The Mirage that Crises Are Opportunities for Tightening Financial Regulation
Carlos M. Pelaez
The administration announced on January 21, 2010, two more proposals of financial regulation. First, banks and financial institutions owning a bank will not be allowed to engage in proprietary trading unrelated to customer services for their own profit and “invest in or sponsor a hedge fund or a private equity fund” (http://www.whitehouse.gov/the-press-office/president-obama-calls-new-restrictions-size-and-scope-financial-institutions-rein-e) Second, there will be “broader limits on the excessive growth of the market share of liabilities at the largest financial firms” (Ibid). The economic rationale for the measures is the contention that the credit/dollar crisis and global recession was caused by banks and financial institutions taking “huge, reckless risks in pursuit of quick profits and massive bonuses” (http://www.whitehouse.gov/the-press-office/remarks-president-financial-reform). The crisis is portrayed as the result of a “binge of irresponsibility” by financial institutions. The cure is enforcing “responsibility” in financial institutions by means of official regulation.
This writing provides systematic analysis of the pure economic issues involved in the new proposal of financial regulation: (1) efficiency and stability of broad or universal versus specialized banking, (2) proprietary trading, (3) hedge funds and private equity, (4) banking sector consolidation and (5) recovery of the economy and job creation. These issues are discussed in turn.
First, broad versus specialized banking. The universal or broad bank engages in all financial services: taking funds from the public to lend, underwriting and brokerage of securities and insurance. The Glass-Steagall Act of 1933 separated investment and commercial banking; the Bank Holding Company Act and the National Banking Act prohibited US banks from engaging in insurance, real estate brokerage and other financial services. The Gramm-Leach-Bliley Financial Modernization Act sanctioned the de facto evolution of US banks into broad banks (Peláez and Peláez, Financial Regulation after the Global Recession, 91-5, Regulation of Banks and Finance, 117-21). There are issues of financial stability and efficiency in the proposed regulation. The financial stability or too-big-to fail argument behind the proposed regulation is that the failure of one or more large financial conglomerates engaging in complex relations with other financial and nonfinancial entities could have “systemic” effects, which could cause the failure of other financial institutions and collapse of the economy. The policy intends to prevent banks from becoming “too big and systemic.” George Benston finds that only 10 of 9440 banks that failed during the Great Depression were not specialized banks with one or few branches (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 92). In 1983-90, 1150 commercial and savings banks, about 8 percent of the industry in 1980, failed, and 900 savings and loans, or about 25 percent of the industry, were closed, merged or placed in conservatorship by federal agencies. The cost to taxpayers of resolving insolvent savings and loans amounted to $150 billion or several times that amount in current dollars (George Benston and George Kaufman cited in Financial Regulation after the Global Recession, 56). There is no reason why well-capitalized broad banks are more prone to failure than a system consisting of a large number of specialized deposit/lending banks. The US system of specialized banks for directed lending to housing through savings and loans, Federal Home Loan Banks (FHLB) and Fannie Mae and Freddie Mac was a source of failure and bad loans in the credit crises of the 1980s and in 2008. The FDIC reports that over 170 smaller banks have failed in the US since 2008 (http://www.fdic.gov/bank/individual/failed/banklist.html ). The US has had more banking panics than other countries because of the large number of small banks with more fragile capital structure, which is a product of regulation.
There is the efficiency issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires large volumes of transactions to reach the minimum cost of operations. There are also economies of scope in that fees and rates for providing traditional banking to clients may be lower because of the savings of jointly using the same originating and distribution activities of traditional banking in underwriting, insurance and brokerage. Intervention by regulation would increase credit rates and diminish volume. Major research efforts show the information benefits of underwriting and syndication by commercial banks without conflicts of interest before the Great Depression and in recent periods (Regulation of Banks and Finance, 121-9, Financial Regulation after the Global Recession, 95-8). Limits on the size of banks imposed by regulators would prevent financial institutions from attaining optimal scale of operations that provide cheaper and higher volume of financial services. The proposed regulation would make US banks uncompetitive in international operations and in financing the large needs of US corporations with adverse effects on the economy and job creation.
Second, proprietary trading. There appears to be only one bank currently deriving significant earnings from proprietary trading, which did better during the crisis than most others. Proprietary trading with computer programs arbitraging small differences in spreads is not a source of risk but rather lowers financial costs, making markets more liquid. Not much can be made out of the proposed measure because of the need for the applicable regulatory definition of proprietary trading together with sound analysis of the risks involved and their past occurrence. As in most of the proposals, there is a transfer of risk and business away from banks to other financial institutions such as hedge funds that betrays the intended effort of controlling “systemic” risk that is also loosely defined. How can a council of regulators control systemic risk if they failed to anticipate it during the credit/dollar crisis and global recession?
Third, hedge funds and private equity. The spiral of financial innovation of the view of Functional Structural Finance (FSF) accompanied the rise of pools of capital in the form of hedge funds and private equity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 101-9, Globalization and the State Vol. I, 59-71, Government Intervention in Globalization, 49-52). There were no systemic problems with hedge funds and private equity in the current crisis even as the pools of capital shrank significantly. The liquidation of Long Term Capital Management (LTCM) has been significantly exaggerated (Pelaez and Pelaez, Financial Regulation after the Global Recession, 103-4, Globalization and the State Vol. I, 60-2, International Financial Architecture, 87-9, 108-12). The initial high returns derived from aggressive strategies are likely to be followed by lower abnormal returns and convergence in strategies with mutual funds and under similar regulation (René Stulz cited in Financial Regulation after the Global Recession, 101). The technological revolution and the global recession will require restructuring of corporate control that can be accomplished without the need of traumatic bankruptcy court by taking a company private and then converting it again into a public company (Pelaez and Pelaez, Regulation of Banks and Finance, 157-66, Globalization and the State Vol. I, 49-59, Government Intervention in Globalization, 46-9). Fracturing private equity and hedge fund markets will prevent restructuring of the economy for faster growth and job creation. The forced sale of hedge fund and private equity operations of banks would cause a decline in their stock prices at the time when they need to replenish capital if the new Basel capital requirements are strengthened. Legislation mandating sale of hedge funds and private equity units in a period of several years would still cause immediate deterioration of equity prices of large banks, harming pension and savings funds held by millions of Americans that own 75 percent of large bank stocks with insiders owning less than 1 percent. The evident beneficiaries are independent hedge funds and private equity funds that would face less competition. Banks would be deprived of sources of diversifying credit losses such as those in real estate that caused the credit crisis. The proposals increase large bank vulnerabilities.
Fourth, banking sector consolidation. The limit on the size of liabilities of banks and the use of antitrust regulation to prevent consolidation would prevent optimum size financial institutions and force the ones in trouble into bankruptcy courts instead of exit via mergers and acquisitions. Consolidation is preferable to bankruptcy (Pelaez and Pelaez, Regulation of Banks and Finance, 157-66, Globalization and the State Vol. I, 49-59, Government Intervention in Globalization, 46-9) and will be required because of new technology and the effects of the global recession. Companies that need downsizing may not be able to sell subsidiaries and segments of business to companies in relatively stronger conditions.
Fifth, recovery of the economy and job creation. The model of economic growth of the US is based on innovation with a university, research and entrepreneurial system applying scientific knowledge to practical problems of production while there are significant efforts in the European Union to move forward in enhancing productivity (Pelaez and Pelaez, The Global Recession Risk, 135-44). The expansion phase of the economy requires dynamism similar to the 6 percent annual growth rates of GDP during eight consecutive quarters after the 1982 recession in order to attain full employment. Risk management of the economy by regulators will restrict entrepreneurship not only in finance but in all economic activities. Strong stable financial institutions are required to finance productive economic activities and investment. Tightening regulation after the credit/dollar crisis and global recession may prevent recovery of full employment by interrupting the flow of funds to production and investment.
A more balanced view of the roles of the government and the private sector is required. The fact is that the credit/dollar crisis and global recession originated in four combined policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury bond in 2001-2005 that caused purchases of mortgage-backed securities equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The successful balancing of private and public roles is the most promising opportunity after the credit/dollar crisis and global recession. Constructive dialogue and cooperation of the public and private sectors will ensure future prosperity. The international forums in Basel provide global coordination toward an agenda that will improve regulation with implementation after the recovery of banking and employment perhaps in 2012. Anticipating stricter agendas in a rush to regulation may cause the exodus of banks and financial institutions and their high paying jobs to foreign jurisdictions that provide more constructive and participatory deliberation. Pursuit of the mirage of opportunity in tighter financial regulation may frustrate attaining the actual opportunity in entrepreneurial innovation of fast economic growth and job creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)