The Obama Administration Proposals for Financial Regulatory Reform: A Critical Audit

This paper offers a critique of the Obama Administration's proposals for regulatory reform, as put forth in an 88-page paper issued by the Treasury, called “A New Foundation: Rebuilding Financial Supervision and Regulation,” which I will refer to henceforth as the Report. The Report offers a misguided diagnosis of the crisis, which in turn leads to questionable recommendations for reform.

Unfortunately, the Obama Administration's proposals for regulatory reform are a product of the same sort of groupthink that helped produce the crisis. In fact, the group does not seem to have changed, with the Report largely a product of the community of regulators that failed to prevent the current crisis. There has been no effort to re-examine fundamental assumptions, or to consider the possible consequences if those assumptions are wrong. Once again, ideas and concerns from outside of the narrow consensus are being ignored.

Groupthink was a major factor in the buildup of risk in the financial system in the decade preceding the recent crisis. Top bank executives and regulators ignored dissenting voices from both ends of the political spectrum which were questioning the excesses that were building up in the system. What was once a comfortable consensus about the strength of our regulatory structure has now been replaced by an equally comfortable and equally flawed consensus about how to fix it.

One may think of my essay as an attempt to audit the Report. Accordingly, I will present my critique as a series of findings.

1. The Report does not offer a comprehensive analysis of the causes of the financial crisis.

2. The Report ignores the role played by housing policy in creating the financial excesses that preceded the crisis.

3. The Report ignores the role played by regulatory capital arbitrage in creating an unstable financial system.

4. The Report calls for a systemic risk regulator notwithstanding the probability that such an agency would be subject to the groupthink that caused the Federal Reserve, the International Monetary Fund, and other government agencies to misconstrue financial innovations as improving the distribution of risk in the financial system.

5. While the goal of protecting consumers from harmful financial products is laudable, the Report does not demonstrate that this issue is important for preventing future financial crises. It does not test its assumptions by going back through history and indicating how various innovations, such as money market funds, web-based stock trading, or debit cards would have been evaluated had such an agency been in place at the time they were developed.

6. The Report calls for requiring mortgage originators to retain at least a five percent interest in mortgages that they sell. However, it never demonstrates that this will achieve the goal of reducing the risk in mortgage securitization, nor does it explain why this approach is better than the techniques that Freddie Mac and Fannie Mae used successfully for several decades until they lowered their standards in a misguided attempt to recover market share in 2004-2007.

7. The Report calls for an expedited process for resolving problems at large, systemically important financial institutions. This is a laudable objective, but there are questions concerning whether such a process in practice can withstand pressures coming from both domestic and international interests.

8. The Report ignores the views of outside critics. Their concerns include the political influence of large financial firms, the risks of combining narrow banking with other financial functions, the insulation from market discipline created by the “too big to fail” doctrine, and the question of whether strong regulation subtracts or adds to the risk of catastrophic failure.

Finding One: The Report does not offer a comprehensive analysis of the financial crisis.

One would think that if the goal of financial reform is to correct the weaknesses of the previous regulatory regime, then it would make sense to start with a thorough analysis of the causes of the current crisis. Instead, the Report merely makes vague allusions to “gaps and weaknesses in the supervision and regulation of financial firms.” With such a shallow analytical basis, it is not surprising that the Report fails to provide compelling reasons to believe that the crisis could have been avoided even if all of its recommendations had been implemented ten years ago.

The financial crisis can be described as consisting of four components:

– Bad Bets

– Excessive Leverage

– Domino Effects

– 21st-Century Bank Runs

The bad bets were mortgage loans and investments in mortgage-backed securities that could not withstand declining house prices. The report focuses very little on these bad bets or on the policies that encouraged financial institutions to place such bets. This will be discussed more below under Finding Two.

Excessive leverage came from the creative use of financial innovation that enabled banks to comply with the letter of risk-based capital rules while violating the spirit of those rules. This was done with the knowledge and approval of the primary regulators. Techniques for creating excessive leverage included abuse of AAA ratings, creation of off-balance-sheet entities, and designation of mortgages as “short-term investments” requiring no capital at all. While the Obama Administration’s white paper speaks to raising capital requirements, it does not address the dynamics of regulatory capital arbitrage, in which banks develop innovations that over time serve to undermine requirements. Regulatory capital arbitrage will be discussed more below under Finding Three.

Domino effects are connections among financial firms that allow adversity at one institution to cause problems at many others. For example, when Lehman Brothers was allowed to go bankrupt, this adversely affected a major money market fund, which in turn threatened to cause a general loss of confidence in money market funds. As another example, AIG's difficulties posed threats to its major counterparties.

Twenty-first-century bank runs emerged when financial institutions had incentives to rush to liquidate positions ahead of one another. For example, money managers were buying commercial paper from banks' special-purpose vehicles that were holding mortgage securities. As doubts emerged about the value of the mortgage securities, it was in the interest of each money manager to curtail funding or to demand more excess collateral, even though collectively these actions may have driven the market value of the mortgage securities well below their intrinsic value.

As another example, consider investors in Freddie Mac and Fannie Mae. Had investors collectively lent to those firms at historical spreads relative to Treasury rates, Freddie and Fannie might have remained viable. However, it was in the interest of each individual investor to demand a significant risk premium, to compensate for the possibility of default.

Finally, there were the counterparties to AIG's credit default swaps. If they had collectively refrained from asking for collateral as the potential increased that AIG would have to pay claims on these financial insurance contracts, AIG would have been able to remain viable longer. However, individually, each counterparty had the contractual right to demand collateral, and the counterparties did so. AIG could not come up with enough short-term, low-risk assets to meet the collateral calls.

Domino effects and 21st-century bank runs are presumably a main factor motivating the call for a systemic risk regulator. However, this raises the question of how such a regulator is supposed to distinguish benign market transactions from those that might produce domino effects and bank runs. This issue is discussed more below under Finding Four.

Finding Two: The report ignores the role played by housing policy in creating the financial excesses that preceded the crisis.

The American housing market has long been the locus of political interference, lobbying, and subsidies. The thrust of policy has been to encourage home ownership and mortgage indebtedness. While a case can be made that home ownership is a public good, mortgage indebtedness and speculative home purchases are, if anything, public bads.

Home ownership is encouraged by preferential capital gains tax treatment. This benefit was expanded in 1999 to include homes purchased for investment purposes. This may have contributed to the increase in the share of mortgage loans that went for non-owner-occupied housing, which rose from less than five percent in the late 1990's to 15 percent at the peak of the housing bubble in 2005.

Mortgage indebtedness is encouraged by many policies. Mortgage interest can be deducted from income for tax purposes. Federal policies serve to subsidize mortgage lending. The Federal Housing Administration subsidies are direct. Indirect subsidies include the implicit guarantee that was provided to investors in securities issued by the Government Sponsored Enterprises (GSE's)--Freddie Mac and Fannie Mae. In addition, Congress and regulators applied pressure to banks and the GSE's to provide loans to “under-served” markets. The Community Reinvestment Act applies to banks and affordable housing goals were applied to the GSE's.

The political support for home ownership helped shape the policy environment during the years when house prices were rising. Concerns over rising house prices, falling underwriting standards, and reduced homeowner equity were muted. Entry into the housing market by households that could not meet traditional standards for income relative to mortgage burdens was encouraged.

These policies ultimately resulted in overbuilding, speculative home purchases financed almost entirely by debt, and unsustainable increases in house prices. However, the report ignores the role played by housing policy in fueling the bubble, and it makes no recommendations for changes in policy.

The most important policy change would be to remove the subsidies that encourage mortgage indebtedness. Until recently, the standard requirement for a down payment was 20 percent. Loans with lower down payments should not be subsidized, and in fact a case can be made that they should be discouraged. Low-down-payment home purchases destabilize the housing market, because such purchases tend to increase when house prices are rising and diminish sharply when house prices are falling.

A more sophisticated approach would be to encourage countercyclical lending standards. That is, when housing markets are booming, regulators should push for tightening of lending standards. Looser lending standards should be fostered only when housing markets are soft. Instead of countercyclical lending standards, the “affordable housing” policy steered lending standards in a direction that was procyclical. As housing markets boomed, regulators leaned on lenders to loosen underwriting standards to allow low-income households to purchase homes even though higher prices made it more implausible that those households could repay the loans needed to obtain such homes.

Finding Three: The report ignores the role played by regulatory capital arbitrage in creating an unstable financial system.

Many of the financial practices that were at the heart of the crisis were motivated by regulatory capital arbitrage (RCA). RCA drove securitization, the use of credit tranches, the reliance on rating agencies, and the growth of the “shadow banking system.”

RCA is the use of financial engineering to enable banks to reduce the regulatory capital needed to bear a given amount of risk. RCA exploited the structure of risk-based capital embedded in the Basel Accords. For capital purposes, assets were placed into risk buckets. An asset in the 100 percent risk bucket required eight percent capital. An asset in the 20 percent risk bucket required just 1.6 percent capital.

A mortgage security that was rated AA could receive a 20 percent risk weight. This compares with a traditional mortgage, which would receive a 50 percent risk weight. Mortgage securities held in off-balance sheet entities, such as Structured Investment Vehicles (SIVs), could effectively receive a zero percent risk weight. The mechanisms of RCA are explained more fully in Jones (2000), Tett (2009), and Acharya and Richardson (2009).

The Report states on page two that agency ratings were used because “Market discipline broke down.” This statement completely ignores the fact that regulators blessed agency ratings and used those ratings as a basis for determining capital requirements.

Thus, the Report offers a very misleading view of how regulations and markets interact. The Report is written as if mishaps necessarily result from under-regulation. However, in this instance, regulation is what steered firms to build the system for distributing mortgage credit risk that ultimately proved to be so fragile.

Finding Four: The Report calls for a systemic risk regulator, notwithstanding the probability that such an agency would be subject to the groupthink that caused the Federal Reserve, the International Monetary Fund, and other government agencies to misconstrue financial innovations as improving the distribution of risk in the financial system.

In 2006, the International Monetary Fund in its annual report looked at existing financial practices and pronounced that they had “helped to make the banking and overall financial system more resilient.” One can find similarly sanguine assessments made by key officials at the Federal Reserve.

The Report makes the unwarranted assumption that the financial crisis was allowed to happen because officials were not looking for systemic risk. In fact, they were looking for systemic risk and not seeing it. If we do create a systemic risk regulator, presumably this agency or council will be populated by the sorts of officials who populate the Fed and the IMF. These officials will be no less fallible within a new agency than they are in their current positions.

Finding Five: While the goal of protecting consumers from harmful financial products is laudable, the Report does not demonstrate that this issue is important for preventing future financial crises.

There are consumers who have limited understanding of financial products. There are consumers who incur large future costs for relatively small near-term benefits. There are merchants and financial entrepreneurs willing to exploit such consumers. Trying to protect consumers from their cognitive and behavioral shortcomings may be a reasonable objective.

However, it is important to recognize that it is hard to evaluate financial products out of context. In a booming housing market, exotic mortgage instruments helped many people obtain homes and earn profits. In a falling housing market, even a plain vanilla mortgage is risky.

How would a consumer financial protection agency evaluate a life-cycle investment fund that increases the proportion of stock market investments in a young person's portfolio? An economist who believes that stocks are relatively less volatile in the long run would approve of such a product. An economist who believes otherwise would disapprove it.

Many economists are skeptical of the value of extended warranties on appliances. Suppose that such warranties were banned as bad consumer financial products. Might manufacturers start to produce shoddy merchandise, because they are deprived of the opportunity to profit from durable products?

Would financial products that are popular today, such as money market funds and debit cards, have been banned by a risk-averse financial product safety commission? Keep in mind, also, that incumbent firms will have an incentive to “warn” the commission of the dangers of innovative products that compete with their own established offerings.

Finding Six: The Report calls for requiring mortgage originators to retain at least a five percent interest in mortgages that they sell. However, it never demonstrates that this will achieve the goal of reducing the risk in mortgage securitization, nor does it explain why this approach is better than the techniques that Freddie Mac and Fannie Mae used successfully for several decades until they lowered their standards in a misguided attempt to recover market share in 2004-2007.

There is a widespread view that the deterioration in mortgage quality resulted from the separation of the functions of mortgage origination and mortgage ownership. However, the proposed solution of requiring originators to retain a five percent interest is downright silly.

The separation of functions gives rise to what is known as a principal-agent problem. The originator is acting as the agent of the ultimate owner, and the challenge for the owner is to align the incentives of the originator with those of the owner. Principal-agent problems are ubiquitous, and they are addressed by many business practices, without government dictating the solution.

Even in a traditional bank, there are principal-agent problems. One challenge is to align the incentives of loan officers with those of the bank's owners. If loan officers were compensated on the basis of loans closed, then they would originate low quality loans. The key instead is to give loan officers guidelines and policies for approving or rejecting loans, and to compensate them on the basis of compliance with those policies. No bank believes that it is necessary to require its loan officers to keep a five percent stake in the loans that they originate.

For decades, Freddie Mac and Fannie Mae bought loans from separate originators without requiring those originators to retain a stake in those loans. Instead, the GSE's issued rules and guidelines to originators and then used various techniques to ensure compliance with those guidelines. Techniques that I saw Freddie Mac use in the early 1990's included:

– Onsite audits, in which Freddie Mac would send its staff to the offices of large originators to observe their lending practices

– Quality control sampling, in which Freddie Mac staff would re-underwrite a sample of loans. If loans were found that failed to meet Freddie Mac guidelines, Freddie Mac would require the originator to repurchase those loans. If a pattern of bad lending was suspected at one originator, Freddie Mac might then re-underwrite all of that originator's recent loans and require repurchase where problems were found.

– Treating all early-payment-defaults (loans where the borrower defaults within the first 12 months) as suspicious, and re-underwriting all such loans, requiring the originator to repurchase if flaws were found.

What happened in recent years is not that mortgage originators became more ruthless in sneaking through loans that failed to meet guidelines. What happened is that the guidelines became much looser. Freddie Mac, Fannie Mae, and the buyers of private-label mortgage securities became willing to buy loans with higher loan-to-value ratios, lower credit scores, and reduced documentation. The originators gave the buyers of mortgages what they wanted.

Going forward, lending standards ought to be tighter than they were in recent years, when too many participants assumed that rising house prices would cover up all sins. Tighter lending standards will have to be enforced, of course. But that can be done without requiring originators to keep a five percent interest in the mortgages.

Finding Seven: The Report calls for an expedited process for resolving problems at large, systemically important financial institutions. This is a laudable objective, but there are questions concerning whether such a process in practice can withstand pressures coming from both domestic and international interests.

The ability of a resolution mechanism to work depends on the willingness of regulators to see it carried through. Many of us believe that existing bankruptcy and FDIC resolution procedures would have been adequate in the 2008 financial crisis. With the exception of Lehman Brothers, regulators were unwilling to see those procedures followed. The opinion about the Lehman decision varies. Some observers view it as a mistake, while observers view the resolution of Lehman as a success.

I am skeptical of the willingness of regulators to stick with a resolution mechanism. For example, in the 1990s, Freddie Mac and Fannie Mae were each given a line of credit of $2.25 billion with the Treasury, which was supposed to be the limit of taxpayer obligations. However, when the crunch came, Treasury chose to effectively guarantee all of the GSEs' liabilities.

Powerful interests, both domestic and foreign, push for bailouts. This skews financial decisions. For example, would the Prime Reserve Fund have invested heavily in short-term paper from Lehman had Prime Reserve known that the government would allow Lehman to fail?

Establishing a time-consistent policy for resolving failed financial institutions is quite difficult. The Report fails to highlight the time-inconsistency problem, which biases regulators in the direction of bailouts rather than following through with established methods of resolution.

Finding Eight: The Report ignores the views of outside critics. Their concerns include the political influence of large financial firms, the risks of combining narrow banking with other financial functions, the insulation from market discipline created by the “too big to fail” doctrine, and the question of whether strong regulation subtracts or adds to the risk of catastrophic failure.

Many critics, on both ends of the political spectrum, believe that large banks and Wall Street firms wield too much political influence. The Report does not discuss the issue of regulatory “capture” and how to prevent it.

The Report proposes dealing with large, complex financial institutions with better regulation. Instead, many critics suggest that such institutions ought to be broken up. In addition, it might be desirable to separate functions tied to the payment system (“narrow banking”) from other functions that relate to capital allocation. The narrow banking function may need a solid Federal backstop and strong regulation. The other functions ought to be treated differently, with market discipline playing a much larger role.

Finally, there is the issue of whether the Report's visionary reach exceeds regulators' cognitive grasp. As Jeffrey Friedman (2009) argues, it is not possible for regulators to anticipate all of the consequences of their actions. As counterintuitive as it may seem, a weakly-regulated financial system may be more robust. A system with individual market actors pursuing a diverse set of strategies may be less prone to catastrophic failure than a system guided by a single strong regulatory framework.

Arnold Kling earned his Ph.D in economics from MIT in 1980. He was an economist on the staff of the Federal Reserve Board from 1980-1986. From 1986-1994 he held a number of positions at Freddie Mac. In 1994, he started one of the first commercial web sites, Homefair.com, which was sold in 1999. Since then, he has been teaching high school statistics as a volunteer and has written several books, including Crisis of Abundance: Rethinking How We Pay for Health Care (Cato Institute); From Poverty to Prosperity (forthcoming); and The Knowledge-Power Discrepancy (forthcoming; title tentative). He is a member of the Financial Markets Working Group of the Mercatus Center at George Mason University.

David Jones, 2000. “Emerging Problems with the Basel Capital Accord. Regulatory capital arbitrage and related issues,” Journal of Banking and Finance, Vol. 24 (January), p. 35-58.

Gillian Tett, 2009. Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan was Corrupted by Wall Street and Unleashed a Catastrophe. Free Press.

Viral V. Acharya and Matthew Richardson, 2009. “Playing by the Basel Rules,” Critical Review, Vol. 21 (Spring-Summer), 195-210.

Friedman, Jeffrey, 2009. “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” Critical Review, Vol. 21 (Spring-Summer), 127-184.