Where Did Greenspan Fail?

This week, former Federal Reserve Chairman Alan Greenspan released a fascinating paper he wrote for the Brookings Institution on the financial crisis. In it, he doesn't so much wish to apologize for his monetary policy choices. He actually argues that they weren't to blame for the crisis. Instead, he believes that lax regulatory supervision was more at fault.

Greenspan actually explains why he chose not to bother trying to pop the real estate bubble even though he saw one growing: because it didn't work with tech stocks. He says:

I raised the spectre of "irrational exuberance" in 1996 only to watch the dotcom boom, after a one-day stumble, continue to inflate for four more years, unrestrained by a cumulative increase of 350 basis points in the federal funds rate from 1994 to 2000.

Indeed, bubbles are a very hard thing to stop. But surely, the Fed had more at its disposal than just the blunt instrument of the fed funds and discount rates to tackle a real estate bubble. What about regulatory changes? He appears to admit that there are some areas where expanded regulation could have helped. He says bank supervision:

- can audit and enforce collateral and capital requirements.
- can require the issuance of some debt of financial institutions that will become equity, should equity capital become impaired (see page 33.)
- can, and has, put limits or prohibitions on certain types of concentrated bank lending.
- can prohibit a complex affiliate and subsidiary structure whose sole purpose is tax avoidance or regulatory arbitrage.
- can inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles (SIVs). When such assets appeared about to fail, sponsoring companies, fearful of reputation risk (a new insight?), reabsorbed legally detached affiliates at subsequent great loss.
- can require "living wills" that mandate a financial intermediary to indicate on an ongoing basis how it can be liquidated expeditiously with minimum impact on counterparties and markets.

Presumably, in retrospect, Greenspan would have liked to have done some of that since the Fed had supervisory power over many of the institutions that helped cause the financial crisis. The fact that it didn't bother is one of the reasons why I'm so cynical about giving the central bank even more oversight and making it the systemic risk regulator. Its track record isn't exactly stellar.

The last bullet point above especially caught my attention. One kind of amazing lack of foresight was that some institutions had grown too big to fail. Just because the Fed at the time never could have envisioned a world where, say, Citigroup failed, that doesn't mean there shouldn't have been a plan in place to make sure the market could handle the unlikely event. Not bothering ensuring that seemingly safe firms could fail would be like never having a fire drill just because you don't think there will ever be a fire.

Greenspan also sees higher capital requirements as an important step in creating a more stable market. I agree. He says:

The most pressing reform that needs fixing in the aftermath of the crisis, in my judgment, is the level of regulatory risk adjusted capital. Regrettably, the evident potential for gaming of this system calls for an additional constraint in the form of a minimal tangible capital requirement. Pre-crisis regulatory capital requirements based on decades of experience designated pools of self-amortizing home mortgages among the safest of private instruments. And a surprisingly, and unfortunately, large proportion of investment portfolio decisions were essentially subcontracted to the (mis-)judgments of credit rating agencies.

And I would additionally argue that creditors and investors understanding the full extent of the leverage that financial institutions are under is almost more important than capital requirements. A big problem with banks was that there was an awful lot of hidden leverage in the system. If a bank's current and potential debt and equity-holders fully understand how severe losses could deplete the capital of the firm, then some self-regulation of the market should follow. No investor would want to have exposure to a firm that would quickly fold due to insufficient capital if an economic shock hit.