Incentive-robust financial reform.

• Author: Calomiris, Charles W.
• Position: Company overview

"Will Rogers, commenting on the Depression, famously quipped: "If stupidity got us into this mess, why can't it get us out?" Rogers's rhetorical question has an obvious answer: persistent stupidity fails to recognize prior errors and, therefore, does not correct them. For three decades, many financial economists have been arguing that there are deep flaws in the financial policies of the U.S. government that account for the systemic fragility of our financial system, especially the government's subsidization of risk in housing finance and its ineffective approach to prudential banking regulation. To avoid continuing to make the same mistakes, it would be helpful to reflect on the history of crises and government policy over the past three decades.

The U.S. banking crises of the 1980s--which included the nationwide S&L crisis of 1979-91, the 1986-91 commercial real estate banking crisis (Boyd and Gertler 1993), the LDC debt crisis primarily afflicting money-center banks from 1979 to 1991, the farm credit crisis of the mid-1980s (Calomiris, Hubbard, and Stock 1986; Carey 1990), and the post-1982 Texas and Oklahoma banking crisis (Horvitz 1992)--were disruptive and pervasive. The resolution costs of the thrift failures alone amounted to about 3 percent of U.S. GDP. And, "large" troubled financial institutions (e.g., Continental Illinois Bank--actually a bank of moderate size and insignificant affairs--Citibank, and Fannie Mae) were either explicitly bailed out by the government or allowed to survive despite their apparent fundamental insolvency.

The underlying policy failures that had contributed to these crises were discussed and reasonably well understood by 1990. Clearly, the monetary policy changes of 1979-82, which caused interest rates to skyrocket and later decline, and which were associated with dramatic changes in inflation, term spreads, exchange rates, and energy prices, were the most important shocks driving events in the U.S. banking system during the 1980s. Changes in tax law in 1986 that eliminated accelerated depreciation were also important for promoting commercial real estate distress. But the U,S. banking crises of the 1980s were not primarily attributable to those shocks; three microeconomic policies substantially magnified the severity of the losses experienced by banks. (1)

First, at the heart of the real estate disaster was a raft of government subsidies for real estate finance that proved destabilizing, especially to real estate markets and to financial institutions operating in those markets. These distorting subsidies included special advantages of the thrift charter, subsidized lending from the Federal Home Loan Banks, "regulatory accounting" rules that purposely masked thrift losses, the absorption of interest rate risk in the mortgage market by the inadequately capitalized government-sponsored enterprises (GSEs), Fannie Mac and Freddie Mac, and the lending policies of the Farm Credit System that promoted the farm land bubble of the 1970s and early 1980s.

Second, the increased protection of banks removed deposit market discipline as a source of control over the risk-taking of banks and thrifts. Protection from deposit insurance increased dramatically in 1980 and has been further expanded subsequently, which substantially reduced the possibility that higher risk-taking by banks would lead depositors to withdraw their funds. (2)

Third, ineffective prudential regulation failed to substitute for the market discipline that deposit insurance and other government protection of banks removed. That was especially visible in the failure of supervisors to identify losses in failing banks and prevent those losses from growing larger as the result of increased risk-taking by "zombie" banks and thrifts.

In the wake of the banking crises of the 1980s, the U.S. promulgated an ambitious program of reform to prudential banking regulation and regulatory accounting practices, implemented through the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. The Mickey Mouse arithmetic of regulatory accounting for losses through the creation of special "goodwill" in the 1980s was eliminated, and the use of loan-loss reserves to count as capital was curtailed. FIRREA and FDICIA focused on the setting of higher capital standards for banks, and created a new "prompt corrective action" protocol for intervening to shut down weak banks and thrifts before they became insolvent, The Federal Home Loan Bank Board was eliminated and replaced by the Office of Thrift Supervision, which was charged with enforcing tougher supervisory and regulatory standards on thrifts.

Too-big-to-fail bailouts also were addressed in 1991 by FDICIA in a clever (but, it turned out, ineffectual) way: any protection of uninsured deposits should satisfy a narrowly defined "least-cost resolution" criterion (showing that the cost to the FDIC from protecting insured deposits was minimized by whatever protections to uninsured deposits were offered); failing that, the government, the Fed, and the FDIC would have to make a special exception to protect any uninsured deposits, and the cost of doing so would be financed by a special assessment on the deposits of surviving banks. The hope was that unnecessary bailouts of large banks (i.e., those that were not warranted by bona fide systemic risks) would be avoided by the lobbying of other large banks, which would bear a large proportion of the costs of the bailout. Unfortunately, when the crisis arrived in 2008, FDICIA was simply put aside, and blanket guarantees of bank deposits and other support were provided irrespective of the contrary language of the FDICIA law.

Reformers in 1989 and 1991 promised that, under the new rules, banks' equity would now be sufficient to cover most problems that would arise. If a bank suffered a significant loss, it would either have to replace lost capital or face tough supervisory and regulatory discipline. Thus, disorderly failures of banks and thrifts would be avoided in the future. Also, the tough new rules would give banks an incentive to maintain adequate capital, because if they did not, they would be subject to the discipline of credible and orderly resolution, whereby their operations, assets, and liabilities would be transferred to new management before a disorderly failure could occur.

These rule changes were further enhanced by a continuous process of fine-tuning by U.S. bank regulators, sometimes working within the Basel Committee to set new global standards for measuring risk and budgeting capital (under Basel I and Basel II), and sometimes acting on their own (e.g., in the post-2000 reforms of off-balance sheet capital standards, described in Calomiris 2009a). Furthermore, in response to objections by European countries to the fact that investment banks were not regulated under the Basel system, in 2002, U.S. investment banks (including Bear Steams, Lehman, Merrill Lynch, Goldman Sachs, and Morgan Stanley) became subject to the Basel capital requirements, under the supervision of the SEC.

People who are unaware of this history of prudential regulatory expansion during the 1990s and 2000s--or government officials who ignore it because it is politically inconvenient to remember it--sometimes wrongly refer to the 1990s and 2000s as a time of prudential bank deregulation. Deregulation in the U.S. since 1980 did occur, but not prudential bank deregulation. The deregulation of the 1980s and 1990s had three main components: (1) interest rate ceilings on bank deposits were largely phased out beginning in 1980, which promoted greater competition in the deposit market; (2) banks' abilities to underwrite corporate securities were substantially increased (the so-called relaxation of the 1933 Act's "Glass-Steagall" prohibitions) beginning in 1987, and those limits were eliminated in the Gramm-Leach-Bliley Act of 1999; (3) banks were permitted to branch across state lines through a combination of state- and federal-level initiatives that culminated in the Riegle-Neal Act of 1994, which was fully phased in by 1997.

None of those elements of deregulation can plausibly be regarded as having contributed to the subprime crisis. Indeed, the ability of investment banks to become commercial banks without ceasing to underwrite corporate bonds and stocks mitigated the cost of the crisis by allowing the orderly acquisitions of Merrill Lynch and Bear Stearns by Bank of America and JP Morgan Chase, respectively, and by allowing Goldman Sachs and Morgan Stanley to convert to commercial banking charters (to have expanded access to the government safety net) as the crisis deepened in September 2008. Branching is also widely recognized as a stabilizing influence on banks that promotes diversification and competition (Calomiris 2000, 2010).

Despite the various reforms of prudential banking regulation from 1989 to 9.002, and the substantial addition of new prudential regulations during that period, there were three key policy errors, all of which had been at the core of the banking disasters of the 1980s, which returned with a vengeance in the 2000s: (1) the government subsidization of risk in mortgage finance, (2) the failure to measure in a timely and forward-looking manner the extent of risk taken by banks and require capital commensurate with that risk, and (3) the implicit protection enjoyed by "too-big-to-fail" financial institutions.

Subsidization of Mortgage Default Risk

With respect to the first of these problems, the successor to the political protection for thrifts in the 1980s was the affordable-housing mandates of the 1990s and 2000s. The federal government's support for mortgage lending by U.S. banks dates from 1913. Prior to the establishment of the Federal Reserve System national banks were prohibited from mortgage lending, but as a political quid pro quo...