DIGG THIS

Part of the current banking crisis is due to the deregulation that Congress brought in known as the Gramm-Leach-Bliley Act of 1999 or the Financial Services Modernization Act. But that deregulation was part of a general movement during the 1990s, approved by piecemeal government regulations and deregulations, that allowed both investment banks and banks to become universal banks.

As universal banks, bankers could engage in all manner of highly questionable financial activities and expansions that are totally inconsistent with the safety of bank deposits. Given the government’s guarantees of bank deposits, these sorts of activities should never have been allowed. When there are such guarantees combined with the central banking money system, market discipline is greatly eroded. No doubt, lobbying efforts and contributions to politicians have much to do with this deregulation and erosion. There are big bucks to be made by gaming the system of government regulation.

The system we have is the furthest thing from lawful free markets. It is not "financial capitalism," as France’s President Sarkozy would have it. To be fair to him, Mr. Sarkozy’s views require separate elaboration. We will be hearing more from him, I am certain. Like De Gaulle, he may want a place for gold. For the moment, statements like these "Laissez-faire is finished" and "The all-powerful market which is always right is finished" should be recognized as incorrect and misleading. We have not experienced either laissez-faire or an all-powerful market. How could we when we have not had monetary freedom at any time and especially since 1913 and then the New Deal?

One might think that the banking crisis has been solely a subprime crisis due to the excessive mortgage lending of such companies as Washington Mutual and Countrywide Credit in conjunction with Fannie Mae and Freddie Mac. This is not the case. If this were true, we would not see such giants as Citigroup falling drastically in price (from $56 to $9) and receiving $25 billion in government relief.

Citigroup has written off all sorts of loans in the past year or two. Eventually the full story of this and other universal banks will be told. This bank has engaged in structured finance deals for a long time. These are done through "special purpose entities" that hide the loans. It hid very large loans to Enron. See here.

Lest there be any confusion among readers about my remarks here and below that favor stringent regulation of bank loans, I will state a few, not all, of my preferences at the outset. I will not attempt to justify them here or even explain them in detail.

We should have entirely free banking with appropriate rule of law. We should have complete monetary freedom with rule of law. The free market with appropriate law and enforcement will provide the market discipline. Our governance should have no power to control, dictate, shape, or in any way regulate or legislate the money and credit exchanges of millions of people. The entire financial superstructure built from 1913 (and before) to the present is faulty. If the authorities spent their time doing what they should do, which is discovering and enforcing the rule of law, which includes paying heed to fraud and ensuring justice by reference to established canons, that would be quite challenging enough

The authorities have a limited and often perverse understanding of what they bring about when they regulate. Their thinking is influenced by false theories, political concerns, and the money contributions of financial firms.

Even more important than any of these is their belief that they can pass a law and control behavior to their liking without setting off other behavior that is well beyond their control. They think they can control anything, without giving rise to the attendant costs and without destroying the very thing they are controlling. They vastly over-estimate the benefits of their laws without seeing the costs and losses that these laws impose and bring about in the future. Politicians are nearsighted purveyors of power.

With my views made clear, there should be no confusion when I state that Gramm-Leach-Bliley was a blunder. But far more generally, banks that are financed by insured deposits should never have been allowed to do what they did. There is no excuse for regulators to allow such banks to write inordinate mounts of insurance via credit default swaps, or to extend inordinate amounts of loan guarantees that are another form of insurance. There is no excuse for government to have encouraged home loans to people who could not afford them. There is no excuse for government to encourage people to take on excessive amounts of debt, period. Insured banks shouldn’t have had large obligations hidden away in off-balance-sheet subsidiaries. These banks shouldn’t be so highly levered. Government is fully responsible, not only for the welter of regulation but also for the inept deregulation and the resulting financial tragedy that has unfolded.

Gramm-Leach-Bliley loosened control over banking while leaving the rest of the regulated system intact. This heightened the moral hazard. Banks then extended many more questionable loans and entered into complex financial agreements that they never should have been allowed to make. All of this was to our detriment.

Between central banks that provide low-cost deposits, bank deposits insured by governments, and the urgings of their governments, banks and other institutions have strong incentives to make risky loans and over-expand. Every 10 years or so, the result is a banking crisis.

The core problem in banking is the incentives that banks face under the various regulations. They respond to these incentives. These incentives are very powerful. Getting rid of one set of restrictions while maintaining others can and has led to excessive risk-taking and eventual disaster.

The incentives are well understood by financial professionals. They have understood them for a long time. They are often well understood by staff researchers at government regulatory agencies. This does not mean that the regulators in power understand, or if they do understand it does not mean that they regulate according to their knowledge. The leaders of regulatory agencies, unlike their staff underlings, are in political positions.

The financial knowledge probably penetrates even less to Congressmen and their staffs. They are even more likely to be influenced by politics, lobbying, and contributions of members of the financial industries. Many of them are lawyers who are unfamiliar with economics and finance.

Some Congressmen may hold philosophical positions favoring monetary freedom and think they are doing the right thing to deregulate, when in fact the deregulation leads to perverse results. These Congressmen may not understand the system of incentives they are dealing with.

In order to make this non-free-market system work even halfway well, the politicians in government sense that banks need to be regulated. But they don’t want that job, even if they had the expertise to understand the issues, which they don’t. Their goal is to raise money, make laws, get votes, and build up their pensions. They turn the regulation problem over to central banks and numerous other regulatory agencies. This is government in action, which means a degree of institutionalized ineptitude that exceeds the usual human norm. It is only when a crisis occurs that, bewildered or scoring political points, the politicians poke around in the ruins of the financial system and promise to rebuild it. They then go about making matters worse.

The core problem in government is the incentives that government authorities face. This problem is insoluble under the existing Constitution and under the typical nation-state form of government.

Well before Congress acted, some regulatory authorities knew what was going on. They knew in 1988 when Basel I was formulated by the Bank for International Settlements. Basel, in Switzerland, is the home of the Bank for International Settlements or BIS for short. The BIS is the central bank of 55 central banks, founded in 1930. Basel I was an accord that, while deeply flawed and itself leading to perverse results, called for minimum capital requirements for banks and a method of measuring the risk of the bank’s loans and other assets. The BIS is emblematic as a failure of central banks to handle their share of regulation of bank loans.

Experts in the area of finance and derivatives have often pointed out the shortcomings of the BIS regulations. The BIS and central bankers knew 20 years ago, in 1988, that derivatives needed to be regulated. In July of that year, with the approval of the 10 major central banks, the BIS published a risk-weighting scheme. They already knew that there were substantial off-balance-sheet items to contend with. They already knew about counterparty risks. Rather than regulate them directly, they devised a weighting method to measure risk.

John Hull, author of a major textbook on derivatives, criticized their scheme in 1989. He noted that unless the portfolio was very large, the distribution of losses could have "fat tails." This means that huge losses thought to be 1-in-a-million events might actually be far more common. He pointed out that the problem was especially acute for off-balance-sheet items where the size of the exposures was unknown. Next, he observed that the BIS formula assumed that losses would be independent of one another, as in the case of insurance. He wrote: "…this is likely to be untrue," the result being that a shock would create large losses and give rise to a fat-tail phenomenon. Finally, he observed that the possible losses or exposures were not independent of the occurrence of bankruptcies in an economy. These tend to cluster. Counterparties would be exposed to failure at the same time that the bank might be under pressure.

Another major textbook on derivatives by different authors discusses the 1988 BIS or Basel I standards as amended in 1996. These authors write: "The Amendment does not alter the main rules applying to credit risk. There are a number of significant weaknesses to these rules." They mentioned that the rules did not differentiate credit risks sufficiently. For example, Turkey with a B1 rating is weighted with no risk exposure while a AAA corporate credit receives maximum weight. The standards require 8% of capital against corporate risks, regardless of which ones. This provides an incentive for banks to lend to high-yield and riskier issuers. The BIS rules make no allowance for the maturity of the credit exposure. They also criticized the counterparty risk weights.

David Harper (Chartered Financial Analyst and Financial Risk Manager) writes: "The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital in the system. Like many regulations, it also pushed unintended consequences; because it does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted the loan securitization that led to the unwinding in the subprime market."

After years of work, the Basel II or Basel Capital Accord answered these criticisms. It delivered a new set of standards in 2004. Their hallmark is complexity. They were too late in coming. Banks worldwide had already participated heavily in the boom leading to the current bust.

One of the clearest examples of a deregulation blunder is the Savings & Loan debacle of the 1980s. This cost taxpayers at least $200 billion. There is a large literature on the S & L failures that occurred. One example is here. You would think that regulators and legislators might have learned from this episode. Think twice.

Moral hazard in the case at hand refers to the incentive of the bank’s managers, acting mainly on behalf of the owners of equity, to make risky and low return (ultimately bad) loans with the bank’s capital. The typical balance sheet capital of the major bank consists of a low sliver of equity. Bank of America had 8.6% equity in 2007. Its deposits were 47% of capital. Much of these deposits are insured. Imagine that a man has $8,600 of his own money in a business, and he manages to borrow another $91,400 to deploy in the business. That’s Bank of America. Now imagine that $47,000 of the total is insured by the government. No matter what he invests in, he does not have to worry about losing that $47,000, other than he may end up out of business. This man has an incentive to gamble with the money. If he loses, he loses $8,600 and his job. If he wins, the depositors do not get the winnings because deposits pay a fixed rate of interest. He and the stockholders get all the gravy. If he loses, most of the losses fall on the non-equity suppliers of capital. This is moral hazard.

In commercial companies, the creditors are aware of moral hazard. They control the managerial incentives through detailed credit agreements and bond indentures. Lenders in unregulated markets know how to control risk. With depository institutions with insured deposits, the depositors (who are the creditors of the bank) have no incentive to control the moral hazard. It is left up to the government. Whether or not it was recognized at the time, there is good reason why the New Deal put in bank regulation that separated banks from investment banks at the same time that it put in deposit insurance. It helped to control moral hazard by ruling certain activities as off limits for insured banks.

When the government deregulates bank lending without simultaneously removing deposit insurance, the moral hazard increases exponentially. The "too big to fail" doctrine amplifies the moral hazard even more. Uninsured deposits then become quasi-insured, and managers are less likely to lose their jobs. Raising deposit insurance limits and extending them to all types of deposits increase the moral hazard still more. These are steps Congress recently took.

The Congress deregulated the S & L industry in 1980 and 1982 as did some states. Within a very few years, great numbers of these thrift institutions failed and cost taxpayers billions. By 1985, many of these thrifts grew very rapidly by making all sorts of more risky loans. Once an industry devoted to single-family home mortgages, overnight it became an industry that was making apartment house loans, commercial building loans, land loans, unsecured commercial loans, and consumer installment loans. S&Ls were investing in real estate and real estate development and buying stocks. These behaviors were most evident in those thrifts that were more susceptible to moral hazard and ultimately failed in greater numbers. These were the stockholder-owned as opposed to the mutual thrifts, the thrifts in the more loosely regulated states (such as Texas, California, and Florida), the more leveraged thrifts with lower equity, and the thrifts that had more risky loan portfolios to begin with.

Deregulation blunders are the natural accompaniment to regulation blunders. The core problem in financial regulation is the regulation itself. We face a very difficult problem here. The ideas that justify financial regulation are as firmly entrenched as they are false.

President Sarkozy represents the contradictory confusions we face in high quarters and really in the thinking of many intellectuals and professionals. Sarkozy speaks very highly of capitalism. He even says that the crisis is not a crisis of capitalism but of a system that has distanced itself from capitalism. On the other hand he says that "the market economy is a regulated market." The key question is this: Regulated by what? Regulated by whom? His answer is the State. He looks for "a new balance between the State and the market…" His answer is a contradiction. The State cannot regulate without at the same time destroying that which it regulates.

My answer is this. The State has had its long day in the sun. Its modern and powerful form has had its say for 100 years. That’s long enough. We have witnessed the horrible results.

We know why the State does so badly. We know that it cannot help but do badly.

Power induces the State to abandon both the Rule of Law and its basic mission of protecting rights.

The more that the State has abandoned the Rule of Law and the protection of fundamental rights, the worse off we have become. The State is nothing more than an instrument that works against Rule of Law and protection of rights. Sarkozy does not recognize this fact, even though it is staring him in the face. Instead, he ardently worries about the remuneration of executives.

And he worries about scapegoats: "We have to find out where the blame lies and those responsible for this collapse must at least pay some financial penalty." Is it not obvious that the system of financial regulation and deregulation, administered by government, has failed in its most basic task? It has failed to control the lending activities of the banks whose deposits it insures. It has failed to control the moral hazard that it has created with its own deposit insurance.

The Best of Michael S. Rozeff