R. Glenn Hubbard, a former Chairman of the Council of Economic Advisers under President George W. Bush, is Dean of Columbia Business School and Co-Chair of the Committee on Capital Markets Regulation.
THE CONVENTIONAL TAKE on the present financial and economic crisis places blame on a dearth of regulation. But that is simplistic at best, entirely inaccurate at worst. The truth is that the financial crisis is the result of not so much a lack of regulation as a lack of effective regulation.
Indeed, portions of the financial system hit hard by the crisis and significantly affecting economic activity—such as traditional banks—have historically been the most heavily regulated. Another center of the crisis was government-sponsored entities such as Fannie Mae and Freddie Mac, which were vehicles through which governmental capital made its impact on the financial markets. While more regulation is certainly needed in some areas, as I describe later, the overriding goal must be to make the present regulatory regime far more effective than it has been.
A focus on effectiveness leads to three themes for reform. The primary one should be the reduction of systemic risk. The second is that the route to enhanced investor protection is through greater transparency in the financial system. The third is that the U.S. regulatory structure must be reorganized to meet these two goals—that is, it must become more integrated and efficient. These themes are highlighted in the report released in 2009 by the nonpartisan Committee on Capital Markets Regulation,1 which I co-chair.
MORE EFFECTIVE REGULATION AND SYSTEMIC RISK
When a systemically important institution is in danger of failure, and its failure could trigger a chain reaction of other failures, there may be no alternative other than to inject public funds. But the requisite amount of these injections has been significantly increased by weaknesses in the current regulatory system. The Federal Reserve financed the acquisition of Bear Stearns through a $29 billion loan, and the Fed and the Treasury financed the survival of the American International Group with assistance amounting to more than $180 billion, largely because of the fear of what would have happened if such institutions had gone into bankruptcy. Similar fears may lie behind some of the Troubled Asset Relief Program injections. There is ample room for improvement in the containment of systemic risk.
First, existing capital requirements leave much to be desired. The elaborate and detailed structure currently in place to regulate bank capital, the international Basel Accord, proved unable to live up to the task of preventing systemically important financial institutions from failing. Indeed, the crude leverage ratio—an object of scorn of many regulators—turned out to be a more reliable constraint on excessive risk-taking than the complex Basel rules. The investment banking sector, which did not have a leverage ratio in its regulation, was not as fortunate. The disparity demonstrates that more detailed regulation does not necessarily make for more effective regulation. Capital requirements are our principal bulwark against bank failure, a key trigger of systemic risk, but can be improved. Larger banks should have higher capital ratios, and the leverage ratio should be reduced. This approach is a much better one than putting size limits on U.S. banks, which will make them uncompetitive with their European and Asian counterparts.
Three changes to capital requirement recommendations would be a foundation for improved stability. As a consequence of the crisis, many systemically important institutions will be able to borrow from the Federal Reserve. And institutions that have the ability to borrow from the Fed in its lender-of-last-resort role should be subject to capital regulation. In addition, given the cyclicality of bank losses, a fixed capital requirement forces banks to raise capital in a downturn as losses mount and capital levels are depleted. An alternative to letting capital requirements fall during a downturn would be to allow, or require, banks to hold some form of contingent capital (through publicly or privately provided insurance) as losses mount. Finally, given the concentration of risks to taxpayers, large institutions should be held to a higher solvency standard—that is, they should hold more capital per unit of risk. The market can also play a role in this process: if investors are given more information about the solvency of banks, as was given to them by the stress tests, they can demand more capital from banks.
Second, we need a better process than bankruptcy for resolving the insolvency of financial institutions. Our framework for banks needs to be extended to other financial institutions and their holding companies. This process, unlike bankruptcy, puts the resolution of institutions in the hands of regulators rather than bankruptcy judges and permits more flexible approaches to keeping systemically important institutions afloat. At the same time, it permits, like bankruptcy, the restructuring of an insolvent institution through the elimination of equity and the restructuring of debt, to prepare the institution for sale to new investors. We do not need to create a special regime for systemically important bank holding companies, as the Dodd-Frank Act does, but we need to extend the features of the current Federal Deposit Insurance Corporation regime from just banks to all financial institutions.
Third, the current substantive framework also suffers from important gaps in the scope and coverage of regulation—gaps that can increase the risk of shocks to the financial system. Hedge funds and private equity firms have not been supervised or regulated. Fannie Mae and Freddie Mac were too lightly regulated; until the Housing and Economic Recovery Act of 2008, they were not subject to either meaningful capital or securities regulation. Investment bank regulation by the Securities and Exchange Commission proved entirely ineffective—major investment banks have failed, been acquired, or become bank holding companies. We need a comprehensive approach to regulating risk in the financial sector if we are to avoid similar threats to the financial system in the future. Casting a broader net does not mean that different activities should be regulated in the same way, but it does mean that the same activities conducted by different institutions should be regulated in the same way.
Hedge funds (and banks that engage in hedge fund activity) should keep regulators informed on an ongoing basis of their activities and leverage. Private equity, however, poses no more risk to the financial system than do other investors. But these firms, if large enough, should be subject to some regulatory oversight and periodically share information with regulators to confirm they are engaged only in the private equity business. Indeed, private equity is a part of the solution to the problem of inadequate private capital in the banking system. Ill-conceived restrictions on the ability of private equity firms to acquire banks should be removed, not just relaxed. This instance is one in which regulation is preventing a solution, not offering one.
Finally, we need to reduce the interconnectedness problem of credit-default swap (CDS) by the use of clearing houses and exchanges, as in the Dodd-Frank Act. If clearing houses were to clear CDS contracts and other standardized derivatives, such as foreign exchange and interest rate swaps, systemic risk could be substantially reduced by more netting, centralized information on the exposures of counterparties, and the collectivization of losses. To the extent that certain CDSs were to be traded on exchanges, price discovery and liquidity would be enhanced. I would go further than just encouraging exchange trading; I would require it for standardized and heavily traded derivatives. Increased liquidity would not only be valuable to traders, but it would better enable clearing houses to control their own risks through more informed margining and easier closeouts of defaulted positions.
GREATER TRANSPARENCY TO PROTECT INVESTORS
Securitization has brought new sources of finance to the consumer market, not only for mortgages but also for auto loans and credit card purchases. It has permitted banks to diversify their risks. Imagine how much more devastating the impact of the fall in home prices would have been on the banking system if all mortgages had been held by banks rather than being mostly securitized (even taking into account the exposure some banks had from investments in the securitized debt itself). There is a great need to rebuild this market from the ground up now that the financial crisis has exposed critical flaws in its operation.
Originators, whether banks or brokers, need stronger incentives to originate loans that are in conformity with what they have promised. Mandatory minimum retention of risk in respect of securitized assets must address a number of important issues in order to be practical and beneficial. Among other things, for example, a minimum risk retention requirement would increase the risk of the banking sector and be difficult to enforce given the possibility of hedging. Furthermore, such a requirement would compel the originator to bear general economic risk—such as risk from interest rate changes—not just the risk of non-conforming assets. A superior solution is to strengthen representations, warranties, and repurchase obligations and require increased disclosure of originators’ interests in securitized offerings. Certain high-risk practices, such as “no doc” loans, should be prohibited outright. Moreover, we would increase loan-level disclosures and encourage regulators to study ways of improving the standardized public disclosure package.
Credit rating agencies should be reformed to reinvigorate the securitized debt markets. In order to restore confidence in the integrity of credit ratings and improve how the global fixed-income markets function in the future, I propose developing globally consistent standards, avoiding governmental interference in the rating determination process, reviewing references to credit ratings in regulatory frameworks, and increasing disclosure pertaining to ratings of structured finance and other securities.
MORE EFFECTIVE REGULATORY STRUCTURE
Even after the passage of the Dodd-Frank Act, the U.S. financial regulatory framework is highly fragmented and ineffective. The fragmentation of regulators is not the product of careful design—it has evolved by layers of accretion since the Civil War. It has survived largely unchanged, despite repeated unsuccessful efforts at reform. The current crisis has demonstrated that this dysfunctional system comes with a very high cost. In contrast to the route taken in the Dodd-Frank Act, a statement by the Committee on Capital Markets Regulation, entitled “Recommendations for Reorganizing the U.S. Regulatory Structure,”2 proposed a new consolidated structure, comprising the Fed, a newly created U.S. Financial Ser vices Authority, the Treasury Department, and possibly a consumer and investor protection agency. This structure can substantially reduce the risk of future financial crises. I disagree with calls for a systemic risk council. The Dodd-Frank solution is only more fragmentation by another name.
Any existing Fed loans to the private sector that are insufficiently collateralized should be transferred to the federal balance sheet. While the Fed cannot go bankrupt, any Fed losses are ultimately borne by U.S. taxpayers and should be directly and transparently accounted for as part of the federal bud get. For the same reason, in the future, only the Treasury should engage in insufficiently collateralized lending.
But rather than reinforcing the Fed’s independence, as our proposal would do, the Obama administration urges amending Section 13(3) to require the written approval of the secretary of the Treasury for any emergency extension of credit. This expansion of Treasury power over the Fed’s use of liquidity facilities in classic lender of last resort situations—that is, where there was adequate collateral—is startling and unwise. Instead, the lines of authority should be clear. The Fed should have strengthened authority to loan against adequate collateral in an emergency. And the Fed should have no authority, even with the approval of the Treasury, to loan against insufficient collateral.
The Fed needs authority to lend in a crisis to avoid the chain reaction of failures of financial institutions, which could result in a complete economic collapse. However, this reason to act should not jeopardize the Fed’s credibility and independence. Instead, these goals can be achieved by giving the Fed full authority to lend against good collateral—a traditional power of a central bank—while requiring bailouts to be undertaken by the government. This change will enhance both the Fed’s credibility and its independence and make our government more accountable.
The Dodd-Frank Act missed a major opportunity for financial regulatory reform. The time for real financial regulatory reform is now. But now is also the time for serious thinking and analysis, not knee-jerk responses. A clear road map for reducing systemic risk, enhancing transparency, and modernizing regulatory institutions is the better medicine.
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