10 Steps to Financial System Stability: Lessons Not Learned

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Recently, BloombergView writer Michael Lewis called attention to tape recordings made by a Federal Reserve Bank of New York bank examiner who was stationed inside Goldman Sachs’ offices for several months during 2011-2012. She released the tapes to This American Life who aired her story on September 26, 2014. Every media article I’ve seen on this begins with a prelude warning how complicated and hard to follow the story will be. Regular readers of New Geography are several steps ahead in their understanding of these causes and consequences of the financial crisis. If you are new here, you can follow the links in this piece to earlier NG articles.

Central to the theme of the story is the release of a 2009 report by Columbia University professor David Beim on why the Federal Reserve – especially the New York office which was supposed to be watching the banks – failed to act to prevent the crisis. Beim listed about a dozen “Lessons Learned” by bank supervisors after the financial crisis. In this article, we list the Lessons not Learned before the financial crisis. These lessons come from decades-old studies of financial regulation from around the world. If any US policy makers had paid attention in school, we would have avoided the global financial collapse of 2008. The United States – which was at the center of that storm – had been preaching these steps to emerging market nations for decades. Unfortunately, they just were not following them for us. In the fall of 1998, those emerging market economies seriously threatened the financial stability of the West. In the fall of 2008, it was the West that brought the threat upon itself and the rest of the world.

Four Policies, Five Tasks and One Idea

Policies not implemented

1. Have private, independent rating agencies: US rating agencies were technically independent because they were not owned by the government. However, with the creation by the Securities and Exchange Commission (SEC) of the “Nationally Recognized Statistical Rating Organization” or NRSRO designation, three big credit rating agencies were the only ones accepted for use to meet regulatory requirements – they were issuing 98% of all credit ratings. This gave a government imprimatur to selected businesses, creating undue reliance by financial markets globally. By 2008, the “NRSRO” term appeared in more than 15 SEC rules and forms (not including those directly used for NRSROs), plus rules in all 50 states. NRSROs are also referenced in 46 Federal Reserve rules and regulations. Even though the SEC sanctioned and required the use of the NRSROs they had no say in the process used to establish the ratings.

Despite even pseudo-independence from the government, the NRSROs were not independent of the financial institutions that paid them to issue credit ratings. The government sanction gave them more power to wield against – or in favor of – the banks and companies they rated. They made money consulting for the same firms, resulting in pressure to rate bonds higher than they should have been rated.

2. Provide some government safety net but not so much that banks are not held accountable:  Many banks – and all of the New York Feds “primary dealers” – achieved “too big to fail” status through the Wall Street Bailout Act. A few were allowed to fail in the months leading up to the passage of the Bailout – most notably Lehman Brothers – in what amounted to the federal government picking winners and losers without accountability. The Federal Deposit Insurance Corporation was nearly bankrupted in late 2009, removing the safety net that protected depositors. The FDIC was so depleted by the epidemic of collapsing banks, they eased the rules on buyers of failing banks, opening the door for hedge funds and private investors to gain access to “bank” status – and the protections that go with it. At the end of September 2009, the FDIC’s fund was already negative by $8.2 billion, a decrease of 180% in just three months. FDIC is projected to remain negative over the next several years as they absorb some $75 billion in failure costs just through the end of last year.

At the same time, bailed-out banks, brokers and private corporations received additional financial support from the Federal Reserve in a move unprecedented in US history. Billions of dollars in loans were made to the banks without proper documentation. The lack of transparency in the process used by the Treasury to decide who would receive bailout funds and what the recipients have done with the hundreds of billions of dollars was the subject of a GAO audit we wrote about in 2011.

3. Allow very little government ownership and control of national financial assets: Four years after the crisis, the U.S. Treasury still owned more than half of American International Group, Inc., (AIG). AIG was the world’s largest insurance company – giving the government ownership in international financial assets, too. The U.S. government took ownership positions in virtually every major financial institution during the bailout, plus some non-banks that had lending arms (like General Motors Acceptance Corporation). The GAO audit of the Fed shows we loaned money to and took ownership stakes in a slew of non-regulated businesses like Target and Harley Davidson. The lack of transparency in these transactions is dangerous. Austrian Economist Ludwig von Mises warned decades earlier that market data could be “falsified by the interference of the government,” with misleading results for businesses and consumers.

4. Allow banks to reduce the volatility of returns by offering a wide-range of services: Until the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, banks were restricted to buying securities defined as investment grade by the NRSROs. Given what we now know about these ratings and the actual riskiness of some AAA-rated investments, the requirement actually made bank investments more dangerous. The process followed in the years (even decades) leading up to the collapse of credit markets was not one that would meet the definition of “unrestricted.” Although there appeared to be a wide range of activities available to US banks, the restriction on credit ratings would eventually increase volatility by concentrating risk instead of dispersing it. Just because a bank can deal in a particular investment does not mean that they should.

The steps outlined here are a comprehensive program, not a menu of options.  There is no sense allowing banks wide latitude to make risky investments if proper supervision and enforcement is not in place. That leads us to the next steps: the necessary tasks for prudent regulation.

Tasks Not Taken

Ten years before the most recent financial crisis (1998), the international financial system had already entered a new era. Speaking at the Western Economics International Association in 2001, Lord John Eatwell said, “The potential economy-wide inefficiency of liberalised financial markets was indisputable.” Eatwell had been writing about these problems for decades.

5. Require financial market players to register and be authorized: US regulators failed to act on establishing registration for hedge funds, failed to establish requirements for registering who can issue collateralized mortgage obligations (mortgage-backed securities), and failed to act on loopholes in regulations prohibiting insurance companies like AIG from issuing credit default swaps through subsidiaries – the list goes on. Dodd-Frank established the Financial Stability Oversight Council to designate “Systemically Important Nonbank” – yet another government imprimatur for unregulated entities. Instead of making sure only authorized businesses perform financial activity they are only making sure those big financial firms are bailed-out faster in the future.

6. Provide information, including setting standards, to enhance market transparency: There were no standards for issuing derivatives. Nor for collateralized debt like the mortgage-backed bonds where there was no link from homes/real estate. Because the financial issuers had no standard for reporting changes in ownership to land offices who keep track of liens on homes (usually county-level property office), probably one-third of the bonds the Fed is buying in their monthly “quantitative easing” purchases are truly worthless.

7. Routinely examine financial institutions to ensure that the regulatory code is obeyed: Without registration and standards, of course, they can be no surveillance by any regulator. Congress admitted that while “most of the largest, most interconnected, and most highly leveraged financial firms in the country were subject to some form of supervision” it proved to be “inadequate and inconsistent.” The story described to This American Life by Carmen Segarra is not news – it is only one more in a long history of problems.

8. Enforce the code and discipline transgressors: Despite existing rules allowing regulators to prohibit offenders from engaging in future financial activity, only minimal fines have been issued.  “Too big to fail” practices allow regulators to “look the other way” on money laundering and other issues that put our national security at risk. According to the Special Inspector General’s Quarterly Report (September 2012), the “Treasury [is] selling its investment in banks at a loss, sometimes back to the bank itself” allowing even banks who have the ability to pay to get out of the program for less than they owe. Those responsible for creating the situation that required the Bailout have not been called to discipline. Quite the contrary, many were paid elaborate bonuses at the same time their financial institutions were receiving bailout funds.

9. Develop policies that keep the regulatory code up to date: More than a decade before the crisis, Brooksley Born raised enormous concerns over derivatives in the US – including credit default swaps – during her tenure as chair of the Commodity Futures Trading Commission (1996-1999).  Both the SEC and the Federal Reserve Board objected to her ideas.  On June 1, 1999, Congress passed legislation prohibiting such regulation, ushering in a long period of growth in the unregulated market. Five years after the financial crisis began, rules are still not implemented. AIG became subject to Federal Reserve supervision only in September 2012 when they bought a savings and loan holding company. By October 2, 2012, AIG had been notified that it is being considered for the “systemically important” designation – the “too big to fail” stamp of approval for everything they do.

One Way Out

Which leads us to one old idea that every student who ever took economics 101 should remember:

10. Create specialized financial institutions: In the context of what we know about the policies and tasks that support financial stability, only one additional factor needs to be considered, and that is an old theory on the economic gains from specialization. In The Wealth of Nations, Adam Smith told us that the bigger the market the greater the potential gains from specialization. With equity markets alone reaching a global value of $46 trillion, the potential gains are enormous.

Peter Drucker made this point on specialization in 1993 in his prophetic book “Post-Capitalist Society.” While diversification is good for a portfolio of financial investments, in large systems it means “splintering.” In a system as large as financial markets, diversification “destroys the performance capacity.” If financial institutions are tools to be used in furthering the efforts of the broad economy, then as Drucker writes “the more specialized its given task, the greater its performance capacity” and therefore the greater the need for specialization.

The rise of the financial sector has been tied to economic expansion throughout our modern business history. The more robust the flow of finance, the more robust is the potential for economic activity. Greater efficiency in capital markets can lead directly to greater efficiency in industry. Our economy, our livelihood and our well-being are inextricably related to finance at home and around the world. It is now necessary to return to the basics and recognize the long run value of economically efficient specialization. We are living in the post-capitalist society described by Drucker. US regulators have been overly focused on the financial theory of portfolio diversification, ignoring the economic importance of gains through specialization. Drucker’s forecast was accurate: “Organizations can only do damage to themselves and to society if they tackle tasks that are beyond their specialized competence.”

None of this is to say that our long-term failure is guaranteed. What happens next will be an experiment on a grand scale. The Financial Crisis Inquiry Commission concluded: “The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.” Carmen Segarra did not tell us anything new: hopefully what she told us – and what ProPublica and others are writing about it – will help a wider public to understand the problem.

Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Dr. Trimbath’s credits include appearances on national television and radio programs and the Emmy® Award nominated Bloomberg report Phantom Shares. She appears in four documentaries on the financial crisis, including Stock Shock: the Rise of Sirius XM and Collapse of Wall Street Ethicsand the newly released Wall Street Conspiracy. Dr. Trimbath was formerly Senior Research Economist at the Milken Institute. She served as Senior Advisor on United States Agency for International Development capital markets projects in Russia, Romania and Ukraine. Dr. Trimbath teaches graduate and undergraduate finance and economics.

Wall Street bull photo by Bigstockphoto.com.