Will reining in regulators better control bank risk?

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To tame future financial crises, the Federal Reserve System and other federal agencies are considering increases in bank capital ratios.

Financial crises, as we know, induce losses to banks, businesses, borrowers, employees and depositors. Excessive bank financial risk is widely believed to lie at the heart of the risk problem. But to prevent future crises, even if induced by regulatory actions, standard wisdom suggests more regulation. Put another way, the one sure cure for regulatory failure is more regulation.

REGULATORS REGARD a bank’s leverage ratio – the ratio of its capital to its total assets – as the single best measure of its financial risk. The higher this ratio, the lower is the risk of failure. In fact, on July 10, regulators were considering doubling this ratio requirement (from 3 percent to 6) for eight of our largest banks.

Remembering that a bank’s loans are a significant portion of its assets, while its deposits are liabilities, how – in the attempt to control bank financial risk – did banks become governed by financial ratios? At best, they are only loose indicators of risk.

Much pre-1933 U.S. banking regulatory history may be explained by political efforts to protect bank depositors through mandating bank observance of various ratios, especially the ratio of bank cash assets to its deposits.

But doesn’t the FDIC take care of depositor risks? Since 1933 it has stood behind depositors, but as will be argued, ironically this insurance is a major part of the current bank-risk problem.

REGULATORY FOCUS on bank depositors has its roots in the 1830s, when the state of New York enacted the first law mandating banks to keep a certain amount of their cash assets relative to deposits as reserves – the so-called reserve ratio. Adherence to this standard was expected to help banks better meet uncertain cash demands of their depositors and thus prevent a “run” on banks, when depositors withdraw deposits in a panic, and thus precipitate bank failures. When the Federal Reserve System was formed in 1913, Congress mandated such reserve ratios for its member banks.

The financial crisis of the Great Depression, however, with its thousands of bank failures and depositor losses, falsely convinced regulators that government insurance was needed to protect depositors. Hence, the FDIC was born, which sought to provide depositor comfort.

BUT THE FDIC brought unexpected consequences. Since depositors were now insured for their losses, banks in search of higher profits were encouraged to assume higher-risk loans and investments. At the same time, deposit insurance encouraged banks to assume riskier liability structures – e.g., greater amounts of short-term debt relative to long-term liabilities – and discouraged depositors from using due diligence to assess the risk and quality
of the bank that holds their deposits.

It wasn’t long, however, that regulators recognized this perverse incentive and swelled the amount of resources devoted to bank-risk regulation. This massive effort, while intended to curb risk appetites of bankers, proved costly to both the taxpaying public and to banks.

Meanwhile, by the early 2000s, government policy (via the Community Reinvestment Act of 1998) was encouraging, if not coercing, via bank examination policies, banking institutions to make higher-risk home loans – subprime and Alt A or “liar” loans – a large proportion of which (26 percent) did default. (However, while such loans are not issued today, pressures to reinstate this policy are building.)

Participation of the Federal National Mortgage Association in this failed program led to a recent federal taxpayer bailout of their resulting losses of more than $150 billion. Mandating FDIC insurance – while (1) promoting subprime and “liar” loans, (2) encouraging bank examiners to wink at high-risk home loans and (3)insisting that banks reign in risky business loans and investments – is asking for great trouble.

TO HELP RESTORE sanity in this inconsistent regulatory policy, we first note that the people best qualified to assess the risk of borrowers are not bank examiners, but those currently serving that function at the local bank. Banks must be made responsible for their losses, failures and bad outcomes; nothing restores responsible decision making more than requiring the decision maker to have some skin in the game. Losses, failures and regrettable outcomes are, after all, a part of life. Successful people learn by failures. To increase borrower responsibility, eliminate moratoriums on defaulted loans as

Because FDIC insurance induces banks to relax their risk standards – a moral hazard – we suggest that deposit insurance be privatized; that the smothering bureaucracy of the FDIC be abandoned and allow the free competitive market to sort things out. Some banks might buy private coverage, but some will not, which will allow depositors to buy personal coverage as a choice. By increasing bank and depositor responsibilities, this policy has an excellent chance of reducing overall bank moral hazard.

A frequently offered objection to this proposal is that people are not skillful enough to evaluate bank risk. Yet, we allow people to evaluate home mortgages, loans, leases, common stocks and countless other financial products even though only a few have the skills to do so. If consumers can handle these products, they can evaluate banks. Moreover, depositors apparently had bank evaluation skills until 1933, when suddenly they vanished with the enactment of the FDIC.

FURTHER REFORMS to bring pressure on banks to reduce financial risk include no more bank bailouts by government, and no more troubled Asset Relief Program loans (the Fed, however, would still be available to banks as a “lender of last resort”). No institution should be too big to fail. As a result, society benefits from significant reductions in regulatory costs, and banks would receive immense savings from the reduction in their regulatory compliance costs.

Following these changes, continued bank reform may take many paths. Discussing them is beyond the scope of this column, but ultimately banks must be made responsible for their survival.

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

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Bodhisattva 09/01/13 - 07:43 am
Let the banks gamble. Let the

Let the banks gamble. Let the little folks lose their money. Well they should have just known enough to buy personal depositor insurance on their own. We've seen what banks, Wall Street, etc. , do when oversight and regulation is reduced. They gamble and go wild. Those in the know get out "when the gettin's good" and make a mint, and happily let everyone else, including the nation's economy tank. No thanks. Been there, done that. Obviously the good Dr. is of the destroy a country and make the people destitute but a few folks come out fabulously wealth no regulation, neo-liberal, Friedman school of economics. It's never worked before. There's no reason it should start now. Oh, a handful of people have made out like bandits. In their wake they have left ruin, poverty, and misery, but then they got theirs, they don't care about the people. It's all about money. People just get in the way.

deestafford 09/01/13 - 09:17 am
Do we really need the Federal Reserve?

I would like the brilliant doctor, whom we are fortunate to have in our mist, discuss why we have a Fed, what brought it into being, what was the financial situation before there was a Fed, how were financial crisis handled before the creation of a Fed, and what would happen if we did not have a Fed.

It appears that many, and it seems to be a vast majority, in our governments have the same attitude and philosophy as does Bod and that being the people are stupid and need the protection of the big parent in DC without whom we would all starve, become destitute and perish.

soapy_725 09/01/13 - 09:51 am
Relocate to somewhere like N. Dakota. Or Belize.

Relocate to somewhere like N. Dakota. Or Belize.

ymnbde 09/01/13 - 10:20 am
my goodness, Bodhisvatta

what a dramatic reply...
the good Doctor does not want to do away with regulation
just make it more effective
the sky isn't going to fall, the world isn't going to end
if we just get something that actually has a chance of working
mostly, it's fixing what liberals have wrought with their arrogance
of using power
and their ignorance
of what actually works

Bodhisattva 09/01/13 - 12:55 pm
Just start by elimiatint the

Just start by elimiatint the FDIC? The one government program that insures the average guy gets his money back if a bank plays it a little too loose and goes belly up. The good Dr. expects everyone from janitors to teachers to soldiers to retail clerks and so on to have the time and know how to examine their bank's books, which I'm sure the bank would freely disclose, to determine if there's a risk of them losing their life's savings simply by having a checking and savings account and maybe a cd with the bank. Without a doubt one of the worst ideas out there. Lump it in with privatizing SS and Medicare. Just another way to throw the little guy to the wolves.

Gill52 09/01/13 - 01:02 pm
Self-regulate? Really?

Yes, the good doctor (the one in our mist?), did suggest that there shouldn't be any regulation. That the bankers know better than the regulators. A lot like Alan Greenspan. Exactly the same thing he went before Congress to apologize for believing. He had to apologize because this belief lead so directly to the failure of 2007-8. The only thing Greenspan forgot was to write a check to Treasury for a trillion or two, because that is exactly what this Ayn Rand fueled idiocy cost our country.

This man (the article author) has a very strange understanding of our financial history. For 50 years after the strongest financial regulation in our history (implemented in 1933) we had ZERO financial crises in America. This is unique in the history of our country. And as we de-regulated over the next 25 years our financial situation grew riskier and riskier, weaker and weaker. Increasing de-regulation lead us first to the Savings & Loan crisis in the 90's and the crash of 2007-8.

Michael Lewis, noted author and former bond trader, has stated that the ruin of the investment banking industry came when the investment banks became public corporations. Playing with other people's money made investment bankers into gamblers betting money from their expense accounts. Who cares if you lose and lose big? Someone else will pay.

Over and over again the banking industry in the US has proven unworthy of our "trust" in their running their own affairs. This is because their business is using other people's money to make money. And that "profession" is ALWAYS worthy of government oversight. As much as we can get.

Dryly 41
Dryly 41 09/01/13 - 04:05 pm
Will Reining in Regulators Better Control Bank Risk?

This is a strange letter. On the one hand it is correct to say that deposit insurance eliminated the runs on banks that plagued the financial system throughout the 19th and early 20th centuries. It is also correct to say that deposit insurance created a moral hazard for bankers using what Louis Brandies termed "other peoples money". Congressman Henry B. Steagall of Alabama was the chief proponent of deposit insurance. Senator Carter Glass of Virginia recognized the problem of "moral hazard" and included provision for "strict supervision" of banks including separating investment banks from commercial banks and retaining the 1927 McFadden Act restrictions of interstate branch banking which prevented too big to fail banks. These restrictions were eliminated in the 1990's along with a refusal to regulate derivatives. This led directly to the crisis after September 15, 2008 when Lehman Bros. filed for bankruptcy when the financial system collapsed for the first time since October 1929. What is truly bizarre is the professors claim, without evidence, that the 1977 Community Reinvestment Act was a cause of the events 3 decades later. The subprime mortgages were made by mortage brokers like Countrywide, New Century and Ameriquest which did not come under the aegis of the Comminity Reinvestment Act, were unregulated(the Federal Reserve had the authority to prevent fraud but Alan Greenspan refused to do so). This assertion is false. Nor did the Federal National Mortgage Association cause this as it was private Wall Street banks that funded the mortgage brokers so they could securitize the mortgages and sell them to unsuspecting investors with triple A rating which they paid the ratings agencies to provide. This is a highly misleading letter and it's hard to see why the professor would put forward so much false information.

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