Financial Regulatory Reform--The Administration's Proposal

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The Administration's proposals for altering the regulation of the financial markets are found in an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation (Treasury Dept., June 17, 2009). This is a well-written report but suffers from two grave weaknesses: prematurity and a failure to address objections.

Now it is true that it is not always necessary to understand a cause in order to be able to eliminate its unwanted effects. If you have typical allergy symptoms, you may get complete relief by taking an antihistamine and not think it necessary to find out what you're allergic to. But generally and in the case of the current economic crisis, if the causes of a problem are not understood it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically--there is no counterpart to the 9/11 Commission's exhaustive study of the 9/11 terrorist attacks--and they are not obvious though treated as such in the report. The report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly on the part of bankers (in part reflected in their compensation practices), credit-rating agencies, and consumers (gulled into taking on debt, particularly mortgage debt, that they could not afford), and defects in the regulatory structure. There is no mention of errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down along with the homeowners the banks and related institutions that had financed the bubble. The report also fails to mention the deregulation movement in banking, which enabled banks to make much riskier loans than in the old days when regulation discouraged competition in banking. And there is no mention of lax enforcement of existing regulations or the complacency of the economics profession, including its representatives in government, though regulators' failure to spot the evolving crisis is mentioned. There is exaggerated emphasis on mistakes by the banks themselves, and no recognition that a regime of very low interest rates and very light regulation encourages perfectly rational, intelligent bankers to take risks that can, albeit with low probability, precipitate a global financial crisis.

Though the Federal Reserve bears a substantial share of the responsibility for the economic disaster because of its misguided monetary policy, the report proposes to heap heavy new responsibilities on the Fed, and there is no discussion of whether it is capable of shouldering these new responsibilities, given an organizational culture that blinded it to the risks that its monetary policy created. There is no recognition of the risks of competition in so inherently risky a business as banking (that is, lending borrowed capital), and hence the report recommends making banking more competitive by removing remaining restrictions on branch banking, restrictions that limit competition and by doing so may make banking safer.

And because the report attributes the high rate of mortgage and credit card defaults in the current economic situation largely to the ignorance of borrowers and deceit and "unfairness" by lenders, rather than to rational risk taking by borrowers facing very low interest rates and therefore able (in the case of mortgagors) to take advantage of a possibly once-in-a-lifetime opportunity to own their own home, the report proposes the establishment of a new agency with sweeping powers to prevent consumers from taking out risky loans. Sophisticated investors, including large banks, pension funds, and sovereign wealth funds, are assumed to have been fooled by credit ratings issued by credit-rating agencies, even though such investors are well aware of the conflicts of interest that characterize such agencies (they are paid by the firms whose debt they rate) and the difficulty the agencies have in rating highly complex securities, such as securities (in effect bonds) backed by hundreds or thousands of home mortgages.

The report suggests that originators of mortgage-backed and other securitized debt be required to retain an interest in the security when they sell it, so that they will be penalized if the security turns out to be a dog. The premise is that this debt was sold to suckers. But in fact it was sold to sophisticated investors. They knew a disastrous, nationwide fall in housing prices would make the mortgages packaged in these securities worth much less, but they thought, as did most of the financial and regulatory community, that the risk of such a disaster was remote. But risks that seem remote even to informed observers do sometimes materialize. Only in hindisght are they seen as inevitable and the failure to have predicted them is attributed to stupidity, greed, and recklessness.

The report is premature in a second sense, one also illustrated by the proposals for limiting the provision of credit allowed to high-risk borrowers. In an economic boom, thrift is a way of reducing the amplitude of the business cycle by reducing consumption and increasing savings, savings that can be reallocated to consumption at the bottom of the cycle. But when we're at the bottom, thrift, by reducing consumption, makes it more difficult for the economy to recover, because the less people spend on consumption goods, the less production there is and therefore the higher the unemployment rate, which by reducing incomes further depresses spending, creating a vicious cycle. To tighten credit at the bottom of the cycle is thus bad timing. Furthermore, throwing a raft of proposals at the banking industry while the industry is struggling to regain its footing is sure to distract the banks' management, not to mention the Administration's economic team. There is a danger, in short, of information overload. And, what will further befuddle the industry, some of the proposals are contradictory: for example, the banks are not to make unsafe loans, but the Community Reinvestment Act, which encourages lending to "underserved" individuals and communities, is to be vigorously enforced, even though many of the individuals intended to be protected by the Act and therefore supposed to be favored by lenders are poor credit risks.

The proposals are presented as if their merit were self-evident, and required no argument. A more thoughtful document would have discussed the objections to each proposal and explained why in the authors' view the objections were not decisive. The proposals include substantial reorganization of the extensive financial regulatory structure. Government officials and politicians all too often respond to a government failure (in this case the failure to prevent the economic crisis that has engulfed us) by proposing a reorganization of the relevant parts of government, because reorganizations are relatively cheap, visible, and easily explained. They usually fail, because of inertia, turf warfare, passive resistance, and lack of follow through, leaving in their wake merely more bureaucracy.

One of the proposals in the report is to create a powerful new agency (the Consumer Financial Protection Agency) for the protection of consumer borrowers from deceptive and "unfair" tactics by sellers of financial products, such as mortgages and credit cards, and this agency, if it is ever actually created, will overlap and therefore probably scrap with the Securities Exchange Commission and the Federal Trade Commission. Another proposal, to create a National Bank Supervisor, will incite conflict with the Comptroller of the Currency, who regulates national banks. (The Comptroller is to give up his "prudential responsibilities" to the NBS.) There is also to be a council of regulators (the Financial Services Oversight Council) layered over the regulatory agencies themselves, and if the council is not merely a committee of kibitzers, it will merely complicate the regulatory process.

The report doubts the competence of bankers, consumers, and other private persons involved in lending and borrowing, but uncritical concerning the capacities of government. Mistakes of regulators are noted, but are assumed to be easily eliminable. Politics, as an impediment to effective regulation, is not mentioned.

The proposals if adopted would impose onerous restrictions on financial firms deemed so large, or so strategically placed in relation to other financial firms, that they are judged to impose "systemic" risk--that is, the risk that if they fail they may bring down the rest of the global financial system with them, which is what the bankruptcy of Lehman Brothers last September almost did, not because of Lehman's size but because of its central position in several important financial markets, such as commercial paper and letters of credit. But the restrictions proposed to be imposed on such firms (including telling them how to pay their traders and loan officers) may induce some of them to limit their size, or their role in particular markets, in order to fall beneath the level that triggers the restrictions. Yet, oddly, if this happened, systemic risk might not be reduced. For such risk is a property of the financial system, rather than of individual firms. That is, systemic risk is correlated risk. If the entire banking industry were heavily invested in home mortgages, and a housing bubble caused a drastic fall in the value of those mortgages, it wouldn't matter if the banking industry consisted of 10,000 banks of equally small size. The whole industry would be brought down.

If there are substantial economies of scale in banking, so that big banks are more efficient than little ones, the onerous restrictions that the report contemplates will not cause the big banks to reduce their size in order to avoid the restrictions. But it is not clear that there are such economies, and, if not, enactment of the restrictions might induce a substantial restructuring of the industry that would reduce the size of banks without reducing the likelihood of another financial crisis.

One has a sense that the authors of the report, having persuaded themselves that bankers and consumers are on the whole rather dumb, decided that government officials (such as the authors of the report) can manage lending and borrowing better than the actual lenders and borrowers can. I was particularly struck by the proposal that the new Consumer Financial Protection Agency will design "plain vanilla" financial products (such as a mortgage), require that they be offered to borrowers, and restrict the terms that the lenders offer in the financial products that they have designed, if the benefits of the restrictions outweigh the costs, as determined by the agency.

Despite its length, the report is lacking in detail. There is nothing about the cost of the proposals, the staff required, the timetable for implementation, or the methods for determining the capital requirements of the banks and other financial institutions thought to create "systemic" risk. The delegation of powers to the Federal Reserve is breathtaking, as it can swoop down on pretty much any large financial institution, including insurance companies and hedge funds, and classify it as a "tier 1 Financial Holding Company" subject to comprehensive limitations on its business. The Fed's prized independence may be compromised by its exercise of broad discretion to impose tight restrictions on the business of firms that are not commercial banks.

There is no discussion of whether tight restrictions on American banks will shift business to foreign banks that do not labor under such restrictions. A host of obvious questions are left unanswered: for example, how it is possible to prevent a global financial crisis such as erupted last September by requiring big banks to buy "tail insurance"--that is, insurance against very unlikely catastrophic events. Insurance is meant to deal with independent risks, not correlated risks: no insurer other than the federal government is big enough to ensure the nation's entire financial system against a risk common to all the parts of the system.

Despite its length and official imprimatur (and, in fairness, it reflects a good deal of work and thought), the report is best regarded as a discussion paper rather than as a basis for action. 

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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