Regulation and the Financial Crisis

October 6, 2008

When a presidential election falls in the middle of a financial crisis, it is not surprising that we are besieged with misinformation. Much of it is finger-pointing about responsibility for the absence of effective regulation that would have stopped or moderated the crisis. This article aims to provide some perspective on this issue.
Political Responsibility For Inadequate Regulation

There are two sectors where more extensive regulation might have made a difference. These are the investment banks and the Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac. Both sectors were major players in the events leading up to the crisis.

In 2004 the SEC adopted a rule that pretty much allowed the investment banks to regulate themselves. While a number of other factors were involved in this decision, the commission’s belief at that time was that self-regulation would be more effective than SEC regulation. This policy was consistent with the free market ideology of the republican administration.

In 2003, efforts to bring the GSEs under tighter regulatory control were defeated in Congress. This was primarily the work of democrats, who feared that tighter regulation would crimp the ability of the GSEs to meet affordable housing goals.

I call it a tie. I also hasten to add that had both financial sectors been subject to regulation, an only slightly less severe crisis would have occurred anyway, for reasons explained below.

Deregulation Was Not a Factor In The Crisis.

The only significant financial deregulation legislated in the last three decades applied to commercial banks. Restrictions on where they could branch, and on their involvement in investment banking, were both removed. Most economists including me believe that these actions made the banks stronger than they would have been otherwise.

Regulation Is a Weak Defense Against Financial Crises.

One major reason is that it tends to look backwards, similar to generals fighting the last war. The savings and loan industry was subject to very extensive regulation in the 1970s, but that did not prevent the subsequent crisis. The problem was that the wrong things were regulated.

The regulatory system was geared to preventing S&Ls from taking on too much default risk because historically, that had always been the major problem. The exposure of S&Ls to interest rate risk was not controlled. The associations were allowed, even encouraged, to make long-term fixed-rate mortgages financed with short-term deposits. When market interest rates exploded in the early 80s, the cost of deposits jumped, income from mortgages barely changed, and the industry began to bleed red ink.

The policy changes that were introduced following the S&L crisis were largely designed to prevent another crisis of that type. Among other things, associations were authorized (and encouraged) to write adjustable rate mortgages (ARMs) on which rates would adjust with the market. This would make S&Ls as well as banks less vulnerable to swings in market rates.

However, ARMs carry more default risk than fixed-rate mortgages, and as the years passed, interest-only and option ARMs evolved that carried substantially more default risk. As the system became increasingly secure against an interest rate shock, it became increasingly vulnerable to a default shock.
Preventing a Default Shock Is Extremely Difficult.

The core tool is capital requirements: the amount of capital including reserves that firms are required to have to cover the risk of losses from future defaults. The problem is that nobody knows how large future default shocks will be.

Regulators have no better foresight than the firms they regulate. The statistical models used by both are based on past experience. A change in the underlying structure of the economy can make such past history irrelevant, which is exactly what has happened. Nobody anticipated the severity of the current crisis because, relative to past history, it is off the chart.

But doesn’t that simply mean that regulators, who are not motivated by profit, should err on the side of caution? To a degree, yes, if that were not the case, regulation would be utterly pointless. But capital requirements that are higher than needed to meet potential future shocks not only reduce profits, they also impose social costs, to which regulators are sensitive. Larger capital requirements reduce loan volume and raise interest rates, a fact well understood by the congressmen who resisted tightening regulatory controls on the GSEs.
Better Regulatory Tools Are Needed.

We should take a hard look at applying the system used to regulate mortgage insurance companies to mortgage lenders. Under this system, lenders would be required to allocate a portion of every dollar they receive in interest above some base rate to a reserve account that would not be touchable for 10 years except in an emergency. The higher the interest rate, the larger the payment to the reserve account.

Can we prevent it from happening again? Yes, the next crisis will almost certainly be different.

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