Regulation for Financial Sanity

The Federal Deposit Insurance Corporation (FDIC) just reported that U.S. banks lost money at a $100 billion annualized rate during the fourth quarter of 2008.  Sounds grim, but it only describes the visible part of the iceberg our financial Titanic has hit.  AIG, a giant insurance company, alone has been covered by the Federal Reserve for $150 billion in losses on derivatives on pools of subprime mortgages, with no end to its hemorrhaging in sight.  According to the FDIC, as of the third quarter of 2008, a total of $13.6 trillion in assets, supported by $1.3 trillion of equity capital, was held by commercial banks in the United States.  But derivatives (held primarily by four banks) totaled $177.1 trillion, or $136 for every dollar of capital.  This massive amount of leverage means that a sneeze (such as derivatives of $2.5 trillion in subprime-mortgage pools) could give the banking system pneumonia.  In fact, it did.

Granted, the banks holding these derivatives diligently “cover” their positions with offsetting derivatives, which are determined by complex econometric software on powerful computers designed to “assure” such coverage.  This is the same sort of “assurance” that Long-Term Capital Management, Bear Stearns, and Lehman Brothers relied on.  But the models failed to prevent unanticipated misbalances, and those companies, like AIG, went insolvent.  How many possible mismatches could strike these four banks?  And how could the Federal Reserve come to the rescue with $2.1 trillion of assets to be the backstop for $177.1 trillion in possible miscues?

Given the complex use of credit default swaps as insurance on credit, the current amount of assets could serve as a reasonable backup for the $7.8 trillion of loans held by commercial banks, and perhaps even for two or three times that value in derivatives, but not for $23 of derivatives for each dollar of loans.  At best, our banks are running a dangerous investment casino, and, at worst, they are engaged in pure speculation and insuring speculators, creating a bubble that eventually must burst.

In America today, the commercial banking system is every bit as vital as the electric or water utilities.  It can be catastrophic to have to shut down the banks, as it was in 1933.  Scores of companies were put out of business, and millions of workers were jobless by the time the banks were back in business.  Recently, the threat of a speculation bubble lurked as the clearing and lending of the banking system nearly came to a stop.

The Federal Reserve is handing out money to banks deemed “too large to fail” without knowing how much funding will be required and how long it will take for them to be restored (or to fail).  The regulators would be wise to consider the experience of the state of Texas, which went through a very severe recession, accompanied by a collapse of banking, in the 1980’s.  First oil and gas, then real estate, went through a “boom and bust.”  Central Texas alone went from 70 to 14 solvent banks.  Most of our banks—from the three largest with multiple branches to small independents—went through a process of “revival of solvency.”  The regulators sought private “negative” bids for failing banks, based on an estimation of the franchise’s current real value of assets (principally loans and fixed assets) and retainable deposits, as well as “goodwill” value.  The lowest “negative bid” from an investor who was deemed capable of managing it, and who held the required amount of equity, bought the bank.  The day the investor closed on the purchase, the bank was taken over, and, in most cases, operations continued seamlessly.  When an insolvent bank required capital from the FDIC, whether to continue operations or because it found itself in a condition of “negative capital” at its sale, it had to terminate its principal executives, directors, and shareholders as if it were in bankruptcy, and void all indebtedness or claims other than deposits.  Seized collateral went into a “bad bank,” to be sold as markets recovered.  Solvent banks were only subjected to the normal oversight of the regulators, and weak ones were put on notice that they must clean up their operations and balance sheets.

When it comes to the reorganization of banking, our goals should determine the means by which we attempt to attain them.  Amar Bhidé proposes simple goals in a BusinessWeek article, “How Banking Diversification Steered Us Wrong”:

Here is my modest, quasi-libertarian proposal: To prevent future meltdowns, let’s revive the radical idea of narrow commercial banking.  Let’s tightly limit bank activity to taking deposits and making loans—loans that bankers and regulators who aren’t theoretical mathematicians can monitor.  (Simple hedging to reduce the risks of making long-term loans with short-term deposits would be allowed.)

Anyone else—investment banks, hedge funds, trusts—would be allowed to innovate and speculate, free of additional oversight.  But they wouldn’t be permitted to trade with or secure credit from regulated banks, except through prudent, well-secured loans.  None of this would require new agencies or more regulators.

The simplicity of Mr. Bhidé’s proposals is a breath of fresh air.  Limit the role of commercial banks to accepting deposits and providing loans for personal and commercial needs.  Use derivatives only if they are limited to hedging the bank’s investments and loans.  Regulators would serve as auditors of risk and the appropriate limits of risk and as custodians of deposits and prudence in loans and investments, seeing to it that banks exhibit transparency in proving their solvency.  The history of financial institutions clearly demonstrates the necessity of this kind of regulation to assure citizens that their banking system is safe and sound.

If these are the goals, what are the means necessary to achieve them?  We could start by eliminating holding companies, because there would be no “off balance sheet” investments allowed for banks, which means that the Federal Reserve would no longer have any reason to regulate banks.  The Office of the Comptroller of the Currency should continue to be the auditor ensuring compliance with regulations regarding security, legality, and liquidity for banks’ deposits, loans, investments, and capital.  The FDIC should continue to issue “call reports” that provide detailed individual and group financial statements for all national and state banks, send warnings, and conduct changes of management and closure as necessary.  Any investment bank, hedge fund, leasing company, REIT, or mutual fund listed on the stock exchanges would be answerable to the Security and Exchange Commission (SEC); others would be held accountable under blue-sky state laws.  Fannie Mae and Freddie Mac should be refinanced and made solvent, then auctioned along with the FHA to private investment bankers under the regulation of the SEC.  Commercial banking should be allowed to deal with derivatives only as hedges for loans or investments held in-house.  This simplification of commercial banking would reduce the number of “problem banks.”  The SEC should organize a “derivatives exchange” for public rating and transparency.

A recent Cato Policy Report features an article by David R. Henderson entitled “Are We Ailing From Too Much Deregulation?”  His answer is no, and in support he cites the public savings that have resulted from “deregulation” of the airline and trucking industries.  But neither industry has really been deregulated; in both cases, regulations have simply been reduced.  Air- and highway-safety standards, which serve the public interest, are still enforced rigorously.  Similarly, the banking regulations proposed here are necessary to ensure public safety; and while they, too, must be enforced rigorously, they amount to an overall reduction in government involvement in the U.S. banking system.

In light of the complex problems faced by investors today, the public needs a more vigorous SEC regulator.  Fraud, conflicts of interest, and unbridled greed can only be restrained by transparent audits, attorneys who provide a check on privateers, and the enforcement of current law.  The “bear raiders” of the early 20th century and the Great Depression were the predecessors of the hedge funds and private equity firms.  Our laws need to be strengthened in order to protect the public against the disproportionate and excessive removal of capital; exorbitant salaries, bonuses, and “perks” provided to executives as “compensation” for no real value added; and hidden conflicts of interest.  Stronger laws should demand that violators return all the capital they have stolen and face serious jail time.

At present, there is no telling just how serious the financial crisis will become.  In a fleeting attempt to get us out of the crisis, the federal government is now spending trillions of dollars that it is confiscating from the American people—either directly, though onerous taxation, or indirectly, by inflating the currency, which robs today’s citizens as well as their children and grandchildren.  The only way out of the crisis is to get at its roots—as quickly and frugally as possible.

President Obama’s budget seeks to “stimulate” the economy by handing out ill-considered welfare and the equivalents of earmarks—all financed by the world’s worst federal deficit.  This will only endanger the currency and hinder us from retaining and creating jobs.  Similar handouts under George W. Bush did nothing to thwart the financial crisis.  An effective increase in liquidity is only possible by making credit available to solvent companies, through the assistance of solvent banks.  An argument could be made for federal funding for economically justifiable improvements to our infrastructure, but political handouts will only exacerbate our financial dilemma.  The most important thing Washington could do to stimulate an economic recovery would be helping to restore frugal, solvent, old-fashioned commercial banking.  If it did so, the markets would rise to the opportunity.

This article first appeared in the April 2009 issue of Chronicles: A Magazine of American Culture.