Financial Reform: “You can’t fix what you can’t explain.”

This week, House and Senate conferees are working out the details in what will likely be the most significant financial regulatory reform in some time. Should the new Consumer Financial Protection Bureau be housed in the Fed? Should the Volcker rule be universally applied? Should banks really be required to spin off their derivative activities? These are important issues and, in some cases, reform may be justified regardless of whether it actually addresses the causes of the financial collapse.

But what if the House and Senate have simply failed to understand the underlying problem? What if they have allowed politically-defined timetables to force premature closure, resulting in regulatory changes that will not have the intended impact?

A piece by Binyamin Appelbaum and Sewell Chan  published in the New York Times on May 2, entitled “Senate Financial Bill Misguided, Some Academics Say,” should have attracted more attention than it did.

The lead paragraph: “As Democrats close in on their goal of overhauling the nation’s financial regulations, several prominent experts say that the legislation does not even address the right problems, leaving the financial system vulnerable to another major crisis.” The piece continues: “A diverse group of critics… say the legislation focuses on the precipitators of the recent crisis, like abusive mortgage lending, rather than the mechanisms by which the crisis spread.”

Some attention is given to Gary Gorton ( I have discussed his book, Slapped by the Invisible Hand, in a previous posting). In a presentation to the U.S. Financial Crisis Inquiry Commission, Gorton summarized his argument as follows (his entire testimony can be downloaded here, along with additional testimony):

  • As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
  • The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo [repurchase agreements]. Repo also grew enormously, and came to use securitization as an important source of collateral.
  • Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
  • In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
  • The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Returning to the New York Times piece, the authors write: “Gorton…said the financial system would remain vulnerable to panics because the legislation would not improve the reliability of the markets where lenders get money, by issuing short-term debt called commercial paper or loans called repurchase agreements or ‘repos.’ … ‘It is unfortunate if we end up repeating history,’ Professor Gorton said. ‘It’s basically tragic that we can’t understand the importance of this issue.’

I find Gorton’s case compelling, although there are additional dimensions to the collapse that need to be explored. Moreover, there are the larger public choice problems and the difficulties inherent in engaging in social engineering via the political manipulation of credit markets).

The New York Times piece, which I strongly recommend to readers interested in understanding the debates, ends on a sober note: “critics point to the words of Nicholas F. Brady, a former Treasury secretary who led the bipartisan investigation into the 1987 stock market crash: ‘You can’t fix what you can’t explain.’”

Does anyone believe that the hard intellectual work of understanding the financial collapse has been completed (note: The Financial Crisis Inquiry Commission created by Congress, is not even scheduled to report its findings until December 2010) Does anyone believe that what we have learned thus far has informed the legislative debates?

By now it has become axiomatic that we should never let a good crisis go to waste. But what if moving rapidly to capitalize on the current crisis does nothing to prevent (or even worse, increases the likelihood of) a future crisis?

One thought on “Financial Reform: “You can’t fix what you can’t explain.”

  1. Right so, the current financial regulatory reform proposal is totally useless in terms of correcting what specifically caused the crisis.

    The current regulatory paradigm based on arbitrary risk-weights, lowers the capital requirements for banks when lending to what ex-ante is perceived by the credit rating agencies as having lower risk of default, and, as a direct consequence, increases the banks’ expected ex-ante returns from pursuing these “low risk” opportunities.

    But since there has never ever been a major or systemic bank crisis that has resulted from banks being involved with anything that ex-ante was perceived as risky; and they have all resulted from lending and investing in what ex-ante was considered as not risky; we can only conclude that those regulations are outright stupid since they reinforce the real risk.

    Even the infamous Dutch tulips would, in their own bubble time, have earned these AAA ratings and if the same set of circumstances and regulations had been in place, the lower capital requirements would have made that boom and bust even worse.

    It would seem that the regulators thought the credit rating agencies to possess some extraterrestrial sensorial abilities that other humans did not. One must be truly desperate for safety to believe such nonsense.

    But that was not all the regulators did. They also imposed on our banks solely their particular concern, the risk of default, a risk that when compared to the many other risks we confront as humans is in fact quite a benign risk; the triple-A rated BP suffices as evidence of that.

    It is always better to fail taking real and worthy risks than to fail taking useless Potemkin risks!

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