early three years have passed since the U.S. subprime lending market first showed signs of distress. During that time, there have been Congressional inquiries, censorious speeches by central bankers, mea culpa as well as I-told-you-so books from ex-Wall Streeters and City bankers, not to mention a soon-to-be-released update of Oliver Stone’s 1987 film Wall Street, that quintessential (if clichéd) account of bankers and their dubious ethics.
Amid the hubbub, it is important to remember a central fact about the banking crisis: it was caused by the failure of the sector to deliver in its fundamental societal role – i.e. to provide the economy with its money cabling and pipework, efficiently assess and spread risk, transform maturities and allocate resources where they are needed. The big question is why? Clearly banks are not the only ones to blame, but if we are to avoid an early repetition of the events of the past three years, it makes sense to work out some of the reasons for those events and to address them.
A Higher Purpose
Banks are different than other companies. If a Walmart or a General Motors goes bust, the consequences will be painful for thousands of workers and investors, perhaps even taxpayers. But there are alternative suppliers. The failure of a bank, however, creates serious practical problems for its customers, triggers panic and has repercussions that can be difficult to contain.
Our banks are essential to our way of life to a degree greater than their mere commercial role would indicate. But that lesson was not learned from the costly savings-and-loan problems at the end of the 1980s or the LTCM hedge fund crisis at the end of the 1990s, or the many other incidents that might have been taken as warnings that all was not well with the financial system.
This obliviousness had a parallel in the culture. Oliver Stone had intended Gordon Gekko – with his “greed is good” ultra-laissez faire credo – to be a cautionary tale. What happened? Thousands of young bankers emulated Gekko’s look, with greased-back hair, two-tone shirts and colorful suspenders.
Similarly, in a widely cited article in the November 2008 issue of Portfolio, author Michael Lewis recounted that when he wrote his 1989 book Liar’s Poker, which told of the reckless culture he found as a young banker working for Salomon Brothers, he too expected it to serve as a warning to readers. As Lewis writes: “I expected them to gape in horror when I reported that one of our traders lost $250 million, but six months after Liar’s Poker was published, I was knee-deep in letters from students who wanted to know if I’d any other secrets to share about Wall Street. They’d read my book as a how-to manual.”
These stories characterize a view of capitalism as being most effective when untrammeled. But the lesson of the past three years – at least from this European’s point of view – is that it ain’t necessarily so.
Feeding the Beast
Lewis’s Portfolio article goes on to chronicle, mainly through the more recent experiences of hedge fund manager Steve Eisman, how the culture fomented in the 1980s culminated in the subprime feeding frenzy of the past decade.
Subprime can be taken as the near-fatal symptom of the collision between Main Street and Wall Street, brought about by the reversal in their traditional relationship. Whereas the banks’ primary role should be to lend to businesses and individuals to facilitate their commercial activities, they encouraged people to borrow, sometimes recklessly, in order to feed the “originate-and-distribute” model that relieved them of any responsibility for loans that defaulted.
In a reality-based market, subprime lending should have been a small, specialized corner of banking, lending at appropriate terms to those with bad credit risk. Instead, it grew to account for 14% of all first-lien U.S. mortgages, with a nominal value approaching $2 trillion. Other variations of mortgage-backed securities and collateralized-debt obligations grew and proliferated, with credit-default swaps supposedly mitigating the risks.
The terms of the loans – eight or 10 times loan-to-value against mobile homes and low-cost urban dwellings – were virtually guaranteed to lead to default. It was a transaction-driven market that gave little attention to traditional models of risk management.
Because banks are essentially “virtual” businesses – their products are almost all variations of accounting entries wrapped up in legal contracts – they can scale up to the extent their regulatory capital ratios and processing systems allow. They also have a nearly limitless appetite for complexity.
So not only did banks balloon in size but too many managers didn’t fully understand their products or appreciate how these products impacted each other. When the financial system began to implode, another inherent weakness of banks was exposed: the fragility of liquidity. Funding short term in order to lend long makes banks susceptible to issues of confidence in both retail and wholesale money markets (as Bear Stearns learned after losing access to the overnight repo market). To paraphrase Warren Buffett, when asset prices fell and the liquidity tide went out, some banks were caught naked.
What allowed this to happen was a combination of several factors:
- the blurring of the lines that had separated commercial banks and investment banks since the passage of the Glass-Steagall Act in 1933;
- high liquidity and low interest rates;
- neffective regulation in areas such as capital standards and the use of ratings;
- a focus on “fair value” as an accounting driver.
The dismantling of the Glass-Steagall Act was done bit by bit under various governments over more than two decades, with legislation usually following practice; but the biggest symbolic piece in the U.S. came with the Gramm-Leach-Bliley Act – also known as the Financial Services Modernization Act – in 1999, which essentially reversed the last vestiges of Depression-era rules.
U.S. President Barack Obama now appears likely to rebuild some of this regulatory architecture, with proposals tabled to separate federally insured bank business from proprietary and speculative activities. There are also proposals to overhaul the oversight structure, with some calling for a lesser role for the Federal Reserve, giving senior authority in an oversight council to the Treasury. Whatever structure is adopted in the U.S., it is likely to set the tone for the rest of the world.
The UK is on course to rebuild some of its regulatory defense walls that had been dismantled, and strengthen its key regulators, such as the Financial Services Authority. But specific proposals to shore up the capital bases of UK financial institutions – including “contingent capital,” a kind of quasi-equity, and a levy-based resolution fund – are controversial and still under discussion. As countries steer a course between the need for a better-regulated system and maintaining competitive advantage, it remains to be seen what oversight gaps might be left unfilled.
However, change must go beyond legislative reform, for it wasn’t simply deregulation on its own that can be blamed. Regulators on both sides of the Atlantic went into this crisis with the powers to approve or disapprove key management, the powers to vary capital to their own requirements and the power to stop individual institutions from doing business they didn’t like the look of. But most regulators didn’t exercise those powers.
There was also egregious failure in terms of macro-prudential supervision – i.e. supervision at a level that takes into account the broader economy – with no one looking at the whole market and saying, “we have high asset prices, too much liquidity – we need to prick the bubble.” Or, to borrow the phrase attributed to William McChesney Martin, the Federal Reserve’s longest-serving chairman, central bankers failed in their primary role, which is “to take away the punch bowl just as the party gets going.”
In the UK, there was no role for macro-prudential supervision in Prime Minister Gordon Brown’s regulatory construct, where it fell between the stools of the Treasury, the Financial Services Authority, and the Bank of England. One of the starkest illustrations of this was the way Icelandic institutions were able to collect £10 billion from UK depositors. That couldn’t have happened in France, where bank regulation has historically been more intrusive.
The New Normal
What should a new regulatory system look like? There are three main elements required for effective regulation, two of which are relatively simple conceptually and one that requires a fundamental shift in thinking about bank governance.
The first element is macro-prudential supervision. This will help to keep banks safe from policies that may facilitate asset price bubbles that draw in borrowers and lenders alike, often at the wrong point in the economic cycle. Oversight requires less bureaucracy and more bright people (with lots of data) who are savvy enough to spot out-of-control liquidity and asset prices, and consequent bad borrowing and lending practices, and are empowered to stand up and say “Okay, we are approaching dangerous territory.”
The second element is customer protection. While fairly straightforward to design, implementation is another matter, as highlighted by the opposition to the proposed U.S. Consumer Financial Protection Agency. Opponents have argued that such an agency could stifle competition and raise the cost of finance for consumers. Its supporters argue that buyers of financial products are inevitably at a knowledge disadvantage compared with the providers, and need protection. It’s a battle about getting the right balance of red tape and market freedom.
The final element is also the trickiest: prudential oversight at the institutional level. Any well-run financial institution is comprised of management; the business; the platform – i.e. technology, processes and information systems; liquidity; and capital. Supervisors need to ensure that all of these functions are present and fit for purpose. In particular, regulators must ensure that management is equal to the challenge of running the business and is adequately challenged – by internal firm functions (finance, risk, internal audit, compliance, and legal) as well as by external functions (non-executive directors, auditors and regulators).
The real issue with supervision at the level of an individual firm is the competence of management and how they’ve organized the business. Oversight challenges have been brought to light by the financial crisis. To cite just one example, the head of group regulatory risk at HBOS, the fifth largest UK bank, claims he was forced out by management in 2004 when he raised concerns over excessive risk-taking, particularly in large commercial and real estate lending. Fast forward to September 2008, and HBOS is taken over by Lloyds in the days after the collapse of Lehman Brothers. The credit losses which have emerged at HBOS are far larger than anyone could have anticipated.
In the year ahead, a number of regulators are set to introduce requirements for better governance. The new norm will be a separate risk committee with wide-ranging powers and a chief risk officer (CRO) who can only be fired by the board. A further step to strengthen CROs’ independence would be to establish a statutory direct line to the external regulator. This change will be reinforced by new requirements around non-executive directors and the engagement of institutional shareholders. And, of course, the supervisors themselves are reinforcing their processes and their people. However, these changes will not amount to much unless there is a clear benchmark of what constitutes robust internal governance.
Accounting philosophy also needs fundamental reform. Accounting has not served banking as well as it might, with the failure to harmonize between different jurisdictions and the aggressive adoption of “fair value.” Fair value can be the wrong type of transparency – it cements a disconnect between real investment horizons and what the numbers show. It tends to accelerate profit recognition (and therefore bonus and dividend payouts), operating in ignorance of the business cycle to which banks are prone. Bank accounting should be more about evaluating cash flows – a “maturity ladder” approach.
It is somewhat bizarre that regulators determine banks’ capital requirements and accountants determine the quantity of capital in place, yet the two have no formal coordination. Having those two sets of people talking would send the right signal to bankers about the kind of regulatory regime they can expect. It is starting to happen, but there are obstacles in the way – not least a difference of opinion between the U.S. and everyone else.
Sorting out regulation is partly about returning to banking’s first principles. As economist John Kenneth Galbraith said, “The process by which banks create money is so simple that the mind is repelled.” Over the past two decades, the accuracy of that observation seemed to diminish. The banking crisis creates the chance to simplify and clarify, and it’s an opportunity that governments should grasp.