The role regulators played in the current financial crisis is a critical question as the Treasury Department gets set to take on bank regulation in the next few months. But standing in the way of the administration's reforms is a counter-intuitive argument that over-regulation, rather than under-regulation, caused the crisis. Specifically, this argument pinpoints blame on an 2001 banking regulation rule, which critics blame for loading the banks with toxic mortgage-backed securities. Is killing this rule the first step toward averting the next financial meltdown? Let's assess:
Had bankers been looking for the safety connoted by triple-A ratings, they could have bought Treasurys, which were even safer. If they were looking for yield, they could have bought double-A or lower-rated bonds. And why mortgage-backed bonds? The answer seems to be an obscure rule enacted by the Fed, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001: the Recourse Rule, an amendment to the Basel I accord that governed banks' capital minima.
Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages--regardless of how sound the borrowers were--sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability.
To be sure, banks that bought mortgage-backed securities to reduce their capital cushions were, indeed, knowingly increasing their vulnerability if the investments turned out badly. But absent the Recourse Rule, there is no reason that banks seeking a safe way to increase their profitability would have converged on asset-backed securities (rather than Treasurys or triple-A corporate bonds)
So that last paragraph is wrong - asset-backed securities, specifically mortgage ones, offered a higher return than Treasury bonds, and thus it is not true that there was "no reason" someone would buy an asset-backed security absent the recourse rule. That's why you see pension funds and school boards and all kinds of institutional investors who don't fall under Basel regulation buying them - it's not simply a matter of capital number recording. When you consider they were rated at the same level, it's a sufficient reason for the pile-on in securitized bonds.
But it's a very valid argument. Arnold Kling also believes that this "Recourse Rule" was the culprit, instead of deregulation, in getting banks to be so dependent on the credit agencies.
How the Rule Works
Let's back up. What did the regulation in question involve? Here is the notice, along with the Federal Register (here FR), explaining the rule's effect on capital reserving. By reserving, we mean holding capital in case there are losses on the portfolio. Banks want to keep low reserves for more profits. Regulators want to keep high reserves for more stability. For our concerns, the big difference in Basel, as opposed to previous bank regulations, is that it divides the capital reserving by asset class, with each asset class getting a "risk ratio." Some assets you didn't need to reserve anything against (short term OECD government debt has a 0% risk ratio) and some you have to reserve more against (mortgages have a 50% risk ratio).
Now what did this new rule do? Let's assume you had a pool of 100 mortgages, and they'd all sit on your book at 50%. Now using a quick metaphor of "slicing-and-dicing" mortgages into security pools. If you got the first few mortgages payments in that pool it becomes less risky. Since it is less risky, it should have less risk attached to it under regulation rules. So for these first payers -- or highest tranches, or AAA or AA rated instruments -- you only had to set the risk target at 20%. But it isn't all free money. Looking at the FR regulatory document (footnote 23), if the tranche is rated A, then it is 50%. And if it is BBB, it's 100%; BB, 200%. So for some pieces of that 50% original pool of mortgages, some slices of it are more risky, some slices of it are less risky. The riskier parts of the mortgage pools had much higher capital reserves than the original.