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.)