Should we regulate banks more? (some comments and thoughts from people who are in the know). What are your thoughts? How can we protect ourselves and our children?
In the wake of subprime losses we are hearing claims that the United States should have regulated its banks more. It is worth pointing out that the U.S. has some of the most heavily regulated banks in the world:
1. The Bank Holding Company Act of 1940, still in force, prevents bank from owning non-financial corporations.
2. The previous Glass-Steagall Act (repealed in 1999) discouraged banks from diversifying out of home mortgages.
3. The Office of the Comptroller of the Currency charters, regulates, and oversees banks, including with respect to risk.
4. Several rounds of the Basel accords, including subsequent fine-tunings, have regulated bank capital holdings and reporting requirements. These are international regulations and not the sole design of a possibly defective U.S. regulatory system.
5. Banks are chartered by individual states and subject to varying regulations, disclosure, and reporting requirements, including with respect to risk.
6. Banks are regulated and supervised by the Fed, especially with regard to their risk-taking.
7. Banks are regulated and supervised by the FDIC, especially with regard to their risk.
8. Banks face additional regulations, both at the state and federal level, to the extent they are involved in commodities and insurance markets.
9. The Federal Housing Finance Board regulates Federal Home Loan Banks, which are involved in mortgage markets.
10. The Sarbanes-Oxley Act applies to publicly traded banks.
11. The Gramm-Leach-Bliley Act, the revision of the Glass-Steagall Act, regulates bank assets, albeit less than in times past.
12. The Home Mortgage Disclosure Act "...requires financial institutions to maintain and annually disclose data about home purchases, home purchase pre-approvals, home improvement, and refinance applications involving 1 to 4 unit and multifamily dwellings." These regulations are intended to limit the ability of banks to discriminate against borrowers; in practice this encourages subprime loans.
13. The Community Reinvestment Act encourages banks "to reinvest in the communities they serve," which again in practice encourages subprime loans.
14. I believe this list is not complete.
I guess we didn't have enough bank regulation!
It is also worth noting that many European banks have suffered heavy losses as well, despite operating under different regulatory regimes.
It is plausible to argue that the United States should have fewer bank regulators (I'll nominate the Fed for the main role), but that consolidation should be accompanied by greater efficacy of regulation. In the meantime there are too many regulatory authorities, and too many regulations. We have completely blurred lines of accountability, legal, political, economic, and otherwise.
Posted by Tyler Cowen on November 28, 2007 at 06:45 AM in Economics Permalink
Comments
The simple accounting rule we need that would have worked in almost all of the problems in recent years --including Enron --is no off-balance sheet assets.
Posted by: spencer at Nov 28, 2007 8:12:37 AM
Utility decreases per each increment added of an item. One snort is fine, two snorts is not twice as fine, three snorts is way less than three times as fine and four snorts is comatose and unfine. Badness however increases with each malum added so thirteen bad things piled up is much more than thirteen times as bad as one bad thing. Now I must return to my printing press where I shall manufacture faux wealth out of thin air with 0 productive input by making fiat money with nothing but a politician's promise to back up the paper. Trust me I am from the Government and I am here to make you free.
Posted by: CK at Nov 28, 2007 8:13:32 AM
Tyler--
The real question to ask is "How bad is the current credit crunch really? Is it even necessary to change existing regulations? and what changes to existing regulations (if any) could have prevented the current credit crunch?" Creating a laundry list of existing regulations doesn't really make a case that we have too many. ("Gee! Tyler thought of 13 regulations in one morning! We must have an overregulated banking system!")
Pre-emptive defense: I'm definitely not saying we need more regulation--posts by Krugman and Delong have convinced me that the current system is handling the crisis fairly well in this case, and subprime borrowers have largely (but not without exceptions!) benefitted from the last 4 years--only that Tyler's isn't making a sound anti-regulation argument here.
Posted by: MostlyAPragmatist at Nov 28, 2007 8:17:23 AM
The regulations failed to provide real-time transparency with respect to trading in derivatives. The regulations do not require disclosures of investments, as made, by private equity firms and hedge funds. Having regulations as to banks makes no difference if 50-60 percent of relevant economic activity can occur in unregulated non-bank banks.
Even the heads of Bear and Citi and the like had no good handle on what they did wrong as they did it wrong. With technology, we have the capacity to have a million eyeballs looking at trades as they occur. Given enough eyeballs, all bugs are shallow.
That said, I have no problem reducing headcount in regulatory agencies. But increased transparency, and real-time transparency, could and should be improved. Tyler could use a year or so on a trading desk.
Posted by: cfw at Nov 28, 2007 8:43:52 AM
The problem with no off balance sheet assets is how do you accout for Cisco/Dell or an insurance company or something else? Cisco and Dell don't really make stuff in the traditional sense, they do a little assembly in some cases but usually the assembly is of pre made systems) both do differing amounts of R&D and both do a very good job of sales. Clearly neither would be able to exist without support from other entities, but neither company owns any interest in their manufacturing partners. In some sense they are more like retailers than manufacturers, while in others they are more like manufacturers.
Next is an insurance company. These firms sell promises to pay if certain events occur, which they believe they more often than not won't have to deliver. What is the value of one of their newly issued promises?
Some things by their very nature are very difficult to consolidate. The problem becomes when a firm structures a vehicle to legally be something that isn't consolidatable (it's fully owned by a third party, with no guarantees from the parent company), but the parent company wouldn't be able to operate if it didn't bail out the subordiante in the event of a loss. The SIVs or Bear's hedge funds legally create very few draws on the parent companies, but Citi or Bear wouldn't be too effective if it simply let the commercial paper investors and hedge fund investors be wiped out. So they are in effect willing to provide unrequired guarantees which are terribly hard to consolidate ex ante.
Posted by: nelsonal at Nov 28, 2007 9:14:13 AM
Cisco and Dell don't really make stuff in the traditional sense, they do a little assembly in some cases but usually the assembly is of pre made systems) both do differing amounts of R&D and both do a very good job of sales. Clearly neither would be able to exist without support from other entities, but neither company owns any interest in their manufacturing partners. In some sense they are more like retailers than manufacturers, while in others they are more like manufacturers.
I don't get this at all. So Dell sells computers made by others, with whom it contracts. Why is this a novel accounting issue? Grocery stores sell food that they don't produce. Do they use off-balance sheet entities to account for that?
I think spencer's suggestion has merit. I suppose there are some legitimate reasons for off-balance sheet entities, but the potential and actual abuse seems so great that it's hard not to think we would be better off without them.
Posted by: Bernard Yomtov at Nov 28, 2007 10:12:45 AM
This post reads like it was written by Alex. I will fire up some stylometric software when I have free time to verify that this post was an outlier.
Posted by: noto at Nov 28, 2007 10:17:40 AM
The calls for regulation are for increased quality/effectiveness and not quantity.
Posted by: Mark at Nov 28, 2007 10:21:17 AM
Whoa. there is a big difference between the "amount" of regulation and - the right sorts of regulation.
Theoretically you could have quite a bit of the former without necessarily enough of the latter.
Posted by: Thomas Purves at Nov 28, 2007 10:57:31 AM
Thomas and Mark are correct. If banks had been required to keep a portion of every mortgage issued on their books, they would have had greater incentive to scrutinize borrowers. Many blame ratings agencies for giving the mortgage backed securities high ratings, but they were just following their incentives; you shouldn't blame people for following their incentives, but rather give people incentives to do the right thing.
Posted by: Dave at Nov 28, 2007 12:33:38 PM
This is nonsense. Lenders, borrowers and investors that made poor decisions will pay for it. End of story. We do not need the government to bail us out nor do we need more regulation. Take one flip side example and see how ridiculous it is - the housing market must be regulated to only go up by a maximum 3% a year because anything more than that must be criminal.
Dave, although not required, most lenders retain a piece of each securitization in the form of the "residual" piece. It is cash flow left over after all loss coverage obligations have been met. It is an asset that is marked down with any prepayments and/or defualts. When prepays and losses are greater than expected, the writedowns can be quite large. In other words, they have some skin in the game even when, for all intensive puposes, the loans are off the books. Additionally, they have incentive to have good performing collateral because otherwise, it will be tougher to sell future deals.
Posted by: Patinator at Nov 28, 2007 12:52:20 PM
The encouragement of subprime lending though points 12 and 13 seem to have been left out of the media frenzy.
Posted by: The Dirty Mac at Nov 28, 2007 1:03:48 PM
Dave, what are the incentives to give people the incentives to do the right thing?
Posted by: Nancy Lebovitz at Nov 28, 2007 1:05:51 PM
Dave, are you the Dave from the old AT’s 'Credit Snobs' debacle? If so how does it feel being right and having strawmen like this post thrown back at us for arguing for better regulation.
Patinator, lenders, borrowers and investors who make poor decisions can create serious cascade effects that damage the economy disproportionately and create market breakdowns for the majority who far removed from the actual decision-making/action-taking. We need efficient and effective regulation to correct market breakdowns such as this one. Unless of course you’re secretly Ron Paul posting here .. 
Posted by: Mark at Nov 28, 2007 1:12:12 PM
This post exhibits what you might call a "list fallacy". Using a list treats each regulatory point as equally applicable to the point.
Posted by: talboito at Nov 28, 2007 1:38:25 PM
Equal Credit Opputunity Act is an important one too that I believe is unique to the United States.
http://en.wikipedia.org/wiki/Equal_Credit_Opportunity_Act
Posted by: RTS at Nov 28, 2007 1:56:38 PM
Mixed feelings about this post. Would love to agree but in fact many of the subprime loans are made by non-banks, which are much less regulated. Also much of the regulation being called for is of brokers who are heavily responsible for many of the frauds and bad loans. So I fall in between your post and the proposals. I do agree with any objection to attempting to regulate the origination of loans by regulating the secondary market. Whether one agrees with the end in mind or not, that is an absurdly inefficient mechanism to achieve it. Finally, I think the proponents of regulation are highly disingenuos in failing to address the likely consequence of regulation which is a tremendous drop in home equity loans and low downpayment mortgages. If all these regulations go through, especially the bankruptcy reform that lets bankruptcy judges write mortgages down to fair value, you'll never see mortgage loans made with less than 20% equity again.
Posted by: mt57 at Nov 28, 2007 2:49:57 PM
Isn't your list a problem in the other direction in that it allows the individual banks to "regulator shop". Banks are not regulated by everyone one of the regulators you list. Rather, individual banks can select which regulator and/or setof regulations they want to work with and ignore the other regulators.
Posted by: spencer at Nov 28, 2007 3:02:10 PM
It is worth noting that the current state of bank regulations can actually cause periods of financial crisis, particularly with regards to liquidity drying up. All the banks have central capital controls which are heavily based on Value-at-Risk (VaR), due to the Basel accords. The size of the VaR numbers scale up with the volatility levels, so when their are big down movements, volatility increases, which increases the VaR numbers. Consequently everyone's capital limits are squeezed exactly at the same time as institutions should be buying up the cheap paper in the markets.
In the most recent flight-to-quality crises it was largely the most unregulated institutions in the financial markets, hedge funds, that ended up providing liquidity and saving the day. It took over a dozen banks to bail out LTCM, but when Amaranth, which was the largest failure, was largely bailed out by a single hedge fund, Citadel. If anyone is going to come in and buy up the Merrill or Citi mortgage paper, it's almost certainly either going to be a hedge fund or Goldman (which at this point has basically become a hedge fund).
Posted by: zeratum at Nov 28, 2007 4:57:19 PM
"We need efficient and effective regulation to correct market breakdowns such as this one."
Mark, why do you consider this a market breakdown? Did you think the same thing when home prices were going up 10% a year?
"Unless of course you’re secretly Ron Paul posting here"
A lot of Ron Paul's ideas are kooky and if elected (laughter), would never be able to implement any of them. However, I like Ron Paul soley from the aspect of shaking up the establishment.
Posted by: Patinator at Nov 28, 2007 6:23:41 PM
Straw man check--you write "...we are hearing claims that..." Can you cite any?
Anyhow, since most of us like having FDIC insurance on our bank accounts, you do need some regulation to prevent moral hazard problems. I don't see why the current situation would call for any new regulation, beyond possibly tuning the Basel capital sufficiency requirements. Anyhow, even counting North Rock, no depositors have lost any money in the current situation, have they?
Or are these calls for regulation more aimed at the sell-side of the mortgages, i.e., that they were being improperly issued? To a large extent, the market is giving the holders of those loans a proper thrashing, which should pretty much solve that problem. But, liberal that I am, it upsets me that many people were sold loans that they didn't understand and are facing serious personal problems because of that. I wouldn't mind if someone updated the truth-in-lending laws, or, my pet idea, have the state issue 'borrowers licences' and declare that their courts will only enforce debt contracts if the borrower has one.
Posted by: TomR at Nov 28, 2007 6:50:22 PM
Nancy Lebovitz: Dave, what are the incentives to give people the incentives to do the right thing?
That's the purpose of regulation. Sticks and carrots designed for better outcomes. The government, presumably, wants to avoid financial crises.
Re Patinator: I think it's clear that recent lending practices were a disaster. Lenders were simply willing to ignore risks because they could sell the loans (save a small residual) to lock in profits. It is possible that this experience will be enough to make further regulation unnecessary, since the demand for shaky mortgages will surely decrease for the foreseeable future. But it is always a good idea to look for incentive problems in markets.
And finally, I am not the same Dave from the Credit Snob post. Sorry to disappoint.
Posted by: Dave at Nov 28, 2007 9:19:13 PM
Imagine Tyler on a boat with a conspicuous leak. Another passenger suggests a patch might fix the problem. Tyler points out that the boat is already heavily patched, points out 14 patches, and sarcastically remarks "I guess you think we don't have enough patches" (as if patching the leak is a stupid idea.)
It's amazing to me the way Tyler alternates between smart economist and crank libertarian ideologue.
Posted by: Mike Huben at Nov 28, 2007 9:42:03 PM
Sometimes you should switch boatmakers, especially if no one was accountable for the quality of the boat you bought before -- Crank Libertarian Ideologue
Posted by: Tyler Cowen at Nov 28, 2007 11:24:27 PM
Mike, it's only you who sees crank libertarians everywhere. The rest of us look at the patches and say "14 patches didn't work; it's not likely that a fifteenth would help, especially given that two of the patches were actually new holes."
Posted by: Russell Nelson at Nov 29, 2007 12:01:02 AM
Mike Huben--
Check out Brad Delong's website for balance. Brad alternates between being a smart libertarian economist and a crank liberal ideologue. Brad seems to have a sense of humor about it :-)
Posted by: MostlyAPragmatist at Nov 29, 2007 6:51:02 AM
"Brad alternates between being a smart libertarian economist and a crank liberal ideologue. Brad seems to have a sense of humor about it :-)"
????????
Brad is smart, but is no way a libertarian. (How many libertarian bloggers delete polite posts that disagree with him?) Also suffers from BDS.
I do agree with the "crank liberal ideologue" assessment, though. His posts are sometimes good, but skip the comments. The drivel there will leave you nauseated.
Posted by: Tom at Nov 29, 2007 9:46:39 AM
Bernard,Because Dell and Cisco are doing in manufacturing the same thing that Citi and others did in banking, the contract manufacturers' contracts are off balance sheet arrangements (or would be if they were financial instruments). Eliminating them would be interesting but doesn't give you a very accurate information about Dell's operations.
Effectively this is similar to Cisco seeing Flextronics starting to get wobbly and deciding that since they were such an important (but historically arms length partner), they'll guarantee their loans, even though they were never required to do so. That's what is beginning to happen with the SIVs. The banks can't screw institutional investors on hundreds of billions in paper (likely sold with a nod and wink that we're backing it) without ruining their franchise to do future deals. So they're trying to come up with a way of not creating losses for the SIV investors without accepting losses they never were supposed to take in the first place.
Posted by: nelsonal at Nov 29, 2007 11:05:03 AM
I have worked as a bank auditor and also as a savings and loan auditor. I can promise you that the heavy regulation on banks prevented them from most of the practices that got the S&L's in trouble.
There is a law in the U.S. against pyramid schemes, but it contains an exception for Amway and other "semi-pyramid" schemes. If you want to bring the banks in line, just eliminate the loopholes and enfore the law.
More to the point, interest rate risk is hard for consumers to understand, but sophisticated investors can't make that argument. If the government bails out a consumer for their own stupidity, that is just another day in Washington. If the governemtn bails out a sophisticated investor for their stupidity, that is welfare for billionaires.
The United States seems to have created a new form of socialism that only protects investors: The rewards are private, but the risk is public.
Posted by: Dave H at Nov 29, 2007 2:50:17 PM
"Sometimes you should switch boatmakers, especially if no one was accountable for the quality of the boat you bought before -- Crank Libertarian Ideologue"
Ah, I forgot that in libertopia the boats last forever and never need repairs!
Or are you suggesting that you are ready to emmigrate? Allow me to recommend one of those floating libertopias that have been proposed so often. Surely they have been built with the quality you demand!
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Posted by: 数据恢复 at Nov 30, 2007 2:24:21 AM
Tyler, You’re making it sound as though banks were innocent bystanders in the sub-prime loan fiasco—they knew what was going on. Banks are like any other industry—their concern at the end of the day is profit, not the welfare of their customers. I wouldn’t feel sorrow for banks—they are one of the most powerful lobbying groups in Washington. I’m curious to know what your view is of how banks were able to lobby and change bankruptcy laws and how they can now charge sky high interest rates on credit cards.
Posted by: J.G. at Dec 1, 2007 11:21:48 PM
We really don't have a regulated banking system. See ol' Bill Gross for the gory details.
http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/index.htm
We are facing a crisis of system threating proportions and Tyler is blaming regulation, while Bill Gross, as a professional money manager is blaming a shadow banking system that is completely unregulated. Hmm...
I think my money is with Bill on this one. The packaging and creation of derivatives is really almost completely unregulated and has far more impact on the way the market was doing business than any of the regulations that Tyler listed. Tyler could be talking about speed limits on the highway for all the impact the regulations he listed had on the derivatives markets.
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