The Chess Game of Financial Regulation

The financial crisis that began in the sub-prime mortgage market is at least the third major financial crisis to include a breakdown in the United States housing finance sector. During the Great Depression, banks and balloon mortgages were involved in a collapse. In the 1980's, we experienced the Savings and Loan Crisis. Currently, we are dealing with the aftermath of a boom-bust cycle in house prices that was exacerbated by risky lending practices.

A sobering fact is that the response to each of the first two crises helped to lay the groundwork for the next – and current -- crisis. It turns out that financial regulation is not like a math problem, which can be solved once and stays solved. Instead, financial regulation is like a chess game, in which moves and counter-moves proceed continually, eventually changing the board in ways that players have not anticipated.

The Great Depression produced two major lessons concerning housing finance. One lesson is that short-term “balloon” mortgages are dangerous. When the borrower must refinance the mortgage every five years, a shortage of credit can prove disastrous. Government policy under President Franklin D. Roosevelt's New Deal instead encouraged the thirty-year amortizing mortgage. PARA Another lesson was that banks are subject to sudden mass panic withdrawals. The New Deal also established government-backed deposit insurance in order to prevent future bank runs.

From the end of the Depression through the 1970s, the mainstay of the housing finance system was the thirty-year fixed-rate mortgage, provided by savings and loan associations (S&Ls) funded with insured deposits. It was exactly these institutions that blew up during the S&L crisis of the 1980s, costing taxpayers more than $150 billion.

The S&L Crisis arose because high rates of inflation and interest rates drove up the rates that S&Ls had to pay to keep deposits, while they were stuck with lower earnings on mortgages that had been issued in earlier years. The costs of the crisis were exacerbated by the reckless behavior of many insolvent S&Ls, who took desperate gambles knowing that the down side would be borne by the taxpayers.

Policymakers learned three lessons from the S&L crisis. One lesson was that funding long-term mortgages with short-term deposits was unsafe. Instead, mortgages should be securitized, so that they could be sold to insurance companies and other institutions better able to hold long-term assets.

A second lesson was that historical value accounting deceived regulators, preventing them from identifying and shutting down insolvent institutions in a timely fashion. Policymakers who had been burned in this fashion came out of the S&L crisis committed to market value accounting.

The third lesson was that regulators needed a structure of capital requirements that was formal and risk-based. Another concern during this period was harmonization of bank capital requirements throughout the industrial world, so that capital requirements were set in an international agreement known as the Basel Accord. (The late 1980's also were a time when everyone feared Japanese competition, and one of the goals of the Basel Accord was to raise the capital requirements in Japan, in order to stem the threat of Japanese banks.)

The Subprime Crisis

The three solutions to the S&L crisis—securitization, risk-based capital, and market value accounting—all are heavily implicated in the current financial crisis. Mortgage-backed securities fueled a housing bubble. When the bubble collapsed, these securities became “toxic assets,” leading to bankruptcy, government conservatorship, or bailouts for companies like Lehman Brothers, Freddie Mac and Fannie Mae, and AIG.

The boom in securitization was fueled by risk-based capital regulations. A mortgage-backed security could be held by a bank with less than half the capital that would have been required in order to hold the underlying mortgages. In fact, Wall Street's financial alchemy became so effective that high-risk, subprime mortgages could be transformed into AAA-rated securities, resulting in high apparent return on equity at banks. This was true around the world, because under harmonized capital requirements, banks everywhere could benefit from holding mortgage securities made in the USA.

When the crisis hit, the problems were exacerbated by market value accounting. To meet capital requirements, one bank might have to sell its mortgage-backed securities in an environment with few buyers. The low price on this sale then became the “market” benchmark that other banks had to use to value their portfolios. This in turn undermined the capital positions of those banks, forcing them to sell their own mortgage-backed securities. The result was a vicious spiral, and there were even proposals to back away from market value accounting.

The Next Moves in the Game

Current proposals for regulatory reform reflect perceptions of the most recent crisis. One main issue is that regulators did not “see” the crisis coming. This is being blamed on regulatory fragmentation. For example, AIG's financial products unit, which wrote hundreds of billions of dollars of credit default swaps that helped fuel the rise in mortgage securitization, was regulated by the Office of Thrift Supervision, away from the auspices of the Federal Reserve or the Federal Deposit Insurance Corporation. Credit default swaps as financial instruments seemed to fall outside of any agency's regulatory jurisdiction.

A natural reaction has been to call for a “super-regulator” or a “systemic risk regulator.” Such an agency would be expected to examine the financial system holistically in order not to leave any gaps.

Another issue in the current crisis is that of systemically important institutions, known colloquially as “too big to fail.” Policymakers want the ability to supervise such institutions closely. Treasury Secretary Timothy F. Geithner and others believe that policymakers need the ability to seize such institutions when their condition presents a risk to the financial system as a whole.

Once again, it seems that policymakers are focused on what would have been useful in the last crisis. The implicit assumption is that by doing so they can create stability. In fact, these reforms probably will produce another system that is subject to severe breakdowns.

Why Regulatory Systems Break Down

Regulatory systems break down because the financial sector is dynamic. Financial institutions seek to maximize returns on investment, subject to regulatory constraints. As time goes on, they develop techniques and innovations that produce greater returns but which can also undermine the intent of the regulations.

This is a normal, human response to attempts to influence behavior. Any CEO who designs an incentive bonus system for the company's sales force knows that over time employees will learn how to “game” the system. The only solution is to constantly adjust the incentive structure in order to realign incentives with the behavior that is in the long-term interest of shareholders. PARA Within regulated industries, another source of breakdown is special interest lobbying. For example, if a firm is designated as “systemically important,” it is safe to predict that such a firm will make an effort to lobby Congress and the regulators to maximize the advantages and minimize the disadvantages of such a label. Hard to Break or Easy to Fix?

Legend has it that during World War II, German Tiger tanks were better engineered and hence broke down less often than the Soviet T-34. However, the T-34 was such a simple machine that it often could be repaired on the spot by the tank crew. When Tigers broke down, they required expert maintenance. In battle, the T-34s that were easy to fix were more effective than the Tigers that were harder to break.

Instead of trying to make the regulatory system harder to break, we might think in terms of making it easier to fix. Ideas such as functional regulation or regulatory consolidation might make our financial system harder to break, but they also could make it harder to fix. PARA Under functional regulation and regulatory consolidation, all mortgage lending would have to conform to the same set of rules. From a hard-to-break perspective, this might seem like a good thing. However, if the set of institutions involved in mortgage lending breaks down, there is no easy way to fix it.

Instead, suppose that we retain a “messy” structure in mortgage lending, with a lot of institutional overlap and regulatory duplication. If one regulator's mortgage lenders fail, a different set of institutions will be available to pick up the slack.

European countries tend to have financial systems and regulatory structures that are more consolidated than ours. The results in this crisis have not demonstrated the superiority of these neater organizational structures.

The best way to make our financial system easier to fix would be to reduce the incentives for high leverage. We promote home ownership by subsidizing mortgage indebtedness. It would be better to provide subsidies and encouragement toward saving for a reasonable down payment. Likewise, in the corporate sector, our tax structure tends to penalize equity finance and to reward debt finance. Changing the system to tilt more in the direction of equity finance would go a long way toward reducing the vulnerability of our economy to crises at banks, insurance companies, and investment banks.

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