There always have been bank failures and always will be. The trick is to allow sufficient risk to promote economic growth but not so much that it leads to widespread failures and financial panic. It’s clear from the three major banking crises in the past 40 years that we have not achieved this balancing act. These crises occurred because of the failure of regulators to use their authority effectively to rein in excessive speculation by financial institutions.
The Dodd-Frank legislation enacted in 2010 is about 2,500 pages long and will produce more than 10,000 pages of new regulations from the same regulators who presided over the last three major financial crises. It offers no new approaches to prevent the next crisis.
So how do we fix this perennial problem? The solution is a combination of greater market discipline and more effective regulators, not mountains of senseless regulations. We must make clear that for any financial institution failure, all uninsured creditors will take a “haircut” on their investment so that neither the Federal Deposit Insurance Corp. (FDIC) fund nor the taxpayer is put at risk.
The role of the Federal Reserve and the FDIC should be primarily to provide the liquidity necessary to liquidate or sell a company but not to bail out uninsured investors of failed financial institutions. Dodd-Frank does not provide a mechanism for this to happen.
What regulatory authority did regulators lack to rein in the risks taken by about two-dozen financial institutions that precipitated this crisis? We can’t think of any.
What regulatory authority did the Securities and Exchange Commission (SEC) lack to rein in the excessive risk-taking by investment banks? Or to properly regulate the rating agencies whose AAA ratings on certain subprime mortgages were incomprehensible? Or to overrule the Financial Accounting Standards Board, which insisted that banks value their securities portfolios at current market price even though the markets ceased functioning?
Why didn’t Congress rein in Fannie Mae and Freddie Mac and their increasingly large portfolios of risky assets after two decades of warnings by analysts that one day Fannie and Freddie would cost taxpayers hundreds of billions of dollars? Finally, why didn’t state regulators properly regulate real estate brokers who originated 70 percent of the risky subprime loans and knowingly falsified mortgage applications?
Regulators need to identify developing problems before they become serious enough to crash the system. There are three warning signs when an institution, large or small, is approaching the danger zone. We need regulators who have the financial skill and political will to take strong actions when they see these warning signs developing.
The first warning sign is concentration of risk. Most financial institutions fail because their risks are too concentrated by geography, industry and/or product line.
During the 1980s, large Texas banks were among the most profitable and highly capitalized in the country just before nearly all of them failed. They failed because they were concentrated in Texas with commercial real estate and energy loans.
Remember the savings-and-loan crisis of the 1980s, which cost taxpayers $150 billion? The S&Ls failed because of concentrations in commercial and residential real estate.
There were a handful of major originators of risky subprime mortgages in the most recent financial crisis. All failed because their risks were concentrated.
The second warning sign is inadequate liquidity. Bear Stearns and Lehman Brothers reported relatively high levels of capital, but they failed because of insufficient liquidity - the proverbial run on the bank. It’s stunning that those institutions were allowed to operate with balance sheets approaching a trillion dollars funded primarily by short-term wholesale liabilities.
The third warning signal is significant exposure to capital markets on either the asset or funding side. Any company that syndicates and sells a large percentage of its loans and other assets is far more at risk of failure than a company that originates and holds its assets. The capital markets can seize up at any time and severely disrupt the business of a company that relies on an originate-and-sell business model. It is especially toxic when this model also relies primarily on short-term wholesale funding sources.
The financial regulatory regime in the United States is highly fragmented and politicized. We need smarter, more streamlined, independent and effective regulation.