Will bank regulation fail?

Note:  The post below presents a very bleak view of our current situation.  I hope it’s wrong.

One consequence of the Savings and Loan crisis in the United States was the decision by Congress to impose strict regulatory capital requirements on banks and other depository institutions.  Through the 1980s regulators had jerryrigged the rules so that insolvent Savings and Loans would not have to be shut down and could try to earn their way to solvency.  This had the effect of encouraging S&Ls to “gamble for resurrection” with the result that the S&L losses grew from about $10 billion in 1982 to more than $150 billion in 1989.  A financial reform act was passed in 1989 with the express purpose of “never again” allowing banks to gamble with a taxpayer guarantee.

The FDIC Improvement Act followed in 1991, set strict regulatory capital requirements and assigned regulators the task of forcing banks to rebuild their capital positions.  Unfortunately requiring banks to improve their capital position is a form of deleveraging and deleveraging is a surefire way of pushing the economy into recession.  Thus, the statement that banks are undercapitalized is also a statement that the economy needs a recession.  And neither Congress nor the regulators were prepared to do what was necessary to put the financial system on a sound footing.

Even as regulators were assigned the task of imposing stricter capital requirements on banks, they were expected to make sure that credit continued to flow to the economy.  These two contradictory goals were met by stripping capital requirements of their meaning and making it much harder to see where the leverage in the financial system was hiding.

There’s a strong argument that the parallel banking system grew out of the desire on the part of both banks and regulators to circumvent the capital requirements of the FDIC Improvement Act.  The parallel banking system is just a bunch of trusts – that is, legally independent entities – that have investors and own assets, but don’t do anything except pass the payments received on the assets to the investors according to the terms laid out in the initial documents forming each trust.  The creation of this parallel banking system allowed a bank to make loans and then sell them to a trust.  Because the bank did not keep the loan, it wasn’t required to maintain capital to cover the possibility that the loan would fail.

From the start there was a huge problem with the system:  when a loan owned by a trust went into default, investors in the trust faced losses.  Regulators repeatedly accepted the argument that, if the bank that sold the loan didn’t cover the trust’s losses, the bank’s ability to sell more loans to trusts would be impaired.  Thus the parallel banking system was built on a fiction: loans appeared to be sold to trusts, but in fact were insured by implicit and explicit bank guarantees.

The most important consequence of the development of the parallel banking system was that on the surface the financial system appeared to be healthy.  Banks met their regulatory capital requirements.  Loans were abundantly available to keep the real economy humming.  Everybody was happy.

Regulators found other ways to circumvent capital requirements.  In 1996 the Federal Reserve approved the use of trust preferred securities (TruPS) as Tier 1 capital.  Tier 1 is supposed to designate the highest quality capital and includes common stock and perpetual preferred stock.  Trust preferred securities are a form of debt with a dual maturity structure:  TruPS mature after 30 years or not at all, but are designed to be called much earlier, because the interest payment on the debt increases if they are not called.  They also include the option to defer interest payments for five years.  According to the Federal Reserve, five year deferral approaches “economically indefinite deferral” and 30 year maturity approaches “economic perpetuity”.  For these reasons securities that were marketed to investors as medium-term debt are comparable as far as regulators are concerned to common equity.  To compound this insanity smaller banks were encouraged to invest in diversified pools of bank-issued TruPS.  (Update 7–7-09:  Did regulators encourage small banks to invest in TruPS?  I’m not sure that they did.  They definitely, however, did not discourage the practice.)

In the 1980s the US concluded that permitting undercapitalized banks to operate only served to make the Savings and Loan crisis worse.  In the 1990s a superficial effort was made to address the problem of an undercapitalized financial system, but in practice this effort just fostered a crisis of unprecedented dimensions.  The concern that this quarter century of history raises is:  Will we just repeat the same mistakes again?

Our problem is that there are no good solutions to the current situation:  costly choices must be weighed against more costly choices.  Unless policy-makers acknowledge that governing requires making hard choices – and that putting the financial system on a sound footing will require a major reduction in the credit available to firms and consumers – any official increase in capital requirements will be circumvented, because the policymakers want the requirements to be circumvented.

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