Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.
Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.
Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.
Like most answers, the truth lies somewhere in the middle.
The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.
On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.
Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.
However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.
Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.
On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.
I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.
It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”
A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.
There are two results of the practice of fractional reserve banking, neither of them positive for the average person.
First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.
Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.
Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.
The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp.
These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.
By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.
The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.
The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.
Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.
This article was previously published at Mises.org.
I’m not aware of any unconditional support for central banking as such around The Cobden Centre but, nevertheless, occasionally a central banker says something worth hearing. Today, that central banker is often Andy Haldane, Executive Director, Financial Stability at the Bank of England.
The Wall Street Journal and the FT (£) report his speech at Jackson Hole, which may be found here. For example,
So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity. For what this paper explores is why the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.
Mr Haldane is a way from Greenspan’s famous defence of gold and free banking but the contemporary debate is also far from that point. Haldane’s speech is an intellectual tour de force which concerns some of the epistemological problems which will be so familiar to Austrians.
In my time-limited speech on the Bill which hands vast discretionary power to the Bank of England, I criticised it, saying, “I sincerely hope that it represents the absolute zenith of contemporary thinking on interventionist bank reform”. Perhaps it may yet: Haldane concludes,
Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.
Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.
It does not yet seem likely that a central banker will produce a speech with which Austrian-School liberals will agree whole-heartedly but Andy Haldane’s recent contribution was a courageous step in the right direction.
As I was reading of yet another spectacular mismatch between bank managers’ competence and their remuneration, and this time at JP Morgan no less, I realized there is a simple solution which really could be implemented.
Make the cost of regulation zero – or very nearly – for unlimited liability partnerships. Then let judicious self-interest, exercised by the partners themselves, do the rest.
My father was what they now call an ‘investment banker’. His firm got it wrong by expanding business into the 1970s’ slump, and when it went wrong the Official Assignee took everything he owned. That was in the days when partners had joint and several liability, which meant that all the top management of a firm were personally liable for the entire debts of their business.
Joint and several liability quickly weeded out the incompetents, the gamblers and the unlucky (my poor old Dad, I like to think). It made managers look very carefully at their colleagues’ strategies, and concentrated everyone’s efforts on controlling risks, rather than seeking bonus-building nominal profits.
The approach was discarded in 1986 after 150 years of pretty effective operation. It wasn’t perfect (what is?) but we were all very stupid to think we could do better by replacing the natural damper of direct personal liability with a combination of salaried and bonused managers, and sixty thousand pages of regulations.
I realised this morning that official regulation of financial services has become so onerous and so unsuccessful at loss prevention that joint and several liability could easily be re-introduced. All it would need would be a subsidiary arm of the regulator, set up exclusively for the regulation of investment businesses run by unlimited liability partnerships.
Lots of reputable financial professionals do not get big bonuses, because they work competently in the low-risk, low-return areas of the industry. Yet within the regulated sphere of financial services, there are so many complex rules that even these firms have to employ more compliance officers than accountants, while at the same time funding the wretchedly unfair Financial Services Compensation Scheme in the UK, or Federal Deposit Insurance Corp. in the US – which is a bit like being forced to pay for the car insurance of your drunken neighbour.
They should be given the choice of submitting to financial services, or choosing a simpler system, where they put up as collateral their house, their car, their holidays and their children’s school fees, and – within reason – are left to get on with managing their business risks as they see fit.
Making management collectively liable for their mistakes has lots of benefits.
- Size – Because partners all want to be able to understand their whole business it encourages smaller and less systemically dangerous organisations – ones which are not ‘too big to fail’
- Growth and competition – It encourages business formation, something which has ground to a halt now because of the huge cost of setting up a compliant organisation;
- Attention to detail – It forces revenue generators to be more critical about risks, rather than leaving it to formulae which pass the rules and get boxes ticked, but do not work in practice;
- Liability – It encourages senior management stability and accountability, and suppresses the job merry-go-round whereby careers advance by sweeping problems temporarily out of sight and quickly changing jobs;
- Rewards – It directly links remuneration to risk, as well as to performance;
- Clawback – It keeps all prior remuneration still in the compensation pot, to be reclaimed in the event of future investor losses.
Our experiment with rulebooks, regulators and salaried managers has been a bit of a disaster. Maybe a partial return to the old ways is not such a bad idea.
A version of this article was previously published at BullionVault.com on the 14th of May.
In 2007 there appeared the first signs of serious trouble in the US subprime mortgage market. While US Treasury Secretary Paulson assured investors that the problems were ‘contained’, by mid-2008, financial markets were pricing in trouble ahead. Sure enough, by fall 2008, it was clear that not only the US but also much of the global banking system was in need of a general bailout. As concerns mounted, equities and other risky asset prices fell and high-quality government bond prices rose. Investors were seeking safety. Yet a fabled safe-haven asset, gold, was also falling in price. Why?
In 2008, banks were scrambling to raise capital, accumulating so-called ‘Tier1’ assets, primarily highly-rated government bonds. In order to do so, they sold liquid, non-Tier1 assets, including gold, notwithstanding its historical safe-haven status. (However much banks would have liked to have sold illiquid non-Tier1 assets, it was impossible to do so, unless the central bank obliged, as the Fed did with Bear Stearns, AIG and other distressed entities.)
Regulatory capital is just that, regulatory. In 2008, distressed banks had no choice but to maintain adequate Tier1 ratios or risk being shut down or taken over by the regulators. As shown in the previous chart, from a peak of nearly $1,000 reached in March that year, notwithstanding its fundamental safe-haven status, gold plummeted 30%, to nearly $700 by November.
However, once it became clear that policymakers were going to ease capital and mark-to-market requirements for banks and, in certain cases, explicitly guarantee their liabilities, the forced selling of gold and other liquid non-Tier1 assets came to an abrupt halt. The gold price rose to over $850 by year end. However, because risk aversion remained high, due to concerns about the broader economic fallout of what had occurred in the financial system, there was no general recovery in the equity markets until the following spring.
Viewed in this way, the gold price can be understood as a deflation or reflation ‘canary’, appearing to buck the trend from time to time but, in fact, giving critical prior warning of deflationary trouble on the one hand or reflationary relief on the other. Gold is unique in this important sense: It is arguably the only non-Tier1 asset to be universally regarded by investors the world over as a safe-haven asset. As such, it is a more reliable indicator of financial system distress or relief than government bond markets, in particular when central banks are actively manipulating the latter via QE, ‘Twist’, etc.
Recent gold price action vis-a-vis Tier1 assets is thus not only a clear indication of rising banking system distress, it is also an opportunity for those who believe that policymakers stand ready to provide some reflationary, palliative medicine to the financial system in the event that things continue to deteriorate. Although reflationary policies are highly likely to put a floor under equities and other risky assets, the primary, first beneficiary should be the safe-haven of gold, artificially depressed as it now is by being excluded from the Tier1 regulatory basket.
THE ‘UNWITTING’ MOVE BACK TO GOLD
A recent study by Fitch ratings calculated that banks need to raise $566bn of Tier1 capital, a 23% increase. That implies much potential selling of liquid, non-Tier1 assets. At first glance, this would appear to be negative for gold. But in fact it is not that simple.
As it happens, given that so many banks are desperate to raise their capital ratios, there is in fact a discussion underway regarding whether or not gold should, in fact, be designated as Tier1 capital. In a recent article in the Financial Times, it was reported that, “The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.”
This is a hugely under-appreciated development. For if it happens, it will be an important step toward the re-monetisation of gold. Gold would be able to compete on a level playing field with government bonds. While the playing field could be levelled in this way, there would be a gross mismatch on the pitch. On the one hand, you have unbacked government bonds, issued by overindebted governments, yielding less than zero in inflation-adjusted terms. On the other, you have gold, the historical preserver of purchasing power par excellence. In my opinion, if gold becomes eligible as Tier1 collateral, the price is likely to soar to a new, all-time high.
Now while the gold price might seem elevated in a historical comparison, notwithstanding the recent correction, most prices are. This is what inflation does. It raises prices over time as the base currency depreciates in value. Yes, the stock market may be roughly where it was a decade ago. But this reflects lower valuations, something entirely appropriate for a world awash in unserviceable debt; with profligate, in some cases essentially bankrupt national, state and local governments; complex, inefficient regulatory burdens; challenging demographics; and political instability in some parts of the world. Sorry but this is not the mid-1990s, folks.
As P/E ratios have declined for these compelling, fundamental reasons, equity prices have struggled to rise. Not so the price of gold, for which there is no P/E. Warren Buffet and his sidekick Charlie Munger may disparage this lack of ‘E’, due to gold being an ‘unproductive asset’, but as these guys happen to own a major insurance company, you would think that they would know better. What, exactly, is the P/E of an insurance policy? Doesn’t it have one? No? Well that’s because insurance, by its very nature, is ‘unproductive’. It doesn’t generate an income. (In fact, in normal circumstances, it has a negative carry cost, or ‘premium’.) But importantly, critically, it protects that which does produce an income against extreme or unforeseen negative outcomes.
Now if you’ve got wealth, and you want to protect it from, say, some combination of inflation, deflation, tax and regulatory uncertainty, excessive debt, poor demographics, geopolitical concerns, what have you, well then do you buy into the Facebook IPO? Or do you take out insurance and buy gold instead? After all, with real interest rates negative in developed countries, gold insurance, at present, does not even have a negative carry cost, or ‘premium’! With uncertainty rising and the cost of carry positive in real terms, the fundamental case for accumulating gold is unusually strong at present, quite possibly the strongest it has been since late 2008.
WHERE IS THE FLOOR THIS TIME ROUND?
Based on the 2008 experience, investors who agree that gold remains a safe-haven asset, the current lack of regulatory recognition thereof notwithstanding, and who also belive that policymakers stand ready to step in the rescue the financial system if so required, now is an excellent time to acquire or add to positions in gold. This is not a technical trading or momentum argument. This is a qualitative judgement call on my part, based on my fundamental understanding of what factors drive the price of gold in the medium-term and what I believe is a critical lesson from 2008 specifically.
While I would not rule anything out, given just how arbitrary economic policy-making has become in recent years, I would be surprised were major central banks not to come to the rescue if the euro-area debt crisis escalates further or if another major global crisis emerges in the coming months. By how much might the price of gold fall in the meantime, as the Tier1 scramble continues? Recent and some past price action suggests a floor around $1,500, but it could fall to the $1,200-50 area. Were that to happen, and were other factors to remain essentially unchanged, I would recommend for investors to increase their exposure to gold to the maximum that their portfolio allocation guidelines permit.
Given depressed valuations, investors could also consider increasing their allocation to gold mining shares. That said there are good reasons why gold share P/Es are depressed at present, the subject of a future Amphora Report.
This article was previously published in The Amphora Report, Vol 3, 18 May 2012.
Adam Smith’s great insight was that in a commercial transaction both parties benefit. Before his time, it was generally believed that in an exchange of goods, one party usually gained what the other lost. The mistake was to misunderstand value: it is different to different people. A seller places greater value in the money than the product he sells for it, and the buyer places a greater value on the product than its cost, otherwise the deal would not happen.
Lovers of regulation do not seem to understand Adam Smith’s perception of enlightened self-interest. They believe unprincipled capitalists steal the widow’s mite. The prevalence of regulation, particularly in Europe, where everything must be regulated, is in this sense a complete denial of all economic progress since the days of mercantilism.
Regulation often defeats its objectives, a point which was made clear to me many years ago. I met the managing director of a spread-betting business at the time when there was a debate about whether or not spread-betting should be regulated as an investment activity. He welcomed regulation, because it would give his business added credibility, despite by definition being gambling. He was right: that is why everyone in the financial services business dealing with the public wants regulation. It enhances their credibility.
Unregulated, a business’s reputation is its most valuable asset. A regulated business does not have the same problem, so long as it obeys the regulations. Regulations replace the overriding need for a business to protect its reputation, and it is no longer solely concerned for its customers: the rule book has precedence. And the more regulation replaces reputation, the less important customers become. Nowhere is this more obvious than in financial services.
Back in the Eighties when single capacity was scrapped in London, and securities businesses were allowed to act as both brokers and market-makers, the conflict of interest was meant to be resolved by the interposition of a Chinese wall. We hardly ever hear the term nowadays, but this sham separation of broking from market-making demotes customers’ interests. Predictably, they have become cannon-fodder for the trading book, where the real profitability lies. And then there is the egregious example of MF Global, which it appears, has been permitted by the regulator to gamble and lose its customers segregated money.
The regulators assume the public are innocents in need of protection. They have set themselves up to be gamed by all manner of businesses intent on using and adapting the rules for their own benefits at the expense of their customers. These businesses lobby to change the rules over time to their own advantage and hide behind regulatory respectability, as clients of both MF Global and Bernie Madoff have found to their cost.
Where is the protection? Adam Smith must be turning in his grave.
This article was previously published at GoldMoney.com.
There have been many books attempting to find and explain the causes of the ongoing financial crisis. Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence. Most of these works are lacking, incomplete, or even flat-out wrong. Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories. There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.
This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis. The authors make the purpose of their study evident from the very beginning. They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence. The data they look at has to do with the regulations which governed the financial institutions that presided over the network of financial instruments which suddenly lost the bulk of their value. The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?
Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009. Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest in the specific financial assets that would soon after be deemed nearly worthless.
Friedman and Kraus emphasize the importance of the fact that the banking industry had no idea — what they call “radical ignorance” — about just what kind of quagmire they were investing themselves into. They use evidence to illustrate the fact that, predominately speaking, the bankers, regulators, politicians, and other major actors in this crisis had absolutely no idea of the relevant potential for a recession to occur, let alone that the highly rated assets they invested into would soon become relatively valueless.
We can see now the broad thesis of Engineering the Financial Crisis. Bankers did not buy large amounts of soon-to-be “toxics assets” because the risk had been externalized to the taxpayer.  Neither is their any evidence suggesting that bankers purposefully ignored high risk in favor of pursuing high profits. The majority of assets purchased were actually AAA rated, and because of this the risk-load they carried, as perceived at the time of purchase, was relatively low. What manipulated the relevant price signals which funneled investment into the housing market were regulations which rewarded these type of investments. To a lesser extent, the authors also point at government programmes which pushed for house ownership and the relatively low rates of interest on new loans which made borrowing seemingly more affordable.
Leading up to the crisis, bankers were generally very risk sensitive, preferring assets with lower revenue returns. Roughly 93 percent of mortgage bonds held by U.S. Commercial banks were AAA-rated mortgage backed securities (both private label [PLMBS] and agency rated [MBS]), and almost another 7 percent were AAA-rated collectivized debt obligations (CDO).  Missing from this collection of assets were any mortgage bonds rated less than AAA, which were usually the bonds which the highest rate of return.
Most commercial banks in the United States were also above their legal capital reserve minimum on the eve of the financial crisis — the twenty largest banks held capital levels averaging 11.7 percent, where the legal minimum was 10 percent of a bank’s total assets (as dictated by the Federal law, whereas the Basel I accords had set it at 8 percent). More specifically, if one only accounts for “Tier 1” capital  banks retained a capital cushion of 50 percent, even while federal law required a minimum of 5%. In other words, most banks opted to retain a substantial capital cushion, where one would expect a bank interested in maximizing profit (while ignoring risk) to push the boundaries of its legal requirements. 
The issue, then, was not about bankers with low risk aversion, seeking high profits by investing mostly in high-risk assets. The evidence suggests quite the contrary. U.S. commercial banks invested in what were perceived as low-risk, low-return assets, and on top of this held higher than required capital cushions. Also going out the window is the “too big to fail” theory, or any other case that argues that it was risk externalization which created an incentive for an over-concentration of investment into the mortgage market. Simply put, there was a high aversion to risk during the years leading up to the crisis.
Friedman’s and Kraus’ explanation of what caused the crisis can be divided into two parts: what caused the over-concentration of investment into mortgage-backed securities and why these securities, which by 2008 had lost the majority of their value, had been rated so highly by the major rating agencies. The strength of their book is found in its accounting of the first — what led to the pattern of investment that characterized U.S. commercial bank assets prior to the recession.
Because different types of investments generally have different degrees of risk, a capital requirement minimum that encompasses all assets is illogical. Rather, it makes more sense to create different capital reserve requirements for different sorts of investments, based on the general perceived riskiness of the different types. The Basel I accord was an attempt to correct the issues of a homogenous treatment of assets by creating different categories and attaching a capital reserve minimum to each category. Higher risk assets, therefore, were categorized into higher “risk buckets” and required a greater capital cushion. In other words, the greater the risk the asset carried, the more it cost the banks to protect against, by reducing the amount of capital available to invest.
The issue, as explained by Friedman and Kraus, is that these regulations led to “regulatory arbitrage”. For example, a bank could invest into mortgage bonds with a risk-weight of 50 percent, then re-sell these bonds to a government sponsored enterprise (such as Freddie Mac and Fannie Mae), and buy them back as an agency bond. These agency bonds were risk-weighted at 20 percent, effectively reducing the capital cushion necessary to back the asset, even though the composition of the asset remained exactly the same. The Basel regulations made it more expensive to issue business loans than home loans, creating a financial incentive to issue more home loans. Basel I created incentives for banks to make certain types of loans and then securitize them.
A further boon to securitization came with the adoption of the Recourse Rule, which borrowed the Basel II accord’s method of rating privately issued securitized assets by risk. This system caused banks to increase investment in AAA-rated securitized mortgage bonds, especially since the risk-weight of unsecuritized mortgages remained at 50 percent (as dictated by Basel I). It remained cheaper to invest in mortgages, rather than other types of loans to consumers and businessmen, and then banks could further increase profitability by securitizing these mortgages and releasing part of their capital reserves for further investments. This explains the concentration of investment in mortgage backed securities.
We see a pattern between 2001 and 2007 of an increase in housing loans and investment into mortgage backed securities. We know that at the time these types of investments being made were being pooled into buckets which were considered generally less risky than other forms of investment. It was not an issue, therefore, of carrying on more risk. In fact, this pattern of investment was created out of the fact that the regulations incentivized purchase of less risky assets. The problem which led to the financial collapse, therefore, deals exclusively with the fact that these assets carried more risk than was originally perceived by the regulators (and banks). In fact, the collapse of the subprime mortgage market came as a total surprise, both for the bankers and the regulators.
It was not just the architecture of the impending financial collapse that the regulatory web was responsible for, but also the magnification of the disaster. Thanks to the capital reserve minima, many banks faced insolvency even though the circumstances did not really call for it. In order to remain legally solvent, U.S. banks are forced to maintain a certain capital reserve minimum. As the crisis unfolded, bonds which had been previously rated at AAA were suddenly downgraded, raising the necessary capital reserve minima for each risk-bucket. In other words, as ratings fell for different types of bonds, banks were suddenly forced to raise new capital to cover their loss.
Furthermore, regulations forced banks to mark-to-market their assets to reveal their “true value”. This process was not done on an individual basis; rather, different bonds were lumped together and them marked-to-market as a group. So, even individual bonds which may have not actually lost value were readjusted on a bank’s balance sheet as assets that were suddenly worth less than had been perceived prior to the crisis. It was on the basis of these new market values that a bank’s solvency was judged. The issue is that by late 2009 many of these same bonds had recuperated much of their value, and so a bank that had been legally insolvent in early 2008 may not have been two years later. In other words, many banks were forced into insolvency that could have survived the crisis, and other banks had to radically contract outstanding liabilities in order to remain solvent.
The consequence of these regulatory restrictions was a giant credit contraction — much larger than was actually necessary. And, of course, the monetary contraction only worsened the situation, as it reduced the financial viability of the various investments that depended on this credit.
Friedman and Kraus blame the inadequate rating of mortgage bonds on the cartelization of the major rating agencies — Moody’s, Standard & Poor’s (S&P), and Fitch. Basel II and the Recourse Rule had effectively tied their capital reserve requirements to the ratings provided by these three agencies. It was these three rating agencies that had been classified as Nationally Recognized Statistical Rating Organizations by the Securities and Exchange Commission (SEC) in 1975, and the various regulations that relied on risk ratings depended exclusively on this cartel. None of the three “nationally recognized” rating agencies, furthermore, had accounted for the possibility of a nationwide hosing crisis leading up to 2008.
There were private rating agencies, though, that had recognized the potential for crisis. According to Friedman and Kraus one such company was First Pacific Advisors, which sold its $1.85 billion investment in mortgage-backed bonds in late 2005.
Friedman’s and Kraus’ analysis hinges on the notion that what was ultimately at fault were these rating agencies. Had they been more accurate in their risk assessments then banks would not have malinvested in so many mortgage-backed bonds. But, why had the banks relied exclusively on the risk-assessment provided by the three “nationally recognized” agencies? Were these banks not aware of the risk assessments being made by private investment companies?
Perhaps the authors put too much weight on the notion that it was this cartelization of the rating agencies which made possible the crisis, and that had there been more competition in this industry the recession may have been less destructive than it turned out to be. But, Friedman and Kraus do not make clear exactly how many private agencies had foreseen the crisis. Few investors sold off their mortgage-backed bonds in anticipation of a market crash. Indeed, the majority of investors were still fairly confident in the strength of the housing market.
Here is where the explanation of the crisis becomes more detached from the data. Friedman and Kraus leave room for further interpretation, since their explanation for why the different bonds were assessed as they were comes off as inadequate (or, at least, incomplete). Understandably, they are looking to separate themselves from ideology — even though the book’s conclusions are extremely pro-market — and thus avoid applying far-reaching theories to the evidence they were able to collect
However, that there is still room for further interpretation is not necessarily a bad thing. As far as their analysis on the impact of regulations on the housing boom and the consequent financial crisis goes, it is difficult to refute. That there is still room for the application of theory means that their empirical findings can easily be assimilated into grander explanations of the financial crisis.
For the task it sets out to accomplish, Engineering the Financial Crisis is undoubtedly one of the best books written yet on the causes of the Great Recession. Jeffrey Friedman and Wladimir Kraus painstakingly dig through the data to provide a solid picture of why there was such an overconcentration of investment in the mortgage market. The evidence clearly shows that it was the web of regulation on the banking industry that shaped the structure of banking investment by favoring certain investments over others. The entire system collapsed when it turned out that these regulations had depended on agency assessments that had totally miscalculated the risk these favoured assets carried. Thus, banks had loaded themselves up with mortgage backed bonds, completely unaware of the fact that these bonds would soon be relatively valueless. It was not the market which caused the crisis, rather the distortions to the market that were created by government intervention.
That banks did not buy mortgage-backed securities and other similar assets because the bankers knew
that there was no risk for them is a very specific claim, and it does not include many banking practices which are
undertaken because of risk externalization (such as the extent of fiduciary expansion, which in our present banking system is a product of its cartelization under the Federal Reserve System).
 Friedman and Kraus 2011, p. 42 (table 1.3).
 Basel I divides bank capital by the type of asset, Type I being the safest pool. Type I is composed of “funds received from sales of common equity shares and from retained earnings.” Ibid., p. 40.
 A capital reserve basically allows banks to take losses, since it gives it a cushion of assets it can capitalize on to make up for net losses (before liabilities exceed assets).
A common interpretation of the credit crunch and ensuing global turmoil is that it was all down to unregulated or under-regulated financial institutions and markets. As a result, one of the most commonly advanced solutions is for more and/or better regulation. Indeed, this call is about as close as we get to a firm demand from the presently fashionable ‘occupy’ protests.
There are many things wrong with this view. First, the underlying causes of the recent boom and bust could be found, as so often, in monetary disturbances. In comparison to the damage wrought by a deluge of credit, any regulatory deficiencies are just hundreds and thousands atop a cake that was always going to turn out pretty sour.
Secondly, nothing says ‘profit opportunity’ to financial institutions quite like some new financial regulation. To give just one of countless examples, the Eurodollar market sprang into life thanks to attempts like Regulation Q to impose limits on interest rates. The financial innovators will only ever be one step behind the regulators for as long as it takes them to read the regulation. Then they streak ahead.
And thirdly, it is a mistake to think that financial markets were notably under-regulated. After redesigning British financial regulation almost from scratch, the Labour government never ceased tinkering with it. As Terry Arthur and Philip Booth wrote recently (PDF)
To obtain permission to carry out regulated activities an organisation must meet certain qualifying conditions. These include having adequate resources (financial resources as well as internal systems and procedures). The conditions are laid out in the FSA’s Integrated Handbook…Regulation is bureaucratic in the extreme. It is no longer possible to determine the number of pages in the handbook, but an indication is given by the following example. There are ten main sections in the book. One of those main sections…is that on ‘Listing, prospectus and disclosure’. This contains three subsections which have between nine and 23 sub-subsections each. Taking one of those sub-subsections, under the ‘Listing rules’, there are six sub-sub-subsections
Fortunately we can look at the economic impact of regulation worldwide with the release by the International Finance Corporation of the World Bank of its annual ‘Doing Business’ report which compares regulatory environments and the ease of doing business across countries. The reports message is unequivocal; regulation is mostly bad and those calling for more of it are calling for economic suicide.
A report on the report by The Economist picked out some notably egregious examples
A typical company in Congo with a gross profit margin of 20% faces a tax bill equivalent to 340% of profits…How long, for example, does it take to register a company? In New Zealand it takes one day and costs 0.4% of the local annual income per head. In Congo it takes 65 days, involves ten steps and costs 551% of income per head…Other procedures the IFC measures include registering a property (which takes one day in Portugal, 513 in Kiribati); obtaining a construction permit (five steps in Denmark, 51 in Russia); enforcing a simple contract through the courts (150 days in Singapore, 1,420 in India); and winding up an insolvent firm (creditors in Japan recover 92.7 cents on the dollar, those in Chad get nothing at all)…A young entrepreneur in Liberia who builds a new warehouse must wait on average 586 days to connect it to the power grid. In Ukraine it takes 274 days; in Germany only 17. Guess which of these countries has a thriving manufacturing sector?”
The chart below illustrates the point
Source: ‘Doing Business 2010′ (PDF) and International Monetary Fund ‘World Economic Outlook Database’ – Puerto Rico, Palau, the Marshall Islands, Micronesia and West Bank and Gaza are omitted for lack of a comparable data point
We see that while a light regulatory environment is not a guarantee of wealth, it is a necessary precondition. Not surprisingly, The Economist sees a causal relationship
Cutting red tape makes countries richer, if the 873 peer-reviewed articles and 2,332 working papers that use the “Doing Business” data are anything to go by. A study in Mexico found that simplified municipal licensing led to a 5% increase in the number of registered companies and a 2.2% increase in jobs. It also lowered prices for consumers. Bankruptcy reform in Brazil caused the cost of credit to fall by 22%. Countries with flexible labour rules saw real output rise by 17.8% more than those with rigid ones”
Calls for more regulation are both pointless and dangerous; pointless in that it won’t solve the undoubted problems in our present economic system and dangerous in that it could end up making us even worse off. More regulation is not the answer.
One significant issue arising in the crisis has been the size of some European underground economies. Politicians seek measures to increase public revenues as public budgets come under strain. As large segments of European, and especially southern European, economies are hidden in the underground, large amounts of otherwise taxable incomes are likewise hidden.
Chapter 4 my new edited collection, Institutions in Crisis: European Perspectives on the Recession, grapples with the issue of these underground economies. With over a quarter of Greek economic activity only unofficially undertaken, we see that in some countries the issue is significant. Indeed, the average underground economy for the PIGS (the PIIGS excluding Ireland) is 21.7 percent of GDP, almost three times the size of America’s, and double that of Germany’s.
Two important questions must be answered. First, what explains the size of these underground economies? Second, how can we integrate them into the official economy?
There are two general reasons why economic activity seeks to be underground rather than official. On the one hand high, tax rates prohibit otherwise mutually beneficial economic activities from occurring. Movements into the underground try to evade these taxes and thus allow trades to be made (for those of you who can remember your first-year economics class, this is a way to reduce those triangular deadweight losses of taxation). On the other hand, regulations add a potentially complex and costly web of rules that entrepreneurs must abide by. In some cases it is only possible, or at least easier, for a firm to operate in the underground instead of the official regulation-abiding economy.
When looking at the general range of underground economies in Europe it does not take long to discern which effect is stronger. Europe is well known for its plethora of taxes, as well as its high marginal tax rates, but there is no clear relationship between taxes and the size of the underground economy. High tax Scandinavian countries, for example, seem to enjoy relatively small undergrounds. Some southern European countries, Spain for example, have relatively low tax rates and large undergrounds.
The answer lies in the distinction between different interventions that Murray Rothbard made in this economic treatise, Man, Economy and State. Binary interventions are those where one party becomes subordinate to the intervener in the transaction. Labor taxes, for example, cause a firm to hire labor at a different price than it originally would have, and under the constraints placed on it by the government imposing the tax. Triangular interventions, in distinction, are those that place both parties to a transaction subordinate to the intervener simultaneously. Testing requirements on drugs subordinate both drug producers and consumers to the government imposing the regulation – no transaction can take place regardless of the desires of the relevant parties.
Northern European countries, despite their high tax rates (a form of binary intervention) enjoy relatively low levels of triangular interventions. Low levels of simple regulations make entrepreneurial undertakings relatively pain free. Business owners can comprehend the binary interventions as an additional cost of business, and proceed cognizant of the fact that they face a minimal level of complex and uncertain regulatory burdens. Consequently, there is not much reason to operate in the unofficial section of the economy. (Keep in mind that although one can save on taxes by doing so, there are costs – the lack of a clearly defined and enforceable rule of law being the foremost.)
Southern European countries, in distinction, are well known for the bureaucratic boondoggles they are. Triangular interventions abound. Complex and uncertain labor laws make firing (and subsequently, hiring) employees a costly or impossible ordeal. Unable to navigate the regulatory burdens endemic in these economies, entrepreneurs hide in the underground. By saving on the expense of the difficulties of complying with complex regulations, entrepreneurs are able to outweigh the added costs by working in less official conditions.
As this problem is most acute in the PIGS countries, it has become an issue as politicians search for means to bolster government revenues. By reallocating economic activity to the official sector, taxes will be able to be collected and government coffers replenished. Calls for more frequent auditing and increased fines have come to the fore. Such solutions are misplaced at best, and will exacerbate the problem at worst.
Increased audits and fines for the “guilty” will doubtlessly decrease the size of the underground economies. This added risk and cost of underground business will incentivize some entrepreneurs to withdraw, or at least curtail, such economic activity. It is doubtful that this will translate into increased official economic activity. Entrepreneurs in the underground are there because the conditions in the official economy are not conducive to business. High taxes and complex regulatory structures drove them out in the first place. Without a change to either of these two facets (primarily the latter), we should not expect any increase in official economic activity.
In my book I spell out one additional reason why EU politicians should not be overly keen on minimizing the size of their underground economies. As unemployment rates have increased, the various undergrounds have been able to cushion part of the blow. Working conditions in the underground economies are certainly not as desirable as in the official one, but the unemployed have few choices. Lacking growing employment opportunities in the official economy, a lack that I stress is caused by excessive and uncertain regulatory burdens, removing the underground options available will only serve to further impoverish the burgeoning unemployed masses.
From Deception of Government Intervention (1964) – an essay in Mises’ anthology Economic Freedom and Interventionism – we learn how governments adopted “the third way”:
Faced with the tremendous challenge of totalitarianism, the ruling parties of the West do not venture to preserve the system of free enterprise that gave to their nations the highest standard of living ever attained in history. They ignore the fact that conditions for all citizens of the United States and those other countries which have not put too many obstacles in the way of free enterprise are much more favorable than conditions for the inhabitants of the totalitarian countries. They think that it is necessary to abandon the market economy and to adopt a middle-of-the-road policy that is supposed to avoid the alleged deficiencies of the capitalistic economy. They aim at a system which, as they see it, is as far from socialism as it is from capitalism and which is better than either of those two. By direct intervention of the government, they want to remove what they consider unsatisfactory in the market economy.
Such a policy of government interference with the market phenomena was already recommended by Marx and Engels in the Communist Manifesto. But the authors of the Communist Manifesto considered the ten groups of interventionist measures they suggested as measures to bring about step-by-step full socialism. However, in our time the government spokesmen and the politicians of the left recommend the same measures as a method, even as the only method, to salvage capitalism.
In the aftermath of the financial crisis, we are now going down a road towards ‘judgement-based’ regulation of financial firms in an attempt to salvage capitalism.
It is proposed that firms will be supervised by what amount to shadow management teams of disinterested, public-spirited individuals more able to reach sound views than firms’ own management teams: they shall possess “the optimal experience and technical ability”.
Quite where these mythical philosopher kings are to be found, I do not know. Presumably, financial firms and regulators already hire the best people available. And the notion that the best people will work for the regulator despite inevitably higher rewards in the firms themselves is silly.
Financial firms will find their business subject to the day-to-day judgement of government officials. To think that those officials will be more capable than the institutions’ traders and managers is a fantasy. The outcome will be, as it has been, a surprise financial catastrophe as regulators fail to foresee the future and, since they are bound to converge on “best practice”, fail as one.
A free society is not one based on constant official interference with business. It is one based on cooperation, choice, competition, profit & loss, predictable rules fixed well in advance and exit from the market: that is, property, contract and the classical rule of law.
Rather than resort to fantastic ideas about the effectiveness of government interference with market phenomena, we would do better to reapply the principles of a free society. Financial institutions should be no exception, for government intervention caused the crisis [1,2].
Postscript: Marx and Engels’ ten measures are available here.
Dalibor Roháč of the Legatum Institute and Matthew Sinclair of the Taxpayers’ Alliance have jointly authored a report on the risks of new global financial regulations:
Around the world politicians and officials are advancing major new regulations of the financial services industry. Those regulations are a response to a major financial crisis, but real care needs to be taken to ensure that they help avoid future crises, and won’t precipitate or exacerbate crises instead.
- The increased internationalisation of financial regulation risks amplifying future global booms and busts. Global regulations lead to global crises as organisations are encouraged to hold similar assets and respond in similar ways when things go wrong. As a result, the new regulation could increase the systemic risk to the world economy.
- Attempts to focus regulation on the institutions that contribute the most to systemic risk carry their own risks. If institutions understand that they are seen as “too big to fail” then that will encourage excessive risk taking.
- Despite attempts to address the issue, the Basel regulations may still be procyclical, imposing more onerous requirements on institutions at times when the system is in trouble.
- Some measures proposed, like attacks on tax havens and hedge funds, are motivated by other agendas and do not actually address the problems that led to the financial crisis.
- There is an important debate over whether or not effective “macro-prudential” regulatory policy is possible. However, the policies introduced since the financial crisis do not live up to that standard. Some of the measures announced are disingenuous political posturing while others continue existing mistakes partly responsible for the problems we are facing today. It is entirely possible that the new regulations being implemented could hurt established financial centres like the City of London while increasing the frequency and strength of global financial crises.
Download the full report (PDF).
The Taxpayers’ Alliance announcement is here: