Could better bank regulation have averted the 2007 United States crisis?
By: Dylan Goode
Tags: The Great Recession, Banks, Regulation, Incentives, Bank Regulation

After the Financial Crisis of 2007/2008, leading economists met up at Squam Lake to make a report which gave a thorough description of the crisis in the US, also making some recommendations on how a crisis of the same caliber could be avoided in the future

To start we need to look at the principal agent problem In financial markets, this shows us how there were many conflicts of interest in the financial markets. Returns are unpredictable and volatile. In most companies, if the company is doing well, everyone wins and is happy and vice versa. But in Financial markets, according to efficient market theory, it probably has to do with luck and not skill. It means then if the company is doing badly, it’s hard to tell if that’s because of the agent or external circumstances. In financial institutions, traders can get giant bonuses but if things go badly, it can be blamed on the market, no bonuses but also no consequences. These guys are incentivised to place gambles with the shareholders money. This is a conflict between the managers and the shareholders. Secondly, if a bank suffers a big loss it can do two things, it can shrink its balance sheet, or it can raise more capital i.e. we want our shareholders to put more money in. Banks prefer to sell assets, the idea is that if they put in more money into the company, most of the benefit of this is going to the bond holders. Bond holders have first claims on the new assets. So if the bank goes bankrupt, the money will go to the bondholders, this leads to a situation known as ‘debt-overhang’, a situation where shareholders don’t want to recapitalise their company because they’ve got too much debt. This is a conflict between the bondholders and the shareholders. Finally, when banks make profits they hang on them, privatising gains. But once they make losses, governments have to come in and bail them out. The losses of the banks are socialised. This is a conflict between the banks and the society.

This bailing out of banks has to do with the notion that some banks are ‘too big to fail’. We can describe these banks as a systemically important bank. A bank has failed to meet its obligations, it can’t give money back to its creditors. If there is a small institution, it’s not a big deal. Depositors are hurt, bond holders are hurt. When the institution is entangled with another institution and can’t meet its obligations, the entangled institutions will also fail, leading to a domino effect which is what happened in 2007. One institution fails and then either the entangled institution will fail too or… people will start to suspect that they might fail. Confidence becomes a big issue, you had no complex derivative positions and nobody was quite sure who owed money to who, and if they were at risk of losing money.

As a result then, when you have systemically important banks, you are going to have some implicit government insurance. You have a situation where we have small depositor insurance, usually up to 100k, and the idea is then that any other bank creditor is crediting at their own risk. In practice however, when a government steps in, it will meet all these banks obligations. This leads to excessive risk taking with the people’s money. By seeing these conflicts of interests exist and the incentives of investors to gamble we can clearly see there wasn’t adequate regulations in 2007.

Bankruptcy is a legal process involving the transfer of the company from the shareholders to the creditors. This is very disruptive to the company’s operations. Not suitable for banks, because of the negative externalities of those dependent on the bank. With large banks, as was the case in the US, with very complex trades involving over the counter derivatives, trading with each other etc. we saw that they had lots of ‘special purpose vehicles’, off balance sheet entities to save on capital. These were implicitly backed by the banks but they were there to take on big trade. In 2007, this was prevalent in mortgage backed securities which wouldn’t appear on the bank’s balance sheet itself. These banks usually had big overseas operations and so you had these rehypothecation of assets of collateral that people put up, moving across several jurisdictions. This issue of who is incharge of judicating these international financial institutions is another aspect of the crisis that should have been addressed well before the crisis.

Banks have always faced the risk of runs, they are highly leveraged institutions, relying a lot on short term debt. So if people suspect something is wrong, they run in a take all their money out. This was a problem with banks right up to the great depression before small depositor insurance. What we saw in 2007 was a run in wholesale markets. So you had banks borrowing from other banks, and these creditor banks looking to take their money out in a big hurry. Something that had never happened before. This seems like an obvious result of systemically important institutions but safety measures were not put in place.

Traditional banking regulation had been aimed at small retail banks. We then saw these very large investment banks appearing in the US, which were not formally banks, so they were not regulated by the federal reserve. In the US then, because of the size and complexity of these banks they ended up being regulated by many different agencies. Some of the biggest disasters ended up occurring without any regulation. Reserve Primary, started making very big loans to Lehmann, this was not being regulated. With Lehman, we saw the big difficulty that these guys had when they went under was that they had these very complex derivatives positions. So effectively, they had placed very complex bets on different financial institutions and other companies all around the world, and again, there were no regulations. These guys then had very large international operations making it harder to regulate due jurisdiction. Again we have the problem of who is meant to be regulating these firms, instead of a division of regulators, there should have been specialists looking in particular at this powerful sector.

In my opinion, the big failure of 2007 was the lack of regulation on systemic risk. Bank regulation is all about ensuring banks have enough capital to handle losses on their loans. Banks should have enough capital on hand to deal with any potential losses in the 3 month period. The focus then is on the individual bank. But, what this meant that you are looking at institutions in isolation, ignoring the impact they might have on other institutions. Goal of regulation should have been to force systemically important banks to internalize the potential bailout costs they can inflict on society.

According to the Swan Lake report, if you have large institutions and they have illiquid assets, trading these over the counter derivatives. These institutions need to hold a lot more capital than normal banks are required to. The next thing is you should have closer regulation of their asset and liability positions. So there is a clear need for specialist regulators who are looking across the entire position of the investment banks and similar institutions.

Secondly is the idea of a living will, that banks will specify that they have particular operations that they are undertaking and then if under specific circumstances, for example, these special purpose vehicles, if they start taking losses of a certain amount, the bank will stop it turning into a big problem.

Thirdly, is the idea of hybrid securities. These institutions issue a fairly large amount of large bonds, these are 5 to 10 year bonds. What happens in specific circumstances, such as if the banks have lost a certain amount of money that the central bank thinks there’s a chance of a systemic crisis, is that these bonds then convert into equity. The bank automatically generates new equity for itself in difficult situations.

Lastly is deferred compensation. Investors have big incentives to make big risks. The idea is you only pay bonuses after several years… that is traders only get compensation on the trades that actually turned out to be profitable.