100,000 per depositor. In the financial crisis of 2008, Congress raised the limit “temporarily” through 2013—up to $250,000 per depositor.

  Nearly all banks are required to pay annual fees to support the insurance fund, and when, as in 2009, these normal fees are insufficient to cover the deposits in failed banks, healthy banks are assessed additional fees. Of course, all that fee money comes ultimately from the general public in their role as bank customers, and any additional shortfall would come from the general public in their role as taxpayers.

  Government-provided deposit insurance shifts the risks on bank deposits from depositors to the general public. In a free market, risk and responsibility would both lie with the depositors, people such as you and me. In accordance with the Profit-and-Loss Guidance Principle, each depositor would enjoy the profits or suffer the losses that result from her decision to deposit—to invest—her money in a particular bank. Each depositor would be responsible for judging the soundness of her bank. She would have a strong incentive to do that carefully, either by herself, or in other ways we will discuss below. If she were to come to doubt her bank’s soundness, it would be up to her to withdraw her money and deposit it—invest it—elsewhere. The general public would not be at risk from her decision.

  Under government-provided deposit insurance, by contrast, risk, reward, and responsibility are all separate. Each depositor still enjoys the benefits of his or her bank accounts, but the government imposes on the general public any losses that may occur. The government, accordingly, bears responsibility to the general public for making sure the banks don’t lose a lot of money. Because the government has put the general public at risk, the government has an obligation to monitor and restrict banks’ activities so as to protect the public from losses.

  Government-provided deposit insurance creates yet another hazard: increases in risky investments by banks. This is so because deposit insurance reduce
s or eliminates the incentive of depositors to monitor their banks’ activities. How might depositors behave if there were no compulsory, government-provided “insurance”? Any time a depositor worried about the soundness of his bank’s investments, he could withdraw his deposits. If many depositors became worried at the same time and made withdrawals, those withdrawals would constitute a bank run. The threat of a run is a very healthy restraint for banks tempted to make too many risky investments, and actual runs on banks that do make too many risky investments serve society well by weeding out banks that waste investable resources.

  Under government deposit insurance, by contrast, lost is the market check on bankers’ behavior that comes from depositors’ actions to protect their money. After all, depositors won’t bear any losses from the unwise, reckless, or just unlucky investments a bank might make—the general public will. Hence there is a real danger that some banks will—and plenty of evidence shows that some do—make more risky investments than they would if market forces were regulating bank activity. The government, having increased the risk of bad investments, must protect the general public from that risk as best it can, by such measures as the Basel rules and the Recourse Rule.

  To sum up: government-provided deposit insurance necessitates capital adequacy requirements, and the Basel capital adequacy requirements were primary causes of the financial mess. That’s regrettable, but isn’t government-provided deposit insurance necessary?

  Why We Have Deposit Insurance

  It is widely believed that market forces failed to regulate bank safety and soundness effectively before 1933 when the FDIC was created. In particular, banking regulated only by market forces is believed to be very unstable, subject to bank runs and panics, such as those that occurred in 1873, 1893, and 1907, and in the Great Depression, when thousands of banks failed.