Tackling the Crisis

8 August 2009

Comments on the global financial crisis at Consilium, hosted by the Centre for Independent Studies in Coolum, Queensland


From the background notes I've read, it seems likely that other speakers today will talk about the on-going debate about how monetary and fiscal policy should be tackling the crisis.  So I'm not going to talk about that, but rather about the causes of the banking crisis and what should be done to reduce the risks of another similar crisis in the future.

The popular media, and far too many politicians, blame the crisis on the greed of bankers.  And when it's announced that bankers have been paid tens of millions of dollars despite driving the institutions which they've run into serious trouble, it's easy to understand why they make very easy targets.  Even I, myself a director of the largest bank in New Zealand, feel outraged!

I don't want to excuse the bankers.  It seems undeniable that many bankers, motivated by what motivates most people in a market economy, took enormous gambles using money belonging to other people in the belief that they could make themselves very rich indeed in the process.

But it probably won't surprise many people here that many other factors were also involved, and those factors were the fault of successive governments and the policies they supported.  Specifically:

* It seems pretty clear that interest rates in several major economies were too low over much of the last decade. Perhaps that was the result of monetary policy being too loose, as John Taylor and I think Jerry Jordan would argue. Or perhaps it was the indirect result of China's determination to keep its exchange rate under-valued - something which both helped to generate enormous savings in the hands of the Chinese, which they invested in US Treasury bonds depressing US interest rates quite directly; and put pressure on the manufacturing sector in the US, thus providing a reason for keeping monetary policy relatively easy. But either way, it was a policy failing having nothing to do with the greed of bankers.

* Then we had ongoing pressure on US banks to lend to marginally creditworthy borrowers. Stan Liebowitz wrote a fascinating paper in October last year, in which he concluded that "in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the (US) government undertook an attack on (mortgage) underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs (the government-sponsored enterprises Fannie Mae, Freddie Mac and Ginnie Mae), and housing activists universally praised the decline in mortgage-underwriting standards as an 'innovation' in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble."[1] Richard Salsman argued that the real problem is what he called the "morality of altruism". He argued that "altruism has motivated the utter debasement of lending standards in the past decade... Highlighting the legal-coercive backing of Washington's altruistic credit policies, the Federal Reserve Bank has for years distributed a booklet to mortgage lenders - Closing the Gap: A Guide to Equal Opportunity Lending - which includes sidebar reminders that fines and jail terms await those found to be deficient in fighting 'discrimination' by (not) lending to the less-than-creditworthy. The booklet, still distributed today, derides as 'arbitrary and unreasonable' such traditional credit standards as a 20 percent down payment..., an above-par credit score, a history of paying one's bills on time, and a steady job yielding an income sufficient to make monthly mortgage payments".[2]

* And then we had the curious American habit of non-recourse lending, whereby borrowers engaged in a "heads I win, tails the bank loses" game - knowing that if house prices rose, the borrower stood to make a lot of money, while if they fell, the bank stood to loose a lot of money. Why banks in most American states lend on this basis utterly escapes me, and whether it is a policy failing or a result of competitive pressures I don't know.

* But what is a policy failing is the practice in many urban areas, in Australia and New Zealand as well as in the US, of tightly regulating the supply of residential land, so that once demand for residential property started to go up there was little or no scope for an increase in supply to meet that demand, and house prices started to rise strongly. While house prices hardly rose at all in a large and fast-growing city like Dallas where restrictions on the supply of residential land were almost non-existent, they rose very strongly indeed in places like Los Angeles and San Francisco. As Thomas Sowell has noted, 60% of all mortgage defaults in the US are concentrated in just five states, primarily those where the supply of residential land was subject to tight restriction.[3]

* And last but not least, I want to blame banking regulation and supervision. I'm not arguing that the crisis wouldn't have happened if bank regulators had been more assertive, or more attentive, but rather that banking regulation and supervision itself may have contributed substantially to the crisis by leading both depositors and, worse still, bank directors to assume that the regulators had everything under control. Mervyn King has noted that "forty years ago, the clearing banks in London held around 30% of their assets in short-term liquid instruments. Today that liquid assets ratio is about 1%. For the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets. At the turn of the new century it was close to zero."[4] It's hard to avoid the conclusion that part of the reason that banks have felt able to adopt much riskier balance sheets is their belief that, in a crisis, the regulator would look after them.

So how should we all avoid crises like the present one occurring again?

There is of course an enormous amount of ink being spilt trying to answer this question.  Quite apart from desisting from some of the things which have caused the crisis - like putting huge political pressure on banks to lower their credit standards, and keeping tight restrictions on the supply of residential land in some urban areas - in my view, there are three things we should not do, and five things we should do.

First, what we should not do.

I think it's a serious mistake to extend the scope of supervision to include small financial institutions which are in no sense of systemic importance.  This has already happened in many countries, and it's about to happen in New Zealand.  Non-bank financial institutions will increasingly be supervised, and more and more the public will assume that any supervised institution is somehow "guaranteed" by government.  There will be enormous political pressure on government to bail out the depositors of any supervised institution which gets into trouble.  Risky institutions will be able to raise money without paying the risk premium that should be paid.

I think there are similar dangers in regulating banks ever more heavily.  In New Zealand, the Reserve Bank has recently taken responsibility for approving all the directors of banks, the CEO, and all the first reports to the CEO.  If I were a depositor with a bank which got into trouble, I know where I'd be looking to lay the blame.

There are dangers of a different sort in mandating counter-cyclical capital requirements.  In a boom, the market sees no need for extra capital, so banks would work hard to circumvent any regulation requiring them to hold more capital.  Conversely, in a serious downturn, the market requires more, not less capital, so for the regulator to require less capital would surely be ineffective.

But there are five things which could well reduce the risk of another financial crisis, or at least reduce its severity when (rather than if) it occurs:

* First, there needs to be a public education programme making it clear that, while the central bank stands ready to provide (expensive) liquidity to financial institutions which can establish their solvency with a reasonable degree of certainty, the government does not guarantee supervised institutions. Only as people begin to understand that will they again start distinguishing between financial institutions on the basis of their prudence and creditworthiness.

* Second, there needs to be a requirement for financial institutions to disclose key information in a succinct and readily understandable way, highlighting a credit rating from a reputable credit rating agency - or the absence of a credit rating if none has been obtained.

* Third, banks need to be able to show the regulator at regular intervals how they would be wound up in the event of their insolvency, and have sufficient capacity available to them (in terms of on-site or accessible IT facilities) to make that feasible for the regulator. This is already being proposed, and seems to me to be a very sensible move.

* Fourth, I think the proposal of Raghuram Rajan (former chief economist at the IMF, and now a professor at the University of Chicago) to require banks to have "contingent capital" has a great deal of merit. In one version of his proposal, outlined a few months ago in The Economist, banks would issue debt "which would automatically convert to equity when both of two conditions are met: first, the (banking) system is in crisis, either based on an assessment by regulators or based on objective indicators; and second, the bank's capital ratio falls below a certain value. The first condition ensures that banks that do badly because of their idiosyncratic errors, rather than because the system is in trouble, don't avoid the disciplinary effects of debt. The second condition rewards well-capitalised banks by allowing them to avoid the dilutive effect of the forced conversion... It will also give banks that anticipate losses an incentive to raise new equity."[5]

* And finally, perhaps the greatest need is to make bank failure a realistic option for banks which are today seen as "too big to fail". Under present arrangements, some banks are too big to be allowed to fail, and that has been amply demonstrated in recent months. The problem is that too many bank directors and bank managers have traded on that belief, and will continue to trade on that belief. They have operated on the basis that they can take very large risks (sometimes even larger than they were aware of): if their gambles pay off, they reap very substantial personal rewards, and rewards also for their shareholders; if their gambles do not pay off, they may still reap substantial rewards in the form of "separation payments"; shareholders may get hurt, but at least depositors will be bailed out by taxpayers. That is a totally unsatisfactory situation. I have some sympathy with the view of Nassim Nicholas Taleb, the author of The Black Swan, who earlier this year wrote "Nothing should ever become too big to fail... Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing". And indeed, this idea that perhaps some banks have become too big seems to be under serious consideration, at least in the UK. Mervyn King in a speech in June said that "if some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big".[6]

As we listen to those calling for yet more intrusive bank regulation, it is worth recalling that every single bank crisis since 1945 has been caused by one of two factors:

* fraud (think BCCI or Barings), and bank regulators (and even bank directors) have little or no chance of detecting that until it is too late; or

* a dramatic fall in asset prices, typically property prices, and bank regulators seem to be no better able to predict those than are bankers.

To me, this suggests that we should never expect too much of bank regulation, but focus instead on creating the right incentives within the banks themselves for prudent behaviour.


[1] Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Stan J. Liebowitz, The Independent Institute, 3 October 2008.

[2] Altruism: The Moral Root of the Financial Crisis, The Objective Standard, Spring 2009.

[3] The Housing Boom and Bust: Thomas Sowell on how government policies made the housing crisis possible, by Brian Doherty, on www.reason.com/news/show/133593.html, 20 May 2009.

[4] Finance: A Return from Risk, a speech at the Mansion House by Mervyn King, 17 March 2009.

[5] The Economist, 11 April 2009.

[6] Speech by Mervyn King at the Lord Mayor's Banquet for Bankers and Merchants of the City of London at the Mansion House, 17 June 2009.

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