14

REFORMING FINANCE

The rules of finance are much too serious to be entrusted to bankers.

—Luigi Zingales (with apologies to Georges Clemenceau)

 

 

 

 

THE STRUCTURE OF FINANCIAL REGULATION IN THE United States resembles sedimentary rock: each layer is the legacy of a crisis, but there is nothing binding the layers together. The Federal Reserve was created in 1913 to address the liquidity problems that occurred during the panic of 1907. The Federal Deposit Insurance Corporation (FDIC) was instituted in 1933 to prevent the kind of bank runs that had forced more than 5,000 banks to close in the early 1930s. The Securities and Exchange Commission (SEC) came into being in 1934 to prevent the stock market manipulations that had prevailed during the 1920s. The Office of Thrift Supervision was created in 1989, following the savings and loan crisis of the late 1980s. And the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which brought us the Financial Stability Oversight Council, was, of course, the result of the most recent financial crisis.

So it’s not surprising, when you consider their origins, that these agencies have been stepping on one another’s toes. Transparency and investor protection, for example, have been pursued not just by the SEC (its proper role) but also by the Commodity Futures Trading Commission (CFTC) and the Fed. Similarly, the Fed, the FDIC, and the SEC have all been trying to help stabilize the financial system since the crisis began.

The current regulatory system runs into problems with coordination and the communication of information. Lack of coordination across different agencies can tempt industry to avoid regulation entirely. For example, state insurance regulators never oversaw credit default swaps, even though they were essentially insurance products, because they were called “swaps,” which made them sound like standard derivatives. As for communication of information, remember the Bear Stearns crisis. Because the Fed didn’t regulate investment banks—that was the SEC’s job—it was late learning about the extent of Bear’s poor financial condition or the risks that Bear’s failure would pose to the entire banking system. Consequently, it had no time to plan a possible intervention. Or consider what happened after Bear’s demise, when two separate teams of regulators, one from the Fed and the other from the SEC, planted themselves in the headquarters of Lehman Brothers. It wasn’t until ten days before Lehman’s bankruptcy that they started to pool their information.¹

How to fix these problems? One common suggestion is centralization, in which all regulatory functions are rolled up into one organization, as Britain does with its Financial Service Authority (FSA). In practice, however, the FSA represents only a partial centralization, because some key monetary policy functions remain with the Bank of England. And during the Northern Rock crisis, Britain’s supposedly centralized system failed at the very job for which it was created: effective coordination.

Another possibility is the so-called functional approach to regulation, in which regulators oversee entities according to the kind of function that those entities perform. So, for instance, the same regulator would oversee money-market funds and banks, since they perform the same function—providing short-term liquidity to individuals and firms. But the functional approach maximizes the risk of capture: the more specific a regulator’s human capital, the more likely the regulator is to be captured by the regulated entity.

Further, the functional approach does nothing to eliminate two more problems with our current regulatory system. The first is trade-offs among different objectives. At the risk of oversimplification, I would say that government intervention in the financial system has three main goals: price stability; protecting investors and borrowers against fraud and abuses; and financial-system stability. At present, the various regulatory agencies have to make troubling trade-offs among these three objectives. For example, when the Fed extended a loan to Citigroup’s ring-fenced toxic assets to help prop up the bank, it traded price stability for financial stability. If those assets turned out to be worth much less than expected, the Fed would find it impossible to recoup the liquidity it injected, which would risk causing an increase in inflation, because it would have pumped money into the economy backed by nothing. Having such trade-offs made within agencies, and thus nontransparently, poses serious risks.

The second problem with our current system is that when responsibilities overlap, it’s hard to hold any one agency or individual accountable for any outcome. Whose fault was it that Bear Stearns was forced into a shotgun merger with JPMorgan? Was it the SEC’s for failing to oversee the risk of investment banks, or the Fed’s for failing to provide liquidity, or was it a lack of coordination between the two or all of the above? As long as fundamental goals are divided in this way, the blame game will prevent anyone from taking responsibility for the results.

Hence the need to rethink regulatory architecture along clear lines of responsibility and goals. We should allocate financial regulation and supervision to three different agencies, each responsible for only one of the three principal goals of financial-system regulation. One agency would be in charge of price stability, more or less conducting the traditional monetary policy that the Fed currently conducts. A second agency would focus on protecting the little guys, whether they’re investing in stock, depositing funds at a bank, borrowing from a bank, or buying an annuity or other insurance product. Finally, a third agency would be tasked with systemic considerations, absorbing some of the extraordinary roles that the Fed has taken on during the current crisis, together with other solvency issues (often overseen by state insurance regulators).

The beauty of such a system is that each of the three agencies would have a simple and easily measurable goal. The price-stability agency would have to control inflation. Its effectiveness could easily be measured by the inflation expectations embedded in the difference between standard Treasury bonds and Treasury inflation-protected securities (TIPS). The investor-protection agency’s success could be measured through surveys of the trust that people feel in the stock market and other financial institutions. The system-stability agency’s goal would be minimizing the risk of a systemic collapse. Its accomplishments could be measured by the price of credit default swaps on the major financial institutions, which captures the probability that these institutions might fail. Major trade-offs among these goals—which, as we’ve seen, present serious difficulties in the existing setup—would have to occur across agencies, not within them, and thus be conducted in a more transparent fashion.

The main challenge of such a design would be striking these compromises across agencies and communicating crucial information among them. A new board could be set up consisting of the heads of the three agencies, together with a small number of other Senate-appointed representatives. Just as with the Fed board, the minutes of this new board would be publicly released (possibly with a delay), so that the trade-off decisions were transparent and the responsibility for them clearly allocated.

In a sense, this board would not be that different from the Financial Stability Oversight Council, with the main difference being that it would have fewer than ten members instead of twenty-seven. Overly staffed committees do not work. Either the legislators who create them are fools or they do so in bad faith, intending them to fail. I favor the second interpretation.

MONETARY POLICY

Let’s examine the three goals of financial regulation one by one, starting with price stability. The relevant agency here is the Federal Reserve, which is charged with making the monetary policy that keeps prices stable. The Fed was wisely designed to be an independent agency, run by experts rather than career politicians. The reason is that when an election is approaching, an elected official could be tempted to increase the money supply to stimulate the economy, even if this would lead to higher inflation down the line.

During the 2008 financial crisis and its aftermath, however, the Fed overstepped its boundaries by acting to ensure the stability of the financial system. This amounted to engaging in fiscal policy—and in a country founded on the principle of no taxation without representation, fiscal authority assumed by an unelected agency is rightly viewed with suspicion. So the Fed has been under severe attack by Congress, which would like to limit its discretion.

Congress is correct, although the Fed’s missteps are the fault not of its governors but of bad institutional design. By dividing the three major responsibilities of financial regulation among three separate agencies, my proposed architecture allows for having a fully independent monetary authority board and a politically accountable financial-stability board.

CONSUMER PROTECTION AND FINANCIAL INNOVATION

Economic theory has a lot to say about which securities should and should not exist but little to say about which new kinds of securities should be created. In other words, it is not good at explaining financial innovation.

One reason for financial innovation is the need to increase the extent to which risk is shared. As companies grew larger in the nineteenth century, the risk of owning them became too big for a single individual to bear. Tradable stock was an innovation that shared risk among many small investors, allowing industry to grow. Another kind of risk is fluctuating home values. Suppose that your job requires you to move to Las Vegas. You do not want to live there the rest of your life, but finding an apartment big enough to accommodate your family is difficult, so you consider buying a house. That step, though, means taking an enormous risk. If you had moved to Las Vegas in 2000 and departed in 2005, the value of your house would have soared 115 percent. If you had moved to Las Vegas in 2005 and departed in 2010, the value of your house would have dropped by 54 percent.² To allow people to share the risk they bear in their house investments, Yale economist Robert Shiller has tried to jump-start a futures contract linked to the price of houses in different markets, with mixed results.

Another reason for financial innovation is the desire to reduce the friction that hampers finance. Automatic teller machines were invented to reduce transaction costs, as were credit cards. Similarly, securities backed by an entire pool of mortgages were invented to reduce the informational asymmetry between the loan underwriter and the buyer. If an underwriter sells individual loans, he can cherry-pick the loans to sell. Anticipating that this cherry-picking will give him the worst loans, the buyer will offer much less for each loan than they might be worth. Selling all the loans issued during a certain period avoids this problem.

In all of those examples, financial innovations created value. Unfortunately, not all financial innovations do so. Some are designed to reduce taxes or elude regulations. Others are designed to dupe or cheat investors. Sometimes these two motives are intermingled. Take, for example, the derivatives sold to local municipalities, which helped those municipalities hide their true fiscal situation from voters. Similarly, the Bush and Obama administrations used financial innovation to hide the subsidies paid to financial institutions. As an assistant Treasury secretary in the Bush administration wrote, “An essential insight of the policies undertaken throughout the fall [of 2008] is that providing insurance through non-recourse financing is economically similar to buying assets—indeed, underpricing insurance is akin to overpaying for assets. But insurance is much less transparent than either asset purchases or capital injections and therefore politically preferable as a means through which to provide subsidies to financial market participants.”³

It might be tempting to conclude that we should regulate financial innovation—to the extent, say, that we already regulate pharmaceutical innovation. Yet drug regulation has been criticized on the grounds that it restricts competition; regulating financial innovation would be subject to the same criticism.

Rather than restricting innovation, I suggest fixing the problems that might lead innovation astray. Here, one problem is that people can easily be duped by overly sophisticated products. But this is not a reason to ban such products; it is a reason to restrict who can have access to them. Fixed-rate long-term mortgages and index funds are products that less sophisticated investors can understand and use. Adjustable-rate mortgages, specialized exchange-traded funds, and individual stocks are intermediate products, suitable for moderately sophisticated investors. And only the most sophisticated investors should use products like double short exchange-traded funds and negative amortization mortgages. To ensure that the appropriate type of investor uses each product, it is enough to assign the burden of proof to the seller. Thus, in case of litigation, the bank that sold a negative amortization loan to an investor must prove that the borrower was sophisticated enough to understand the product.

Another potential problem with financial innovations is that CEOs may use them to “manage” earnings. The solution, again, is not to prohibit these innovations outright but to forbid managers from using sophisticated products unless explicitly authorized by the shareholders. With provisions like these, we can enjoy the benefits of financial innovation without bearing its costs and the cost of regulation.

SAVING MARKETS

Many free-market economists think that well-functioning markets arise naturally in a laissez-faire economy.⁴ Unfortunately, this is not the case. A free market’s infrastructure and liquidity—the presence of many buyers and sellers at the same time—are the ultimate public good: everybody benefits with no cost. Yet individual market participants, especially powerful ones, can benefit from trying to restrict competition and hollow out liquidity. Here lies a fundamental challenge for libertarians. Unrestricted freedom of contract can lock in potential traders in a way that dries up liquidity and prevents market development. If companies could lock in workers at a young age, for instance, the labor market for managerial talent would be constricted. The more comprehensive contracts can be, the shallower the market. This is one of the reasons for prohibiting indentured servitude (in which a person sells his future labor services). The same applies to securities markets. As powerful banks try to exchange securities over the counter, markets become less liquid. For this reason, separating investment and commercial banking, as required by the Glass-Steagall Act, was essential to jump-starting the development of a liquid securities market in the United States.

As I explained earlier, securities markets need to be regulated because in anonymous markets, reputation cannot restrain fraud and abusive practices. The backbone of US securities law was designed in the 1930s to protect small investors against the abuses perpetrated in the 1920s. At that time, individuals owned 90 percent of publicly traded equity.⁵ By 2007, that figure had dropped to less than 30 percent.⁶ Most of this share is represented by management and insiders, who collectively own 24 percent of the equity in a typical company. At the same time, the percentage of US equity owned by institutions has risen from less than 10 percent to more than 60 percent. Since institutions account for more than a proportional share of trading, we can assert that institutions do almost all daily trading of US stock. On the one hand, this change in stock ownership has made the need to protect unsophisticated investors less urgent. On the other hand, this dispersion of ownership heightens the need to reform corporate governance, empowering institutional investors and making corporate managers more accountable.

The past thirty years have seen over-the-counter (OTC) markets expand at the expense of organized exchanges. The notional values of derivatives contracts traded OTC went from less than $100 trillion in 1998 to almost $700 trillion in 2007.⁷ Similarly, funds raised in the private equity market (that is, equity not traded in an organized exchange and not sold to small investors) rose from less than $5 billion in 1980 to more than $250 billion in 2006.⁸ This migration from public to private markets suggests that the regulatory gap between the two is excessive. To narrow it, we should deregulate public markets and introduce some disclosure standards into the private one. In public markets, empowering institutional investors, as I have recommended elsewhere, would make it possible to transform some mandatory regulations into optional rules, following the British comply-or-explain system. On the private front, there are compelling reasons to mandate a delayed-disclosure provision in which hedge funds, private equity funds, and even companies’ private equity funds report information and performance with a one- to two-year delay. This delay has the benefit of reducing the competitive cost of disclosure, while at the same time allowing for a serious statistical analysis of this market, which will improve allocation of savings.

To fix the stability problems associated with OTC derivatives, we need to move the bulk of derivative trading onto organized exchanges, where daily collateral requirements would guarantee systemic stability and price transparency would force competition, reduce margins, and increase the market’s depth. In the United States, the Dodd-Frank Act moves in this direction, and similar efforts are under way in Europe. Nevertheless, the journey is still a long one. The major investment banks are fully aware that every day they delay appropriate market regulation, they earn millions of dollars for their managers’ bonus funds.

CURBING RISK ON WALL STREET

We would like the market to be able to assess the risks of large financial institutions. But it cannot do that if market players know that those institutions will be bailed out in a crunch; that is, the existence of a “too big to fail” policy makes it difficult for the market to measure and analyze risk, as I noted in Chapter 4. One option is simply to outlaw the “too big to fail” policy—but such an inflexible approach might prove very costly one day, preventing Congress from acting as catastrophe loomed.⁹

Fortunately, there may be another solution. As many observers have noted, the government’s reason for bailing out large financial institutions actually isn’t that they’re so large that their demise would crush the whole system. Rather, the concern is that they have such extensive interconnections with other financial institutions—through their various transactions, obligations, and contracts—that a default might trigger losses among an enormous number of counterparties, producing further defaults that could cascade out of control.

To function properly, the financial system needs to operate under the assumption that certain assets, such as deposits, are worry-free. A depositor with money in, say, checking and savings accounts should not have to monitor counterparty solvency or worry about which banks his own bank has dealings with. This sense of security saves a great deal of anxiety and cost and allows the system to operate more efficiently. But the system can sustain this trust only if people do not question the prompt and full repayment of so-called sensitive or systemically relevant obligations. People need to know that even if their banks collapse, not just bank deposits but also short-term interbank borrowing and the network of derivative contracts are secure enough not to suffer.

Once we understand that the issue addressed by “too big to fail” is the interconnectedness of large financial institutions, and therefore the stability of the larger system, we can make some important distinctions. Not all of the debt issued by large financial institutions and not all of the transactions they engage in are systemically relevant or in need of comprehensive protection. Specifically, long-term debt is not systemically relevant, since it is mostly held not by large financial institutions but within the massive portfolios of mutual and pension funds, which can absorb losses in such debt in the same way they absorb losses in equity investments. A default on long-term debt, therefore, would not trigger a cascade of bank failures the way a default on short-term debt could.

The solution is regulation that protects the systemically relevant obligations of large financial institutions—making sure that these institutions, not the taxpayers, would repay the obligations in case of bankruptcy—but that leaves open the possibility that nonsystemically relevant obligations would not be protected. Under this new system, banks would be required to hold two layers of capital to protect their systemically relevant obligations. The first layer would be basic equity. This requirement is not very different from today’s standard capital requirement, except that the amount of equity required would be determined not by an accounting formula but by a market assessment of the risk contained in the second layer.

That second layer would consist of so-called junior long-term debt, which means that the institution would repay it only after making good on its other debt. This junior debt would therefore involve more risk for those who bought it, as well as higher rates of return. It would provide an added layer of protection to basic equity because, in the event the institution defaulted, the junior debt could be paid back only after other, more systemically relevant obligations had been repaid. Perhaps most important, because this layer of debt would be traded without the assumption that it would always be protected by federal bailouts, it would make possible a genuine market assessment of its value and risk—and therefore of the value and risk of the financial institution itself.

This is the crucial innovation of my proposed approach. The second layer of capital would allow for a market-based trigger to signal that a firm’s equity cushion was thinning, that its long-term debt was potentially in danger, and therefore that the financial institution was taking on too much risk. If that warning mechanism provided accurate signals and the regulator intervened in time, even the junior long-term debt would be paid in full. If not, the institution might burn through some of the junior debt layer, but its systemically relevant obligations would generally still be secure. The firm could suffer, but the larger financial system would remain safe.

This remedy would work more or less like the margin call system in the stock market. When an investor buys stocks on margin, he puts down only part of the cost; as a result, he must show that he has enough collateral to cover the risk his broker is taking in lending him the money to make up the difference. If the stock price drops below an agreed-on level, that risk increases. The broker then issues a margin call, which means that the buyer must either provide additional collateral or sell his stock to pay back the broker in full. The system of financial regulation I am proposing would treat large banks in the same way. They would have to show the regulator that they had enough collateral (in the form of equity) to ensure that all of their debt—not just the systemically relevant part—could be paid in full. And if declines in the value of their underlying assets put the banks’ debt at greater risk, they would face a kind of margin call from the regulator, forcing them either to post additional capital or to submit to liquidation. Either way, their debt would be repaid.

The success of this system rests, of course, on the timely intervention of the regulator. If the “margin call” is too slow in coming, the bank’s long-term creditors could be at risk (though as long as the delay is not too severe, the systemic obligations would still be shielded). Thus it is essential to have an effective mechanism that assesses risk and triggers a response, warning the regulator and compelling swift action.

In a normal margin account, a broker considers the total value of the investment—which is easily determined, since all assets are traded—and compares the value of the collateral his client has posted with the likely risk of loss. If the collateral is insufficient to cover a plausible decline in the stock’s value, he calls for more. But in the system I propose, the value of the financial institution’s assets is not as easy to determine, since those assets—commercial loans and home equity lines, for example—are not standardized and not frequently traded, which means that they do not have a clear price. It is therefore difficult to tell when the equity the bank has posted is too thin to protect the existing debt. What, then, would the triggering mechanism be?

Ideally, such a trigger would be market-based—tied to the price of some traded security. The breadth and diversity of the market would shield such a signal from political pressures like those that can be focused on a single credit-rating agency or government regulator. To avoid unnecessary fluctuations and false alarms, the trigger should be a security traded in a market with a lot of liquidity and therefore stability. And its price should be closely linked to the financial event we want information about: whether or not an institution’s long-term debt is at risk. Equity prices fail to satisfy this final criterion. As long as there is the possibility of a significant upside, equity prices will stay relatively high even when the company is close to bankruptcy and its debt is at risk of not being paid in full. The price of the junior long-term debt would be a better place to look. When the equity cushion is running thin, that long-term debt becomes endangered and will start trading below par. This option, though, fails to meet another criterion, since the bond market, where such debt might be traded, is highly segmented and illiquid. Bond prices are therefore unreliable signals.

There is one security that is linked to bond prices but remains very liquid—the credit default swap (CDS), essentially an insurance claim that pays off if the underlying entity fails and creditors are not paid in full. The buyer of a CDS for a bank’s debt, for instance, makes periodic payments to a third-party seller; if the bank defaults on that debt, the buyer receives a payoff. (A CDS differs from insurance in that the buyer need not actually own the underlying security—here, the bank’s debt.)

Since a CDS is basically a bet on the odds of a particular firm’s failure, its price reflects the market’s assessment of how likely it is that the firm’s debt will not be repaid in full. It thus offers exactly the instrument we seek. Under my system, the CDS price for a bank’s long-term debt would be used to gauge the risk of the equity cushion’s being devoured by losses. If the CDS price were to rise above a critical threshold—thereby flagging imminent danger—the regulator would force the institution in question to issue equity by offering new stock for sale until the CDS price moved back below the threshold. If the price did not fall below that threshold within a predetermined period, the regulator would intervene.

Credit default swaps have developed a bad reputation and are often cited as one cause of the financial crisis. The problem, though, was not with credit default swaps but with the way they were traded: in opaque markets in which companies like AIG could sell the swaps without posting the proper collateral. When traded in an organized exchange with proper collateral, the CDS is a useful instrument for reducing exposure to credit risk. Fortunately, there is a clear trend toward moving credit default swaps onto exchanges, which will naturally require better collat-eralization to protect exchange members. Thus it seems likely that CDS prices will become increasingly reliable.

Another benefit of this transparent, market-based signal is that it helps address two major risks posed by regulatory intervention in the financial system. One is that a regulator could arbitrarily close down well-functioning financial institutions for political reasons. The other is that a regulator, under intense lobbying by the regulated, might be too soft—a phenomenon known in banking literature as regulatory forbearance (and a contributing factor to the 2008 crisis). My mechanism removes most of the regulator’s discretion to make either error. The regulator cannot intervene if market prices do not signal distress but would find it difficult to avoid intervening if the market did signal—to everyone—that a firm is in trouble. I would even allow bondholders in a regulated institution to sue the regulator for not responding to a trigger that was clearly set off.

What form should the regulator’s intervention take? Here, too, the presence of a market-based trigger for action makes it possible to adopt targeted, prudent measures that avert both overreaction and underre-sponse. If the trigger were set off by a CDS price that was too high, the regulator would be required to subject the financial institution to a stress test to determine if it was indeed at risk. In a stress test, regulators use sophisticated algorithms to run “what if” scenarios that examine whether a financial institution has sufficient assets to survive serious financial shocks. It would be important for the regulator to apply the stress test before taking any other actions; otherwise, those actions could cause panic that could damage the institution. If, for instance, the regulator allowed rumors to spread about a bank’s strength, investors might lose confidence in the bank, start buying credit default swaps as protection, and make the CDS price rise still further.

If the bank passed the test and proved that the CDS price was not accurate, the regulator would then declare the company adequately capitalized. But if the bank failed the test, the debt was found to be at risk, and issuing equity did not improve its situation, then the regulator would replace the institution’s CEO with a receiver or trustee. This person would be required to recapitalize and sell the company, guaranteeing in the process that shareholders were wiped out and junior creditors—while not wiped out—received a “haircut,” meaning that the value of what they were owed would be reduced by a set percentage. That haircut is crucial to ensuring that the market prices credit default swaps in a way that takes regulator interventions seriously—showing that creditors will pay a price for an institution’s failure—and so makes the trigger more reliable.

This regulatory receivership would be similar to a mild form of bankruptcy. But while it would achieve the chief goals of bankruptcy—imposing discipline on investors and management—it would avoid bankruptcy’s worst cost—the possibility that one firm’s failure could take down the entire financial system.

A potential risk of this proposal is that the news that a regulator is performing a stress test on a bank might scare off the short-term creditors and induce a run on the bank. This problem can easily be fixed by having the regulator guarantee the bank’s senior debt for the duration of the stress test. With my early warning system and double layer of protection, the systemic obligations (which, in my mechanism, are all senior debt) will essentially always be paid. So the government is not assuming real risk; it is only defusing the risk of a run. This guarantee can then be lifted when the bank is deemed well capitalized (and more junior debt is issued) or, if the bank is put into receivership, when it emerges from receivership.

CONCLUSIONS

A financial system that helps penniless entrepreneurs transform their dreams into reality is a laudable goal, as is facilitating homeownership. Any laudable goal, however, can be abused when it is used as a fig leaf to cover naked self-interest. The combination of strong vested interests and a powerful ideological justification is irresistible: intellectuals who want money are bought off, and those who are principled are captured by the ideology. To avoid a similar problem, I have tried to design market-friendly financial regulations that begin with identifying the inefficiencies in the marketplace.