This analysis is written by Dr. Bento Lobo, UC Foundation Associate Professor of Finance, with research assistance from Tyler Forrest, Will Hudson, Kaytie Oldham, and Stephen Tilstra, all students in his international finance class at the University of Tennessee at Chattanooga this past spring semester.
A year ago, the national unemployment rate was 10 percent. A year later, this rate has inched lower to 9.5 percent. Some believe this statistic reflects the fact that many of those unemployed have chosen to give up looking for a job. Ironically, these folks are not counted among the unemployed. This economic crisis is already characterized by the longest average duration of unemployment: over 45 percent of those currently unemployed have been out of work for more than 6 months, according to the Bureau of Labor Statistics. Compared to the 1976-2007 average of about 15 weeks, the average unemployment duration as of June 2010 is about 35 weeks. Moreover, The Atlantic reports that globally more than one billion people are currently unemployed.
The mood on Main Street USA is unhappy. A recent WSJ/NBC poll (June 23, 2010) shows that 62 percent of adults in the survey feel the country is on the wrong track, the highest level since before the 2008 election. Just one-third think the economy will get better over the next year. Amid anxiety over the nation's course, support for incumbent politicians is eroding. Indeed, 57 percent of voters would prefer to elect a new person to Congress than re-elect their local representatives.
The Washington Post reports that a massive wave of borrowing will begin this year when the U.S. and European governments sell an estimated $4 trillion in new bonds as countries, corporations and banks borrow record amounts of money to repair the damage from the financial crisis and pay back loans from the boom that preceded it.
Will markets be able to smoothly absorb the new debt, or will less-creditworthy governments be pushed into a Greek-style crisis? Will weaker banks and corporations get pushed into default that could trigger another downturn?
The latest financial crisis and ensuing recession have left some deep scars. However, the legacy of this crisis is likely to reside in the reform measures and financial legislation crafted in Washington DC.
How does a financial crisis shape financial reform?
As America and Europe go down different fiscal paths in the wake of the recent financial crisis, the debate concerning financial reform rages on. The nature of reform, however, is predicated on a succinct distillation of the causes of the crisis.
In their 13th Annual Global CEO Survey, Price Waterhouse Coopers asked 1,198 global business leaders what lessons they had learned from the financial crisis. The importance of good risk management practices was by far the most frequently cited "lesson learned." CEOs faulted their own approaches to risk as much as they did the risk practices in the financial sector, pointing out that the time to manage risks and address complacency is when conditions are improving.
Fed Chairman Bernanke said in recent congressional testimony regarding the failure of Lehman Brothers: "The Lehman failure provides at least two important lessons. First, we must eliminate the gaps in our financial regulatory framework that allow large, complex, interconnected firms like Lehman to operate without robust consolidated supervision... Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks."
An International Monetary Fund report shows that neither market oversight nor prudential supervision were able to stem excessive risk-taking or take into account the interconnectedness of the activities of regulated and non-regulated institutions and markets. This was due in part to fragmented regulatory structures and legal constraints on information sharing. Once the crisis hit, weaknesses and differences in national and international approaches to dealing with cross-border bank resolution and bankruptcy came to a head. The crisis drove home the limitations of existing mechanisms for central bank liquidity support and the need for significant changes in practice on this front.
The Bank for International Settlements (BIS) pointed to the need to broaden the focus from the supervision of individual institutions to taking into account system-wide risks. However, better regulation is not enough if not implemented as intended and in a consistent manner across countries.
A report from the Council on Foreign Relations points out that we should recognize that enduring, sustainable reforms must mold the incentives of private actors such that the system sufficiently self-regulates. Moreover, effective, long-term policy responses to the financial crisis must understand that the requirements for securing the financial system are very different from those of improving risk management within individual institutions - or individual countries, for that matter. The existing framework for financial market supervision wrongly assumes that the system as a whole is made safe by making the individual institutions safe - a traditional "fail-safe" approach. As the current crisis has shown, actions taken by prudent institutions, such as selling assets and ceasing lending, affect other prudent institutions in ways that may undermine the safety of all of them.
This sentiment is echoed in the Squam Lake Report (2010 Princeton University Press), a synthesis of the views of fifteen of leading economists who gathered in n the fall of 2008 at Squam Lake in New Hampshire to craft a long-term plan for financial regulation and reform. The group makes two major recommendations. First, policymakers must consider how regulations will affect not only individual firms but also the financial system as a whole. Second, regulations should force firms to bear the costs of failure they have been imposing on society.
Indeed, this crisis has shined a spotlight on the term "systemic risk." In the context of the recent crisis, systemic risk refers to the risks arising from interlinkages and interdependencies in a system or market, where the failure of a single entity could potentially bring down the entire system or market.
In the finance literature, there is some confusion about the nature and causes of systemic risk, and consequently, uncertainty as to how to control it. Gerald Dwyer, Director of the Center for Financial Innovation and Stability at the Atlanta Fed, points out that the first appearance of the term systemic risk in the title of a paper in the professional economics and finance literature occurred as recently as 1994.
This ambiguity is at the heart of recent policy measures that seem inconsistent: the need to save Bear Stears, AIG, Fannie Mae and Freddie Mac, but the decision to let Lehman Brothers fail.
Capitalism on the upside + socialism on the downside = bad policy
The notion that some firms are systemically so important that they are essentially deemed too-big or too-interconnected-to-fail has financial economists scrambling for suitable regulatory and incentive-based solutions. After all, picking winners and protecting favored individual participants in a system can engender moral hazard in that system and weaken the resilience of the system as a whole. Clearly, the perception that some institutions are "too big to fail" - and its implication that, for those firms, profits are privatized but losses are socialized - must be ended.
In fact, Charles Plosser of the Philadelphia Fed emphasized that "first and foremost, financial reform must eradicate the notion that any financial firm is considered too big to fail. If it does not, we are sowing the seeds of the next financial crisis.... To prevent this behavior, a credible, and I emphasize credible, commitment by government to not intervene must be the centerpiece of reform."
Financial Reform
The 2,319-page Dodd-Frank Wall Street Reform and Consumer Protection Act that passed through the Senate on 15 July 2010 is being hailed as the first major overhaul of the nation's financial regulations since the 1930s. The bill contains many clues to the way policy makers view the recent credit crisis. It contains ideas to end too-big-to-fail, provide consumer protection on unfair and abusive financial products, and give shareholders a "say on pay" - an advisory vote on pay practices including executive compensation and golden parachutes. It also contains approaches to regulate, for the first time ever, the over-the-counter (OTC) derivatives marketplace. The bill takes steps to monitor and control systemic risk.
Highlights of the bill as presented in the Wall Street Journal include:
* Establishes a 10-member Financial Stability Oversight Council to monitor financial stability/systemic risk; gives the government powers to seize and break up troubled financial firms deemed to be a systemic risk
* Limits proprietary trading by the largest financial institutions, sets tougher capital standards for banks, and requires banks that packaged loans to keep 5 percent of the credit risk on their balance sheets. This is part of the "Volcker Rule", named for Paul Volcker former chairman of the Fed under Presidents Carter and Reagan.
* Establishes a quasi-government entity to address conflicts of interest in the credit rating industry; allows raters to be sued by investors for "knowing or reckless" failure
* Regulates the OTC derivatives market by requiring most products be traded on exchanges with trades routed through clearinghouses
* Establishes a new watchdog Consumer Financial Protection Bureau within the Federal Reserve to examine and enforce regulations for all mortgage-related businesses; sets new national minimum underwriting standards for home mortgages
* Permanently increases the level of FDIC insurance for banks to $250,000
* Seeks to increase transparency by requiring hedge funds and private equity funds to register with the SEC as investment advisors, and creating a new wing under Treasury to monitor the insurance industry for systemic risk
Will reform by regulation work?
At the heart of all such regulation is whether such reform would have prevented a crisis of the sort we just experienced, and, more importantly, prevent crises from happening in the future.
Economists surveyed by The Wall Street Journal were evenly split on whether they would have voted in favor of the financial reform bill that passed in the Senate on July 15. In characteristic fashion, some 21 of those surveyed said they would have voted yes; 22 said they would have voted no.
Among those who said they would vote against the bill, Diane Swonk of Mesirow Financial raised concerns about moving too fast. "The legislation is outpacing our understanding of the crisis, and I would like to make sure that we learn something from what went wrong before we legislate a new problem," she said.
She may be on to something. The American Enterprise Institute for Policy Research points out that financial crises produce very powerful effects on the real economy. In a crisis, dynamic and somewhat unpredictable causal connections involving basic economic relationships come to light that policymakers need to appreciate more fully. Current models of the macroeconomy which tend to exclude a financial sector and are based on linear relationships, unlike those that emerge after a financial crisis, are likely to need a major re-think.
Critics of the bill include Nouriel Roubini of NYU, who predicted the crisis. He believes financial regulation reform is planting the seeds of the next financial crisis; the too-big-to-fail problem has not been properly addressed; the Volcker rule has been massively diluted; restrictions on derivatives trading are not meaningful; the distortions in bankers' compensation have not been addressed; Fannie and Freddie have not been reformed.
Chattanooga's U.S. Senator Bob Corker voted against the bill he had once hoped to cosponsor, saying the legislation is a "net negative" for the American public. Corker said the bill will make credit less available and more expensive and hurt community banks and small- and medium-sized businesses essentially because "...we punted most of the work to regulators who will spend the next several years making and implementing rules, which leaves tremendous ambiguity and instability at a time when businesses large and small desperately need certainty to survive and expand."
Indeed, The Economist magazine points out that it would take "thick rose-tinted glasses" to accept President Obama's assertion that the new law will ensure an end to bank bail-outs. Moreover, it is unclear to what extent the bill impacts the incentives of private economic agents or fosters global regulatory cohesion. The precise impact of the bill is hard to gauge, not least because the new law hands a lot of discretion to regulators. Much of the text is essentially a template, which regulators are expected to flesh out. They have been told to conduct 150 studies and write 350 detailed rules that could run to 15,000-20,000 pages, according to Barclays Capital. This could take a while, and in some cases give banks up to the year 2022 to comply. By comparison, banks were required to comply with Glass-Steagall in two years.
Dave Altig, Director of Research at the Atlanta Fed, cautioned in the lead-up to the legislation, that "In a world with the capacity for rapid innovation, rule-writers have a tendency to perpetually fight the last war..." Indeed, some argue the bill is too busy fighting the last war. It is unlikely that the source of the next financial crisis will be identical to the last - it rarely is.
According to former Treasury Secretary Hank Paulson, even with better regulation, regulators can not have perfect foresight. It is essential that we preserve market discipline that can only come from knowing that no institution is too big to fail. Uncertainty about too-big-to-fail will persist until key people, facing a crisis, decide when and how to use these powers.
Today's reform is likely to sow the seeds of tomorrow's crisis, cautions Stephen Mauzy, writing for the CFA Magazine. He points out that efforts to separate commercial and investment banking á la Glass-Steagall, for instance, are likely to reduce the diversification benefits of marrying nontraditional and traditional banking activities.
More CEOs surveyed by Price Waterhouse Coopers are "extremely concerned" about over-regulation than any other threat to growth. Moreover, the survey shows that concerns over protectionist tendencies are also up ten percentage points over last year's survey.
Seeds of the next crisis: Regulators, rules, and the bureaucracy
Mauzy argues that the unintended consequences of regulation can be significant. The passage of the Sarbanes-Oxley legislation, for instance, has resulted in a significant increase in average compliance costs for firms. He also points to evidence that the likelihood of small foreign companies listing on an American exchange declines due to the inability of firms to absorb the incremental costs associated with compliance.
Moreover, the more regulations one has in place the greater the regulatory arbitrage that occurs. Regulatory arbitrage (often abbreviated to regarb) is financial engineering that strives to legally circumvent unwelcome regulations. Thus, to get around capital adequacy requirements, banks will continue to find ways to transfer, not reduce, risks to off-balance sheet venues.
Undoubtedly regulation has costs. But perhaps deregulation is a more costly alternative. Can we bear the social and political cost of letting innocents pay the price for the errors of a few?
The ideological stance that had shifted in recent times from regulation to deregulation and self-regulation is already changing. None other than former Federal Reserve chairman, Alan Greenspan, a champion of market-based self-regulation, famously remarked in 2008, "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief."
Are more rules and regulations the answer? A focus on the behavioral aspects of financial decision-making could provide more meaningful guidance to policy. Hans Monderman, a Dutch engineer working on traffic efficiency and safety, explained to Wired magazine in 2004 that "The trouble with traffic engineers is that when there's a problem with a road, they always try to add something. To my mind, it's much better to remove things." A wide road with a lot of signs [such as traffic lights, railings, curbs, road markings] tells drivers "go ahead, don't worry, go as fast as you want, there's no need to pay attention to your surroundings. And that's a very dangerous message...If you treat drivers like idiots, they act as idiots," said Monderman.
Does a regime of regulators, rules, and bureaucratic overlording lull markets into a false sense of security and induce mental flaccidity? Is there a lesson for financial regulators here? In isolation, many of the proposals in the reform bill are reasonable. In combination, they could represent death by a thousand cuts. Fewer rules could well mean fewer faux safety barriers that might encourage more intelligent individual and institutional decision-making.