If you want to understand how the US economy is producing big gains for those at the top and stagnation for everybody else, the financial sector is clearly a big piece of the puzzle. Is finance really overregulated, or simply misregulated?
In our new book The Captured Economy (see previous excerpts here, here, and here), we argue that the twin ills now plaguing the U.S. economy, slow growth and high inequality, are not simply the result of deep structural trends and unchecked market forces. In addition, they reflect the operation of government policies that actively worsen both problems. We call these policies “regressive regulation”: perverse rules that hinder innovation and growth by squelching or distorting market competition—and redistribute income and wealth up the socioeconomic scale in the process.
In any search for policies that slow growth and drive inequality, financial regulation is an obvious place to start. After all, the financial sector was Ground Zero for the worst economic crisis to hit this country since the Great Depression. As Harvard economists Carmen Reinhart and Kenneth Rogoff have documented, financial crises are terrible for growth: recoveries from them are generally slow and arduous. And while prone to causing cataclysmic wealth destruction for the economy as a whole, the financial sector has also been generating immense gains for a favored few. Financial executives and professionals account for an estimated 14 percent of the much-discussed top 1 percent of earners—and over 18 percent of the top 0.1 percent.
So if you want to understand how the US economy is producing big gains for those at the top and stagnation for everybody else, the financial sector is clearly a big piece of the puzzle. But, a skeptical reader might ask, is finance really an example of activist government gone awry? Or are the problems in the sector instead just a function of an absence of government action?
We think that in important ways the presence of state action is central to the problems in finance, but we recognize that many will be skeptical. After all, the story of the financial crisis is widely understood as a story of deregulation and free markets run amok. Can we really be arguing that the egregious excesses and blunders of the housing bubble are evidence that risk-taking by financial institutions was excessively restrained by regulators?
Let us be clear: this is not our argument. Our contention is not that the financial sector is overregulated, but rather that it is misregulated. Here we want to focus on one fundamental flaw: the whole regulatory system is premised on the inevitability and even desirability of extreme reliance on debt for funding the operations of financial institutions. Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute refer the current state of affairs as the “bankers’ new clothes”—a shocking vulnerability that both industry participants and regulators do their best to ignore and deny.
This regulatory model thus concedes at the outset that financial systems are inherently disaster-prone (since it is the extreme leverage of financial institutions that makes them vulnerable to runs and systemic crises) and then tries to prevent such calamities through a combination of prudential regulation and safety nets to protect creditors. As the sorry record of rolling crises and near-crises in this country and around the world attests, this regulatory model fails to deliver the stability it promises.
Accordingly, the overall design of the current regulatory system acts as a massive subsidy for debt-fueled excessive risk taking. The result is not just an endless succession of crises and near-crises, but a swollen financial sector larger than it needs to be, chronic misallocations of capital, and a growth-sapping diversion of some of the nation’s best minds into unproductive or counterproductive pursuits.
To understand the problem, it’s first necessary to note just how strikingly unusual the financial sector’s reliance on debt is compared to the rest of corporate America. For US nonfinancial corporations, a company’s balance sheet is referred to as “strong” when the ratio of debts to assets is low. For most US companies, total outstanding debt amounts to less than 50 percent of assets—and for many companies, debt levels are appreciably lower.
For financial firms, the situation is radically different. Debt loads in excess of 90 percent of total assets are the norm, and debt-to-asset ratios as high as 97 or 98 percent are not unusual. This state of affairs has persisted long enough that people now take it for granted as somehow normal, but it wasn’t always the case. Until the middle of the nineteenth century, debt levels for banks averaged 50 to 60 percent of assets; in the early decades of the twentieth century, debt-to-asset ratios of 25 percent were still typical.
Why do financial firms take on so much debt? They are drawn to the magic of leverage—the capacity of debt to dramatically increase returns on successful investments. To take a simple example, let’s imagine you buy one share of stock in Company A for $100 and sell it two weeks later for $110. Well done—you’ve made $10 and a 10 percent return on your investment. But if instead you borrowed $900 to buy $1000 of stock in Company A and then sold that two weeks later for $1,100, you can pay back your loan and pocket $100 in gains for a 100 percent return on your investment.
Alas, the flip side of these heightened rewards is heightened risk. This time, let’s imagine you bought stock in Company A for $100 a share but now the stock price has fallen to $90 a share and you have to sell. If you bought one share with cash, you’ve lost $10 or 10 percent of your original investment. If, however, you borrowed $900 to buy $1000 of stock, you’re now wiped out: you can pay off your $900 loan but your original $100 is gone.
The funding structure of financial firms results in their fragility and instability. For a bank with a debt-to-assets ratio of 90 percent, a decline in the value of its assets (i.e., outstanding loans and other investments) of greater than 10 percent will render it insolvent. And since many of the bank’s assets are illiquid loans whose present market value is uncertain, any perceived downturn in the value of a bank’s assets will start to trigger concerns about insolvency—which could lead to liquidity problems as short-term creditors stop rolling over their loans. The bank will then be forced to sell off assets quickly, which likely means at a steep discount, further deepening fears about the quality of the bank’s assets, leading more creditors to head for the exits, and prompting more fire-sale disposition of assets in a downward spiral. In short, financial firms’ extreme reliance on debt makes them a house of cards that any stiff breeze can topple.
|“The overall design of the current regulatory system acts as a massive subsidy for debt-fueled excessive risk taking. The result is not just an endless succession of crises and near-crises, but a swollen financial sector larger than it needs to be, chronic misallocations of capital, and a growth-sapping diversion of some of the nation’s best minds into unproductive or counterproductive pursuits.”
The precarious nature of the financial sector’s funding structure is widely treated as normal—an unavoidable state of affairs that is inherent in the nature of financial institutions. Banks are said to engage in maturity transformation (i.e., they borrow short and lend long) and liquidity transformation (i.e., they fund their illiquid assets with liquid liabilities); accordingly, exposing themselves to the risk of runs by creditors is an essential part of what banks do. But first, there is absolutely no necessary reason why loans, by banks or anybody else, have to be funded by short-term liabilities. Institutions funded purely by equity, or funded by equity to a considerably greater extent than banks are today, are perfectly capable of making loans. Second, there is a fundamental (though not always clear) distinction between liquidity risk and insolvency risk. A bank with much more equity funding than is the norm today—say equal to 30 percent of assets—would still face liquidity risk as its short-term liquid liabilities would usually far exceed its liquid assets. Yet its insolvency risk would be much lower than that of a typical bank today, because its relatively large equity cushion would allow it to weather a sizeable downturn in the value of its assets.
How then do financial firms sustain such high levels of indebtedness? Given the general expectation that borrowing costs rise with increasing leverage, why are banks able to borrow so much without facing sky-high interest rates and onerous conditions?
First of all, financial firms may be able to rely more on debt because the assets they are borrowing against are much more stable in value than those of nonfinancial firms. As John Cochrane has pointed out, a diversified portfolio of loans and securities just isn’t very risky—certainly not in comparison to the expected future profit flows of a single company.
Beyond the difference in market fundamentals, financial firms’ predilection for debt may also reflect a market failure. Specifically, in judging the tradeoff between risk and reward when choosing how much debt to take on, financial firms may look only at their own individual situation and not take account of the destabilizing effects of aggregate leverage in the financial system. Given the fact that banks borrow from each other and also the risk of contagion during bad times, levels of leverage that might be fine for a single institution become problematic if more widespread. This market failure may be exacerbated by compensation practices in the financial sector, in which return on equity is a major factor in determining executives’ compensation. Executives therefore have a personal incentive to lever as extensively as possible—especially if the tail risks lie years down the road well after fat bonuses have already been paid.
But instead of correcting any market failures that leads to excessive risk taking, regulatory policy actually makes matters worse. Specifically, the government’s efforts to reduce the harm caused when financial firms fail ends up subsidizing the heavy reliance on debt that makes firm failure more likely.
The main explicit subsidies consist of (1) the Federal Reserve System’s discount window, established in 1913, through which the Fed can act as a “lender of last resort” and supply emergency liquidity to distressed banks; and (2) federal deposit insurance, first instituted in 1933, through which covered depositors are held harmless in the event of a bank failure. Both these policies are justified on the grounds of preventing and containing bank runs—a particularly serious problem in the United States because historical limits on branch banking rendered US banks underdiversified and consequently crisis-prone.
Yet even as they reduced the risks of contagion and financial meltdown, these policies simultaneously reduced the risks of high leverage. Access to the discount window made banks less vulnerable to liquidity shocks and thus made it safer for them to borrow more. Deposit insurance, because it has never been priced in an actuarially sound manner, acts to subsidize heavy reliance on deposits to fund banking operations. Insured depositors are rationally indifferent to the financial soundness of the banks they patronize, as they will get their money no matter what. Accordingly, they do not demand higher interest rates from undercapitalized banks to compensate them for the risk of insolvency. It is no surprise, then, that the creation of a formal safety net for banks led to higher levels of indebtedness.
In addition to these explicit subsidies, an implicit subsidy created by a string of ad hoc bailouts has further incentivized financial institutions to ramp up their leverage. Continental Illinois in 1984, the Latin American debt crisis of the 1980s, the peso crisis of 1994, the Asian financial crisis of 1997-1998, Long Term Capital Management in 1998, and of course the financial crisis of 2007-2009—again and again the US government has intervened with emergency assistance to prop up American financial institutions deemed too big or too important to fail. This implicit safety net has extended far beyond the traditional banks covered by deposit insurance to include investment banks, the government-sponsored enterprises Fannie Mae and Freddie Mac, hedge funds, money market mutual funds, and insurance companies. As a result, creditors of those financial institutions have been spared the consequences of their misplaced trust. Given the expectation that bailouts will again be forthcoming the next time a crisis hits, the riskiness of lending to highly leveraged institutions is much lower than it otherwise would be—and thus the interest rates that those institutions pay to their nominally uninsured creditors are kept artificially low.
The perverse incentives created by deposit insurance and bailouts are known as “moral hazard”—an expression that comes from the insurance industry to describe the reduced motivation to guard against risks that have been insured against. How moral hazard operates in the financial sector, though, is widely misunderstood. The common picture is that, if moral hazard is present, it must mean that financial sector executives are consciously making business decisions with an attitude of “heads I win, tails you lose.” In other words, they deliberately make investments they know are risky because they understand that they will make big profits if the investments pay off—and if they don’t, well that’s the government’s problem.
It’s clear enough that such thinking is fairly uncommon. Yes, when a financial institution is already insolvent or close to it, executives may try “hail Mary” investments because they face no downside risk—their equity stakes have already been wiped out so they are effectively making one-way bets. Such behavior was seen during the savings-and-loan crisis, as “regulatory forbearance” allowed thrifts with negative net worth to stay in business and attempt to recoup their losses with increasingly desperate gambles. This is precisely the pattern of behavior that Charles Keating notoriously engaged in back in the 1980s, and which the “Keating Five” senators helped to protect.
In the recent housing bubble, though, many of the most disastrous decisions were made by people with plenty to lose. Huge fortunes and sky-high incomes were on the line, and few could be complacent about the prospect of losing them. Far from seeing themselves as reckless, the unwitting architects of the financial crisis were highly confident that they were managing risks expertly and were shocked when the facts proved otherwise. Accordingly, it would seem that moral hazard wasn’t a major factor in explaining what went wrong.
But in fact moral hazard was absolutely central to the story, and it is at the heart of why the financial sector remains a disaster waiting to happen. The main effect of moral hazard, though, isn’t on the incentives facing the executives of financial institutions. Rather, the main effect is on depositors and other creditors. Because their risk of loss has been artificially reduced by the formal and informal safety net created by government, they do not respond as normal market actors would to the heightened risk of insolvency created by extreme leverage. Because they do not bear the risk, they do not demand higher interest rates to compensate for that risk. Financial institutions can keep piling up more and more debt without market consequences, with the result that those institutions and the financial system as a whole grow increasingly fragile and disaster-prone. Sooner or later, a relatively minor reversal of fortune will suffice to spell catastrophe because almost all margin for error has been eliminated.
The system as currently constituted is especially vulnerable to insidious, slow-fuse risks lurking in the tails of probability distributions. The economist Tyler Cowen has characterized the problem as a strategy of “going short on volatility”—in other words, “betting against big, unexpected moves in market prices.” This strategy can appear to work well for many years, as by definition the contingencies being bet against are rare events. During these good times investors earn above average returns, amped up by leverage. Complacency sets in, as backward-looking risk management systems assure everyone that all is well. These systems, for all their mathematical sophistication, rest on a highly dubious and dangerous proposition—namely, that just because something never occurred in the relatively recent past for which data are available, it will never happen in the future. Eventually, though, a blue moon or a black swan appears in the sky, and all those highly leveraged bets now generate losses big enough to threaten the whole system with collapse.
|“Reducing the rents from regulatory subsidies would mean a smaller financial sector—and a healthier one. A smaller, healthier financial sector, meanwhile, would mean a larger, healthier real economy.”
If subsidies are the primary reason for the financial sector’s heavy dependence on debt, and if these high levels of leverage are the fundamental cause of the sector’s vulnerability to crisis, isn’t the obvious solution to get rid of the subsidies? Alas, if only the world were that simple. No matter how opposed to bailouts policymakers might be ex ante, in the throes of an actual crisis it is virtually impossible for policymakers to just stand by and allow big institutions, or lots of little institutions, to fail. The threat of contagion that leads to systemic collapse and economic meltdown is simply too plausible to ignore, so policymakers feel compelled to act—and acting means saving the failing institutions’ creditors from the consequences of their folly. This conundrum is known as the problem of time-inconsistency: a credible commitment in advance not to bail out would lead to less risky behavior and thus no need for bailouts, but such a credible commitment is impossible because everybody knows that politicians will come to the rescue in a crisis.
Nobody likes ad hoc bailouts or defends them as good policy. The problem is that policymakers feel they have to do them when the need arises, which then makes it more likely the need will keep arising. With the formal core of the financial safety net, deposit insurance, the situation is different. Here there is a plausible case that the policy is a necessary element of a well-functioning financial system, albeit one with unfortunate side-effects. Even if banks are well-capitalized enough to keep insolvency risk at bay, they are still subject to liquidity risk. At the heart of what banks traditionally do is converting short-term liquid liabilities (deposits) into longer-term illiquid assets (loans). They don’t keep enough cash and other liquid assets on hand to pay all depositors at once, so if depositors make a mad rush to the exits even otherwise healthy and profitable banks can be driven to ruin. Deposit insurance holds out the promise of reducing liquidity risk by assuring depositors they will get their money and thereby eliminating the incentive to stage a run on the bank.
Although the leverage subsidies created by deposit insurance and bailouts are difficult to eliminate directly, they can at least be contained—specifically, by capital adequacy requirements. Such regulations, designed to ensure that banks have sufficient equity cushions, have long been on the books. Yet it is clear enough that existing rules have been inadequate. The basic flaw in regulatory approaches to date has been to assume that extreme levels of leverage are normal and necessary in the financial sector. Regulation, then, has been limited to tinkering around the edges, managing isolated risks created by a few exceptional cases while leaving systemic risks endemic to the whole sector unattended.
Eric Posner of the University of Chicago Law School has surveyed five different iterations of minimum capital regulation for US banks over the past 30 years, and he has found that none of those efforts was ever informed by any serious economic analysis of the pros and cons of different levels of minimum capital. Instead, regulators engaged in what Posner calls “norming”—taking existing practice as the benchmark and then making “incremental change designed to weed out a handful of outlier banks.” As Posner notes, “US regulators took pains, even as late as 2013, to argue that their regulations would affect very few banks, only the bottom 5 percent or so.” Since, as we argue, it is the heavy reliance on debt by financial institutions across the board that is at the heart of the sector’s fragility, that means that capital regulation as traditionally constituted has been limited to the proverbial rearranging of deck chairs. This judgment applies as well to the Dodd-Frank Act passed in the wake of the most recent crisis: although it nudges capital requirements in the right direction, it did not come close to doing what was really needed.
The subsidies for excessive leverage conferred by the combination of the financial safety net and low capital requirements are not the only regulatory subsidies that swell the sector’s size and profits—far from it. Mortgage finance benefits from enormous largesse—from the tax deduction for home interest to the pioneering and now dominant role of Fannie Mae and Freddie Mac in mortgage securitization. In addition, the 401(k) tax preference has helped to fuel the huge increase in active management of investments and associated fees.
Reducing the rents from regulatory subsidies would mean a smaller financial sector—and a healthier one. A smaller, healthier financial sector, meanwhile, would mean a larger, healthier real economy—an economy no longer convulsed by period financial crises, and one in which the focus of innovation is more on new products and production methods and less on circumventing regulation. And although the country’s most talented young workers would no longer have as many opportunities to earn lavish riches in finance, the bright side is that they would face improved incentives to make valuable contributions to the nation’s economic future rather than robbing from it.
Brink Lindsey (@lindsey_brink) is vice president and director of the Open Society Project at the Niskanen Center. Steven M. Teles is associate professor of political science at Johns Hopkins University and a senior fellow at the Niskanen Center. This piece is adapted from their new book The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality (Oxford University Press).
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