Financial Regulatory Reform--Posner's Comment

I have blogged at considerable length about the July 17 report, see http://correspondents.theatlantic.com/richard_posner/, and also written a short op-ed on the subject, published in the New York Times on July 25 ("Our Crisis of Regulation," p. 21). I have emphasized both what seem to me fundamental failings in the report and weaknesses in particular proposals. The fundamental failings include prematurity, one-sidedness, and overambitiousness, and let me dwell for just a moment on the first of these, or rather one aspect of the first, and that is the Administration's determination to revamp financial regulation in light of the financial crisis of last fall before the causes of that crisis have been determined. In other words, first the sentence, then the trial to determine guilt, specifically the guilt of the finance industry (of "banking" in a broad sense that includes other financial intermediaries--the members of the "shadow banking" system, of which more shortly). Without pointing to evidence, the report asserts that the financial crisis was the product of irrational decisions both by lenders and borrowers and of major gaps in the structure of financial regulation. Ignored is the role of error and inattention by the regulators, notably including the Federal Reserve and the Securities and Exchange Commission; the deregulation movement in finance; lax enforcement of the remaining regulations; and failures of understanding by the economics profession. And thus the role of the Fed in forcing interest rates too far down, and keeping them too far down for too long, during the early years of this decade, and in neglecting growing signs of housing and credit bubbles (caused by low interest rates), goes unmentioned. Since senior economic officials in the Administration were implicated in these failures of regulation, and since the thrust of the report is that we need more regulation, it is not surprising that the report should give regulators a pass. It should be a rule of regulatory reform that before the regulatory structure is changed, which is likely to be a time-consuming endeavor with at least some unanticipated consequences, the government make sure that the regulators are employing their existing powers to the full. And indeed just last week the SEC announced that it is imposing reserve and capital requirements on money-market funds, requirement that had they been in force last September would have reduced the systemic consequences of Lehman Brothers' collapse (see below). Had this rule been honored by the authors of the report, there would have been much less emphasis on structural reform, as in the proposed creation of new regulatory entities and the proposed expansion in the powers of the Federal Reserve. The centerpiece of the Administration's proposal, and the only specific proposal in the report that I will discuss in this comment, is the proposal to authorize the Federal Reserve Board to regulate any financial enterprise that creates "systemic risk." The Fed would designate the enterprise a "Tier 1 Financial Holding Company," and having done so would have the same (perhaps even greater) powers that it has over commercial banks that are members of the Federal Reserve System. Its focus would be on "macroprudential" regulation--that is, on assuring that a failure of the Tier 1 FHC would not imperil the financial system as a whole. The Fed would be expected to limit the leverage of these firms (the debt-equity ratio in their capital structure) and take other measures to reduce the risk of failure, for example by forbidding them to engage in proprietary trading (that is, speculating with their assets). To prevent the gaming of this new regulatory power by firms that would go up to the very edge of whatever line was chosen to separate Tier 1 FHCs from other nonbanks, the Fed would have a broad discretion in so classifying financial firms. Financial firms that are not commercial banks are now significantly larger sources of credit than banks, and they can create systemic risk. An example is (or rather was, because it is now defunct) Lehman Brothers, a broker-dealer. Lehman, among its other activities, was a dealer in the commercial paper and money-market markets. It would issue its own commercial paper (short-term promissory notes) to money-market funds and use the money it borrowed in this manner from the funds to buy commercial paper from (that is, lend to) nonfinancial firms with sterling credit records, such as Proctor & Gamble, that finance their day-to-day operations by issuing commercial paper. When, last September, Lehman Brothers became insolvent because of losses in other parts of its business, it could not repay its loans from the money-market funds or lend money to issuers of commercial paper. The commercial-paper and money-market funds froze, contributing to the credit crisis. Lehman was not among the largest nonbank financial enterprises, but because of its interdependence with other participants in the overall credit market its sudden collapse had serious repercussions. Although the Federal Reserve claims that it lacked the legal authority to save Lehman from collapsing by lending it the money it would have needed to stave off bankruptcy, the claim is unpersuasive. Section 13(a) of the Federal Reserve Act authorizes the Federal Reserve to lend money to a nonbank provided the loan is "secured to the satisfaction of the Federal reserve bank." Lehman did not have good security for the loan it needed, but, in the emergency circumstances of a collapsing global financial system, the Fed could, it seems to me, have been "satisfied" with whatever security Lehman could have offered. If this interpretation seems a stretch, Congress could amend the statute easily enough to add "in the circumstances" or "in the sole discretion of the Federal Reserve Board," after "satisfaction," or it could delete the reference to security altogether. But the fact that the Federal Reserve, has, as it seems to me, all the power it needs to prevent a nonbank that poses systemic risk from failing, and in failing carrying part or all of the entire financial system with it, is not a rebuttal of the Administration's proposal, because the government would like to be able to prevent the collapse of such enterprises rather than having to spend tens or hundreds of billions of dollars to save them. The first question to ask, however (it is not addressed in the Administration's report), is whether these enterprises that are not banks but might create systemic risk are already regulated. I mentioned money-market funds, which are regulated by the SEC, as are broker-dealers. One might think that closer liaison between the SEC and the Fed would go far to minimize the "macroprudential risk" posed by broker-dealers. Most important, if the Federal Reserve simply identified the firms that it believes pose systemic risk, a combination of market forces, public and legislative opinion, and the implicit risk of regulation would probably impel the firms to take steps to reduce the systemic risk that they pose. This possibility should at least be explored before the Federal Reserve is given enhanced regulatory powers. After all, the principal reason--or so at least I think--for the financial collapse last September was that the regulators were asleep at the switch. They are now awake, indeed insomniac. If the Federal Reserve needs some additional staff, and perhaps authority to require financial information from financial enterprises that it does not at present regulation in order to identify the firms that pose systemic risk to the financial system, and perhaps some minor tinkering with the Federal Reserve Act to clarify its existing authority to deal with nonbank banks, these modest reforms can be adopted without restructuring the entire system of financial regulation, as the report proposes.

Comments

[Anonymous]

I agree with most of what you wrote and have these questions:
(1) is the "prematurity" necessary due to political/temporal considerations? i.e. there won't be the public interest or political will down the road?
(2) if the principal cause lies with sleeping regulators, and knowing that over time they will fall asleep again, especially as success or the appearance of success breeds contempt (and excessive greed), how do we set up long-term protection for our nation?
(3) how do we choose competent regulators who have both the necessary knowledge and experience but also an independent mindset?

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[Anonymous]

Judge Posner's arguments, if persuasive (as I believe they are), raise a variety of questions he makes no effort to deal with. Why, for example, would someone as intelligent and economically sophisticated as Chairman Bernanke believe that the Fed had no legal power to deal with the Lehman Bros. crisis? Why do policymakers in the executive department and Congress believe that comprehensive structural reform is the only current solution? I do not know the answers to such questions, but I do think that Judge Posner's comments betray a rather touching faith in the rationality of the policy-making process. Perhaps the political equivalent of belief in the Efficient Market Hypothesis?

[Anonymous]

Regarding Bernanke on Lehman and the Fed's legal stance:

Being generally intelligent (or, more particularly, versed in economics) does not guarantee that one is skilled in jurisprudential matters. Bernanke is an economist and a government executive, not a legal mind of any sort.

Of course, Bernanke 'had people' (e.g., staff lawyers). But lawyers--particularly government lawyers--tend toward conservatism. The status quo for the fed has been inaction--it is, almost by nature, a non-interventionist institution, particularly outside of its core functions (e.g., organizing the open market committee actions). Before the crisis, the fed rarely if ever acted on the additional 'non-core' powers that, by black letter law, it is granted. I'd imagine you'd be hard pressed to find 1 in 50 treasury lawyers who would have stood up in September and said 'sure, roll the dice, we have this power.' Bernanke likely received a series of memos, all of which read--in far more technical and guarded language, of course--'um, ... we've never done this before ... we should be cautious ... we may not have the ability to act here ...'

In addition:
Your comment regarding Posner's 'touching faith' is rather condescending, particularly given the man to whom you direct it. It's also a bit of a non sequitur. Posner doesn't hang his rhetorical (or logical) hat on the rationality of the policy-making process as much as on the possibilty of being able to improve the process as it now stands, utilizing many channels of reform, some of which draw on rational assumptions. You critique along straw man lines in that regard, and ought to reconsider your position.

[Anonymous]

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[Anonymous]

I don't have time to write an epistle here. Judge Posner gets this one right. We (our elected Congress) fixed the deficient federal BANKING laws in 1989 and 1991. But the ink barely had time to dry before the bankers squealed like stuck pigs to be loosed from Henry Gonzales's shackles. They were quickly joined by the stock & bond boys who absolutely hated private securities fraud civil damages and class actions. Together, the bankers and the Wall St crowd progressively bought their way out of the law while the regulators yielded at every choice between strict law enforcement and appeasement. The money looked good and flowed freely. I regret to say I have seen NOTHING from the new President (or the last one, for that matter), the Treasury, the Fed, the regulators, or the current Congress to inspire confidence in their policymaking competence or their grasp of an American public interest. We're going to run out of road, soon, down which to keep kicking the can. In the meantime we just prolong and multiply the pain.

Brian Davis
Austin, TX

[Anonymous]

Government regulation of "systemic risk," and government regulation of "man-made global warming" share common roots (and advocates, not surprisingly). Both ideas rest on false premises and would lead to quixotic regulatory efforts.

[Anonymous]

Someone needs to implement a CAPTCHA system--this blog is being hijacked by bots designed to increase traffic to various (often quasi-legal / scam-based) websites. Come on guys--welcome to 2009: preventing that sort of abuse is extremely easy.

[Anonymous]

Commercial banking and thrift and credit union regulation didn't fail. Yes, a few dozen of these institutions, only a handful big and none "too big to fail" collapsed. Yes, a few dozen more have had bailout funds more or less forced upon them -- including a handful of "too big to fail institutions" some of whom probably needed the funds. But, these industries, because of FDIC type reserve requirements in the case of banks and thrifts, and the incentives created by depositor ownership in the case of credit unions and also downside risk concerns in the case of regional family owned banks, were not rocked to the core.

In contrast, non-bank lenders who are subject only to imperfect SEC/CFTC/FTC disclosure regulation and unregulated private transaction financial players regulated only by contract law and 10b-5 fraud rules, utterly collapsed. Not a single free standing major investment bank survived as a free standing investment bank. Something like 95% of subprime lenders went out of business and both subprime lending and Alt-A lending virtually ceased to exist. Even sound mortgage backed securities were tainted by complex ones. Credit default swaps, supported by chains of CDS "reinsurers" defaulted, and far more would have defaulted if AIG, near the top of the reinsurance pyramid, had not been bailed out and nationalized. The money market came to the brink of a run that would have ruined it.

In short, 99% of reserve requirement regulated financial institutions are still here, while probably a majority of all non-bank, non-government sponsored, non-mutual financial institutions have collapsed or survived solely by dint of government assistance.

The financial crisis has shown that regulation works and that failure to regulate fails. History shows the same thing. The percentage of commercial banks failing in any given two decade period pre-FDIC frequently hit more than 50%. The percentage of commercial banks failing in any given two decade period post-FDIC approached 1%.

The FDIC works like title insurance. It micromanages what it insures in the ways that matter in advance, so that it doesn't have to clean up afterwards. The micromanagement isn't comprehensive: the FDIC basically micromanages only a couple things that matter to its insurance obligation -- reserve requirements (and there only at the bottom line level) and permitted transactions/investments (commercial banks can't go bet depositors money on the stock market no matter how sure a thing it seems to be).

But, mere transparency isn't sufficient, and transparancy also isn't necessary if substantive regulation is sufficient (banks make very little substantive disclosure of particular transactions which come under the rubric of banking privacy, despite the fact that they have the theoretical capacity to hide immense risk as they did in the mortgage backed security industry). Empirically, the SEC/Truth-In-Lending disclosure is enough formula of regulation simply does not work, standing alone. You either need to regulate the variables that can make a government feel it would need to do a bailout (mostly leverage), or you need to create better incentives (a la credit unions, mutual insurance companies and non-profit lenders -- the Department of Education, Small Business Administration, FHA and VA didn't indulge in risky, poorly documented lending and loan guarantee underwriting in their respective subfields, for example).

When banks do get into trouble, the FDIC has another tool that has saved taxpayers (in the short term) and FDIC premium payers (i.e. banks) in the long term, huge sums of money, while protecting the vast majority of uninsured deposits as well. It has the power to make pre-bankruptcy loans that have the priority over other creditors of post-bankruptcy debtor-in-possession lending, and the ability to quickly sell the assets of troubled institutions free and clear of creditor claims without a full fledged bankruptcy (a bit like the Chrysler sale to Fiat), in a way that stiffs shareholders and some long term creditors, but protects trade creditors and depositors.

The Fed didn't have these powers in the Lehman case, and these FDIC powers are the ones the Obama Plan obliquely mentions and delegated to regulatory wonks and Congressional staff to implment in detail, when it talks about given the Fed power to intervene pre-bankruptcy in non-bank situations.

[Anonymous]

Richard Posner may be a brilliant jurist, but it obvious that he has never managed a company, traded a stock or bond professionally or been involved in real financial markets.

Just one example:
"Most important, if the Federal Reserve simply identified the firms that it believes pose systemic risk, a combination of market forces, public and legislative opinion, and the implicit risk of regulation would probably impel the firms to take steps to reduce the systemic risk that they pose."

Does anyone think that Wall Street doesn't know who the systmatically important firms are? Here's a hint for one: G-----n S---s. And I figured it out without the using my Ben Bernanke lifeline.

It must be nice to have an interpretation of current events that always jibes 100% with one's political philosophy. I wonder why I see that so infrequently in the money management business. I guess it's just survivor bias.

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[Anonymous]

Nice Post. The Fed didn't have these powers in the Lehman case, and these FDIC powers are the ones the Obama Plan obliquely mentions and delegated to regulatory wonks and Congressional staff to implment in detail, when it talks about given the Fed power to intervene pre-bankruptcy in non-bank situations. Thank.

[Anonymous]

Ahh... what we have here appears to be a classic "Systems Control" problem. That is, the problem of over compensating for a deviation from setpoint versus the problem for under compensating for the deviation from the setpoint.

What to do? What to do? From the Political standpoint, tis better to over compensate than under compensate. That way the opposition can't say you didn't do enough. Whereas, if you under compensate the opposition can say you didn't do enough.

What to do? What to do? You're damned if you do and damned if you don't. Is this what is meant by "Catch-22".

Meanwhile, the Economy continues to degenerate or as the sage of Omaha likes to put it, "The Economy is a shambles". We need action NOW; good bad or indifferent.

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In today's (July 8) NY Times the following quote appears:

“It is the regulatory authority’s business to make sure the markets work,” said Edward L. Morse, head of research at LCM Commodities, a brokerage in New York.

Could you and Posner comment on this?

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