Regulation and Financial Crises: Cure or Cause?

Sam PeltzmanBooth School of Business

University of Chicago

A Much Discussed Topic…

“A certain idea of globalization is dying with the end of a financial capitalism that had imposed its logic on the whole economy and contributed to perverting it…..The idea of the all-powerful market that could not be contradicted by any rules, by any political intervention…. [was] …a crazy idea…. The idea that the market is always right is a crazy idea.…Laissez-faire is over” •Nicholas Sarkozy quoted in “Sarkozy Stresses Global Financial Overhaul,” Erlanger, Steven. New York Times, September 26, 2008, p C9.

“The banking crash might not have occurred had banking not been progressively deregulated beginning in the 1970s.”Capitalism in CrisisRICHARD A. POSNERWall Street Journal May 7, 2009

Overview What does regulation (and deregulation) in financial

services really mean? What is regulated? How? Why?

Brief history of regulation

Connection between regulation and financial crises Does regulation make things better or worse? What role in recent financial crisis? What changes have occurred?

What lessons for the future? Tislach li – mainly about US

Two Kinds of Financial Regulation

• Services– Where located

• Branching & entry restrictions– What could be provided

• Banks and savings banks– Mortgages v commercial loans

• Banks and other intermediaries– Lending & deposits v ‘universal banks’

– How much could be charged or paid• Maximum interest rates on loans & deposits

• Financial safety & soundness– How much risk ?– The main topic of this talk

Very Different Histories

• Service regulation has decreased significantly (since 1970)– Any US bank can open a branch anywhere in the US– EU– They can pay any interest rate on deposits they wish– They can (mostly) charge any interest rate on loans– Savings bank/commercial bank distinctions have eroded

• This kind of deregulation has increased bank safety– More diversified assets– Less ‘disintermediation’ risk

• Financial safety regulation has increased in the same period

What is Financial Safety Regulation ?

• Goal: Make sure bank honors obligations to depositors

• Two aspects: liquidity & solvency– Liquidity: bank has enough cash to meet withdrawal demands– Solvency: bank assets > deposit liabilities– Related: fear of insolvency bank “run”

• Focus on solvency regulation here• Two concerns

– What kind of assets can bank invest in?– How much capital (owner’s equity) should bank have?

So Why is the Government Worried About Bank Safety?

• Two answers– Historical: worry that unregulated banks provided “too little” – Contemporary reality: because of this worry, governments

intervened to assure liquidity• This creates incentives for ‘too much’ risk taking• That the government then tries to suppress

• Here I’ll focus on the contemporary problem

• Start with a bank that is not regulated

A Typical Bank

This bank has $100 in assets. $80 came from depositors & the bank’s owners invested the other $20. (‘capital ratio’ is .2)

This means that the $100 of assets can lose up to $20 of value before depositors are threatened with loss.

Unregulated Competition

• What if another bank in town had a capital ratio of only .1?– That bank could attract depositors only if

• It offered higher interest rates on deposits, or• It held less risky assets

– $100 in cash or treasury bills would require little or no capital for safety

• So the market offered a tradeoff– Banks with riskier assets or lower capital ratios offered

higher interest rates– And they also failed more often

This World Ended in the 1930s

• Many banks insolvent• A ‘run’ on the system• Met by government deposit guarantees

– FDIC established in the middle of 1933 bank run– Many other countries follow

• These guarantees are often de facto – Israel: 100% of deposits insured

• And often extend beyond deposits to other claims v bank– Israel: bank equity in early 1980s– US,EU,UK: many uninsured claims 2008 & earlier

Guarantees Change Bank Incentives

• Insured depositors do not care about a bank’s safety Do you know what your bank’s capital ratio is? Or what it is investing your money in? Do you care?

You shouldn’t care

And the bank should act accordingly

The “Moral Hazard” of Government Guarantees

• Because depositors no longer care about safety, the bank owners want to:1. Reduce capital ratios

• If I reduce the capital ratio to .1 (or .01 or .001) I will not have to pay higher interest rates to keep my depositors happy

• So why should I tie up $20 in this bank?

2. Invest in riskier assets• $100 in treasury bills becomes a terrible investment • If the government absorbs (most of) the risk• Example: the bank invests its $100 at the casino…

The Bank Goes to Las Vegas

• Our bank invests its $100 on a risky bet that – Doubles the $100 if red comes up– Pays $0 if black or white come up

• You wouldn’t do this with your own money– It gives a 1/3 chance of getting $100– & a 2/3 chance of losing $100– It has an ‘expected value’ of -$33

• But how does it look to the Bank’s owners?

Ans: Not Bad. Better than Staying Safe

1. If black or white come up we lose our equity– Loss of $20 max (probably much less)

2. But if red comes up we gain $100

3. So, we have– 2/3 chance of losing $20 (or less)– 1/3 chance of gaining $100– [the expected value of this bet >0

• 1/3*100-2/3*20 = +20]

4. This beats playing safe (expected value ~0)

What Does the Example Tell Us?

1. Banks have powerful incentives to take risks by– Preferring risky assets to safe assets

• Even if those risky assets have negative expected value

– Leveraging their balance sheet

2. The source of the risk incentive is deposit insurance (or similar guarantees)

– This turns a negative EV bet into a winner for the bank– Because the downside risk is borne by the government

• If black or white (or red) depositors don’t care• They would have cared in the bad old days

Corollary• Unless that incentive is suppressed expect banks to

– Take risks rather than play it safe– Reward risk taking within the bank

• Big bonuses instead of fixed salary

• Failure to understand that risk incentive will get all of us into trouble

Including Regulators

“those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.”•Alan Greenspan, October 23, 2008

Moral Hazard: A Brief History

• First response to deposit insurance: ‘leveraging up’– Capital ratios fall by half

Moral Hazard: A Brief History

First response to deposit insurance: ‘leveraging up’ Capital ratios fall by half

Little effect until 1980s: S&L crisis Macroeconomic turmoil & undiversified institutions Lead to losses & negative capital for many Which regulators try (unsuccessfully) to ignore

Continental Illinois (1984) – first major bank rescue

Response: tougher regulation FDICIA (1991) Higher minimum capital ratios ‘prompt corrective action’

Round 2: Emerging Markets Crisis (late 1990s)

• FDICIA focused on capital ratio– But said little (new) about composition of assets

• Large banks invest in emerging market debt– Mexico, Russia, Thailand,…– Thai devaluation massive losses on all emerging

market debt

• Response: more regulatory tightening – Minimum risk weighted capital ratios– = ‘ $1 of a risky asset requires more $ of capital than $1 of

safe asset’

The Response to Tougher Regulation

1. Convince regulator that your assets are safe– To avoid higher capital charge for risky assets– ‘1 subprime loan is risky but 1 share of 1000 separate

loans is not’ (asset securitization)– Pay rating agency to say this, lobby regulators to agree

2. Move risky assets off the balance sheet (shadow banking system)

– To unregulated entity – hedge fund, SIVs, investment banks,…

– But (quietly) provide guarantees that do not show as a liability

The Unraveling (2007-08)• A loan package is no safer than any single loan if

– They all go bad at the same time– As sub-prime mortgages did when house prices declined

slightly (2007)– Suddenly those ‘safe’ AAA rated packages lost most of

their value

• SIVs call on their bank guarantees– Suddenly regulators see the liabilities– SIVs begin to go on bank balance sheets (late 2007)

• Other shadow banks become distressed– Bear Stearns (spring 2008)– The rest of the investment banks (Fall 2008)

The Collapse of Fannie & Freddie FNMA & FHLMC – ‘Government Sponsored Enteprises’

Largest suppliers of credit to mortgage market All liabilities implicitly guaranteed by US

In return: carry out govt housing policy Which included expansion of ‘sub-prime’ mortgage market No significant constraints on leverage

A toxic brew of risky assets and high leverage Capital ratio ~ 1/3 of typical commercial bank Any slight uptick in sub-prime defaults could wipe them out Which happened in 2008

Now explicitly government owned And losses subsidized for foreseeable future

The Short Run Response to the Crisis

• “Too Big to Fail” made explicit• Very large banks will be rescued by government• Stockholders will lose• But no depositor (insured or not) or other unsecured

creditor will lose anything

• TBTF extended to non-banks– Investment banks– Large insurers (AIG)– Money market funds– And more

The Long Run Response? Two Paths

• The “moral hazard” incentives remain• So, consequences can be reduced only if1. The incentives are further suppressed

– More regulation of day-to-day operation– E.g., “Volcker rule” – no trading for bank’s account

2. Or the incentives are reduced (“deterrence”) ‘do what you want, but pay the consequences’ E.g., higher capital ratios

The Actual Longer Run Response?

• A little of both• But mainly more regulation• Capital ratios have increased

Capital/Assets. US Commercial Banks. 1920-2013

The Actual Longer Run Response?

• A little of both• But mainly more regulation• Capital ratios have increased

– By ~ same as after S&L Crisis

• Dodd Frank Act (2010)– 16 Titles & 2000+ pages– More regulation and more regulators

• SIFI= systemically important financial institution– All large banks + insurers + money managers + investment banks+…

• How? TBA– More deterrence?

• “No more bailouts”

But the Deterrence is Not Credible

• SIFI = TBTF• So, how can you commit not to bailout SIFI?• Answer: you cannot. So

– “if there is a bailout it has to be repaid by a tax on the surviving banks”

• The inevitable consequence: more moral hazard– SIFIs have funding cost advantage (est 23 bps)– Being safe is now taxed

Have We Outlawed Financial Crises?

Unlikely

There is a little more capital in the system And a lot more regulation

But there is more moral hazard And no credible commitment to impose losses on uninsured

creditors of SIFIs

Not just US EU problem is worse & policy mix is ~ US

In Conclusion

• Financial Crisis has many sources

• Regulation is one of them– It was supposed to suppress the risk taking incentive

created by government guarantees– Instead, it has generally made that incentive worse– Even as the regulation has been increased

Insanity is doing the same thing over and over again and expecting different results