Humans have a remarkable capacity to be surprised by the obvious. We are frequently astonished not just by events that were easily predictable, but by outcomes that were, in fact, widely predicted. The crash of 2008 had many causes. Yet one critical precondition was an error so banal, and so widespread, that it makes your head spin. People seemed to believe that American house prices literally could not fall.
In a rational world, the run-up in prices, especially pronounced after 2000, would have eventually undermined this conviction; instead, it strengthened it. Well before the peak, house prices had come untethered from more or less every known factor that anchors them in the long run; all signs pointed to a steep drop. This risk was not overlooked: analysts and journalists wrote extensively about the likelihood that house prices would fall. Yale’s Robert Shiller, whose track record commanded attention (he predicted the stock-market crash of 2000), published a much-discussed book on the subject. To be sure, not everybody reads the financial press, but had anyone failed to notice the house-price boom? Was anyone in doubt about what follows a boom—always?
Yet innumerable fools kept buying, and bidding prices higher. (Did I mention that I was among them? I bought a house in December 2005, timing the peak of the market almost perfectly.) Meanwhile, Wall Street’s financial engineers designed their models for pricing mortgage-backed securities in such a way that if you asked, “What happens if house prices fall?” the models replied, “Cannot compute.”
This propensity for self-delusion is evidently a fact of life. The modern history of finance suggests that it cannot be regulated away, partly because regulators are people too, as susceptible as anybody else to the madness of crowds. What we can hope to do is recognize the problem and then contain it—limit its scale and curb its dangerous consequences. Once the present emergency has subsided, that is what governments will try to do. Even that, however, will be much more difficult than you might think.
Financial regulators are in a perpetual state of war with financial innovators—a war they’ve been losing for decades; a war they cannot, ultimately, win. In any industry, a rule that adds to the cost of doing business or closes down an opportunity to make profits creates an incentive to get around it. But in finance, any such sliver of opportunity may yield enormous profits. The best brains in the world therefore get hired to seek these slivers out. Lately, because of advancing technology, regulators have found it impossible to keep up.
For decades, traditional banks have been subject to stringent regulations. Banks are inherently fragile yet systemically indispensable institutions. Indispensible because they reward savers for thrift, channel capital to firms that need it to grow, and provide the backbone of the payments system. Fragile because they “borrow short” from depositors (who can demand their money back virtually at any time) and “lend long” to homeowners and institutions that generally make repayments over many years. If confidence in the banks should fail, depositors will rush for their money and, as James Stewart explained in It’s a Wonderful Life, fundamentally solvent banks will be brought down by mere panic.
So governments long ago struck a bargain with traditional banks. The safety of deposits was guaranteed, alleviating the fears of depositors. In return, since depositors would no longer insist on prudent use of their funds (they’d be guaranteed to get their deposits back no matter how recklessly banks used them), governments regulated bank lending to prevent excessive risk-taking. This system hasn’t worked perfectly. (Before it was nationalized earlier this year, investors clamored to get their money out of Northern Rock, a big British bank and an early casualty of the crisis. It was Britain’s first outright bank run since the 19th century. Not coincidentally, perhaps, sales of home safes boomed throughout Europe this fall.) But it has worked well enough.
Here’s the problem, though: banks make up only part of the financial system. Over time, new technologies and new financial products have enabled their more lightly regulated non-bank cousins to take on many bank-like functions—and often have allowed such entities to profit from these functions to a degree that traditional banks could not.
The development of mortgage-backed securities, deeply implicated in the crisis, is a telling instance. A traditional bank keeps loans on its own books and has to worry about the creditworthiness of its borrowers. Regulations require it to hold some safe, low-yielding assets as a reserve against loans going bad. But the packaging of loans into tradable securities let some of the risk be moved to non-bank financial entities. The loans could then be shuffled into baskets of varying risk, and traded globally: the safest securities, as judged by credit-rating agencies, would be bought by conservative investors, and the riskiest by the more adventurous. The system as a whole would then be safer, it was believed, because the risk would be spread to the parts best able to bear it.
One result of the development of mortgage-backed securities, among other innovations, was higher leverage in the financial system as a whole. In the 1950s, bank capital ratios of 30 percent were common. Ratios eventually fell to 10 percent or less before the crisis struck, and regulators saw no problem with the reduction, since the banks were carrying less risk. Meanwhile, the investment banks that were creating and sometimes holding mortgage-backed securities got by with much less in reserve—sometimes as little as 3 percent. When the crash came, reserves of capital throughout the financial system proved to be much too thin. But again, few people believed that was the case before the crash; more sophisticated management of risk was thought to have made the system safer.
Like most financial innovations, mortgage-backed securities married regulatory avoidance, undue optimism (new means better), an inadvertent narrowing of commercial oversight (because of sheer complexity), and, yes, good-faith striving for financial and economic efficiency. Complex financial models were used to bundle and rebundle the loans, and to price and rate the different securities. Innovations in information technology and the application of advanced mathematics drove the process, and obscured the risks from regulators and investors alike.
Financial innovation serves a useful economic purpose, which has made many governments ambivalent about their regulatory wars. Seen from one angle, the invention of mortgage-backed securities, which to a large degree enabled the expansion of lending to subprime borrowers, was a way for financial firms to squirm around the rules and get a piece of some very profitable action. Seen from another angle, it was a way to widen homeownership and empower the working class—to get loans to people who had previously been financially disenfranchised, despite being able, in the great majority of cases, to afford their loans. Many observers viewed subprime lending as a good thing. Mostly, it was a good thing. It was not a problem until it became a problem.
At any rate, once information technology and instant telecommunications upped the pace of financial innovation, the battle tilted dramatically toward the innovators. If the executives in charge cannot understand what their repurposed physicists and computer scientists are doing, how likely is it that regulators can stay on top? As long as taxpayers are unwilling to buy these officials multimillion-dollar Manhattan apartments and Ferraris to get to the office, there will be a disparity of intellectual resources. In the struggle between regulators and innovators, most of the firepower will stay on one side.
Lacking the will as well as the means to resist, governments went with the flow, coping as best they could, choosing to let finance, up to a point, regulate itself. Governments would insist on disclosure and openness, so banks and non-banks could keep an eye on each other; private, profit-making monitors—the rating agencies, among others—would play a large role as well. But the basic idea was that the professionals could partly be left to take care of themselves, knowing that if they behaved recklessly and things went wrong, they would bear the losses.
Well, as I say, that was the idea.
This decades-long compromise—an evolving and uneasy accommodation with the forces of financial innovation—has been smashed by the crash of 2008. But what comes next is far from obvious. The popular view that the current mess is all the fault of “deregulation” is misleading, at best. The implication that all we need do is return to an earlier era of stricter supervision is an illusion. To repeat, regulators did not choose to retreat; they were forced to. In the United States, Democratic administrations, rarely inclined to see deregulation as an end in itself, ceded at least as much ground as Republican ones. The main forces that spurred the retreat—the incentives to evade close supervision, and the technological opportunities to do so—continue to grow more powerful. So what do we do?
First, the financially sophisticated cannot be trusted to monitor themselves and each other—not to the extent that they have been lately, at any rate. They have made a hash of it, and the rest of us are now paying the price. Even if it means suppressing innovation, at significant cost to the rest of the economy, top-down supervision will have to be tightened. The scale of the present crisis will force a new balance to be struck.
Second, the idea that banks can be neatly segregated for regulatory purposes from other kinds of financial firms must be ditched. When firms that are not ordinary deposit-taking banks act in many other respects like banks—transforming short-term money into long-term money—they face the risk of collapses in confidence and bank-like runs. Moreover, they may be so big, or so interconnected with the rest of the financial system, that when they go bust they cause as much collateral damage as would big conventional bank that fails.
A new approach to financial regulation is already taking shape. The Treasury began to dissolve the distinction between banks and non-banks, for instance, when it widened access to emergency borrowing from the Federal Reserve—a privilege once held only by deposit-takers. Having extended the assistance they are willing to offer, the authorities must extend their supervision as well. The logic is the same as with deposit insurance: if you socialize the costs of failure, you have to regulate against recklessness. The broadening of intervention and supervision will need to go further.
For example, in the United States, when the net worth of an ordinary deposit-taking bank falls to a certain point (but before it gets to zero, so the bank is not yet insolvent), a procedure overseen by the Federal Deposit Insurance Corporation kicks in. The bank is acquired, its shareholders are wiped out, its depositors and creditors are protected, and its business is wound up in an orderly fashion. At present, there is no such procedure for non-banks, and this needs to be remedied. It is why Bear Stearns had to be forced (over the course of a weekend) into a merger, and Lehman Brothers (over the course of another) into a disorderly bankruptcy—an event that many observers regard as the immediate cause of the financial crash, of the subsequent part-nationalization of America’s biggest banks, and of the severe recession that is now taking place.
Under a wide new umbrella of regulation, which watches non-banks as closely as banks, new attention will also be paid to the dangers of leverage. Without excessive leverage, there would have been no financial crisis, even if every other mistake had still been made. Too much leverage weakened the industry and doubled down on the bets it had made. When the bets went wrong, the system crashed.
There is a catch, however. In moderation, leverage is essential. It is how financial firms make money. They hold a base of capital, let’s say in the form of low-yielding government securities. Then they borrow, either from depositors or in the capital markets, and lend on at a higher price. The higher the ratio of loans to capital, the greater the leverage, and the larger the profits. But the price you pay for a narrow base of capital is greater risk of insolvency if things go wrong, since capital is the reserve that a bank or non-bank holds against unforeseen losses. An age-old rule of finance, often forgotten but never repealed, is that higher returns entail greater risks.
One way or another, the new regime is going to tell banks and non-banks to hold bigger reserves of capital. To be sure, the new agenda for financial regulation will turn to myriad other issues as well: oversight of complex financial derivatives; a central clearing system for those products (at the moment, most derivatives are sold “over the counter,” which makes them less liquid and riskier to hold); new liquidity requirements; rules for pay and incentive schemes for financial executives, to discourage reckless bets; extra supervision of housing loans; new curbs on the role of rating agencies; and much more. All of these matter, but the critical points will be to insist on more capital, and to apply this rule more broadly, so that its reach extends beyond traditional banking, making the entire financial industry, and hence the wider economy, more resilient.
Of course, these regulations will exact a price. The financial industry will grow more slowly. Banks and non-banks will be less eager to grant loans, especially to marginal borrowers. Investment might suffer. Finance will be less exciting, and there will be a lot less money to be made.
As much as the industry may choose to stress the other reasons, it will resist because of that last one. It will argue, among other things, that stricter rules would put it at a disadvantage relative to foreign competitors. As memories of the crisis fade, regulators will likely be sympathetic to this argument. They usually have been before. And this time around, they will be big bank shareholders in their own right. When governments come to divest the enormous stakes they acquired in these firms during the crisis, they will face an intriguing conflict of interest: the stricter the capital requirements they impose on banks—the safer they make the system—the less those shares will be worth.
In the past, though, the clinching argument in debates about how tightly to regulate finance has been the need to compete and thrive in the global financial system. Do Americans want their financial firms to be global champions? Or do they want them overrun by (less stringently regulated) foreigners in their own backyard? Under the onslaught of continuing innovation, broader and more effective financial regulation would be difficult to achieve in any case. If governments cannot bring themselves to co-operate, the cause may be hopeless. A country can go it alone in setting tighter rules, but must expect to lose business if it does.
Why, you might ask? Surely well-regulated markets promote trust and confidence, which reduces costs. Business will migrate to those jurisdictions. True, but it is a question of balance. After a certain point, stricter rules (on holding low-yielding capital, say, or on minimum levels of liquidity) add more to the cost of doing business than they subtract. In a globally integrated financial system, firms, within limits, can choose their regulator. For example, the Sarbanes-Oxley Act, written in haste to tighten accounting rules and improve corporate governance after the Enron scandal, is partly responsible for the rise of London over New York as the global center for initial public offerings of corporations. In any case, even if the U.S. did choose to go ahead with tighter regulation on its own, it still would not be safe. Financial operations are internationally connected. Some risk would remain that a financial crisis born of poor regulation abroad might spill over at home.
The crash has focused minds. Interest in coordinated intervention and financial rule-making has surged. But national regulators still go about things in their own way, and they are jealous even now of their independence. At one post-crash meeting of finance experts, I heard how difficult it would be to persuade Europe’s governments to create a single securities or banking regulator for the European Union—even though Europe’s governments have a long history of pooling sovereignty and cooperating closely. When I asked about creating a single global financial regulator—a big idea, you might think, whose time has come—I received incredulous looks. “That will never happen.”
Just like American house prices would never fall? With or without better financial regulation, there will be more asset-price bubbles and credit-driven booms; more asset-price collapses and credit-crunch recessions; more economic shocks that propagate worldwide. If the United States wants to weaken these cycles, it will have to strengthen its financial regulators in their long war against the industry’s innovators. More than anything else, what regulators need in fighting that fight is allies abroad.