Did Regulation Cause the Financial Crisis?

(Cross posted at The Atlantic Business Channel.)

The role regulators played in the current financial crisis is a critical question as the Treasury Department gets set to take on bank regulation in the next few months. But standing in the way of the administration’s reforms is a counter-intuitive argument that over-regulation, rather than under-regulation, caused the crisis. Specifically, this argument pinpoints blame on an 2001 banking regulation rule, which critics blame for loading the banks with toxic mortgage-backed securities.

Will Ambrosini wants to know if this argument presented at Causes of the Crisis is true:

Had bankers been looking for the safety connoted by triple-A ratings, they could have bought Treasurys, which were even safer. If they were looking for yield, they could have bought double-A or lower-rated bonds. And why mortgage-backed bonds? The answer seems to be an obscure rule enacted by the Fed, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001: the Recourse Rule, an amendment to the Basel I accord that governed banks’ capital minima.

Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages–regardless of how sound the borrowers were–sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability.

To be sure, banks that bought mortgage-backed securities to reduce their capital cushions were, indeed, knowingly increasing their vulnerability if the investments turned out badly. But absent the Recourse Rule, there is no reason that banks seeking a safe way to increase their profitability would have converged on asset-backed securities (rather than Treasurys or triple-A corporate bonds)

So that last paragraph is wrong – asset-backed securities, specifically mortgage ones, offered a higher return than Treasury bonds, and thus it is not true that there was “no reason” someone would buy an asset-backed security absent the recourse rule. That’s why you see pension funds and school boards and all kinds of institutional investors who don’t fall under Basel regulation buying them – it’s not simply a matter of capital number recording. When you consider they were rated at the same level, it’s a sufficient reason for the pile-on in securitized bonds.

But it’s a very valid argument. Arnold Kling also believes that this “Recourse Rule” was the culprit, instead of deregulation, in getting banks to be so dependent on the credit agencies.

How the Rule Works

Let’s back up. What did the regulation in question involve? Here is the notice, along with the Federal Register (here FR), explaining the rule’s effect on capital reserving. By reserving, we mean holding capital in case there are losses on the portfolio. Banks want to keep low reserves for more profits. Regulators want to keep high reserves for more stability. For our concerns, the big difference in Basel, as opposed to previous bank regulations, is that it divides the capital reserving by asset class, with each asset class getting a “risk ratio.” Some assets you didn’t need to reserve anything against (short term OECD government debt has a 0% risk ratio) and some you have to reserve more against (mortgages have a 50% risk ratio).

Now what did this new rule do? Let’s assume you had a pool of 100 mortgages, and they’d all sit on your book at 50%. Now using a quick metaphor of “slicing-and-dicing” mortgages into security pools. If you got the first few mortgages payments in that pool it becomes less risky. Since it is less risky, it should have less risk attached to it under regulation rules. So for these first payers — or highest tranches, or AAA or AA rated instruments — you only had to set the risk target at 20%. But it isn’t all free money. Looking at the FR regulatory document (footnote 23), if the tranche is rated A, then it is 50%. And if it is BBB, it’s 100%; BB, 200%. So for some pieces of that 50% original pool of mortgages, some slices of it are more risky, some slices of it are less risky. The riskier parts of the mortgage pools had much higher capital reserves than the original.

In other words bonds consisting of mortgages are treated, for bookkeeping purposes, more like actual bonds instead of mortgages. It’s hard to argue that the asset-backed securities market was created in 2002 as a result of this amendment since it had been around for decades. Kling is correct that this gives the ratings agencies a lot more control over the value of these loans, and figuring out what to do about the way the ratings agencies got the value of these loan pools entirely wrong is a really important question. The Atlantic‘s Daniel Indiviglio has written extensively on this question.

Demonizing Deregulation

So let’s look at this new amendment more critically. It takes an older, blunter government rule (all mortgages at 50% risk), and makes it more market friendly (mortgages at the level where the market prices risk). It outsources risk-management to private companies, the ratings-agencies, assuming that companies willing to pay to get ratings on their mortgage bonds would lead to more efficient information than government regulators. It takes as granted that financial innovation has “worked” and that government regulation should act to help move the latest financial innovations more coherently into the regulatory regime.

With this in mind, it’s hard not to plug this amendment into the familiar narrative of “deregulation” that has taken place since the Carter administration. This deregulation narrative includes, in my opinion, some big success stories (telecoms, airlines), some positive but more mixed stories (de-unionization, NAFTA, de-industralization), and a disaster in the case of finance. One can spend a long time talking about these stories – but from my point of view there’s nothing about this amendment, and the political economy about how to measure financial risks, that doesn’t fit into this narrative.

The idea that we are trusting financial markets to handle this themselves, because markets will know as well if not better than regulators what risks people are taking on, is written into the very fabric of this regulation. Look again at the FR document:

The [regulatory] agencies expect that banking organizations will identify, measure, monitor and control the risks of their securitization activities (including synthetic securitizations using credit derivatives)...Banking organizations should be able to measure and manage their risk exposure from risk positions in the securitizations, either retained or acquired, and should be able to assess the credit quality of any retained residual portfolio…Banking organizations with significant securitization activities, no matter what the size of their on-balance sheet assets, are expected to have more advanced and formal approaches to manage the risks.

It is telling banks to handle this themselves, because the “science” of risk management is well provided within private financial services, and it is better for it to be handled this way rather than with the crude tools public regulators used. And I think that this narrative, that new changes to banking regulations were more friendly to the financial community in the general move to deregulation, is a real challenge for those who think that markets would have been able to do better without any regulation – what stopped them this time around?

Regulation and Capital Requirements

Let’s try a final thought-experiment. The Basel accords established a capital floor underneath which regulators wouldn’t allow banks to go. Why are they to blame for banks taking on too much risk? As a crude example, let’s say regulators required banks to hold 8% of capital, but that was too low and banks should have held 16% of capital. If banks would have naturally held 16% without regulators because markets work here, why wouldn’t they hold 16% with regulators requiring a floor? I can understand how arguments that banks are holding too much capital, and stifling growth and keeping credit artificially low, could follow, but that doesn’t seem relevant for this crisis. There’s no reason board members, shareholders, CEOs with “skin in the game” and reputation concerns couldn’t have made their companies hold 16%.

I understand the moral hazard argument, and though it obviously applies to government-sponsored entities like Fannie Mae and Freddie Mac, I think it needs to be proven rather than assumed that it applies to the banking sector. I’m willing to be convinced, but I think that’s a serious question for people who think that regulation caused the crisis. Would no regulation really have been any better?