April 9th, 2013 | By Nick SargenOn April 8-9, 2013 The International Economic Forum of the Americas presented The Palm Beach Strategic Forum – 3rd Edition. Nick Sargen was invited to be among the prestigious lineup of speakers that included foreign heads-of-state, U.S. state governors, central bank governors from around the globe, Fortune 500 chief executives and other influential market participants. The following is from Nick's presentation at the Forum:
Thank you very much for the opportunity to discuss the issue of financial market regulation after the 2008 financial crisis. My perspective is that of a Chief Investment Officer for a U.S.-based financial institution. I will first discuss the factors contributing to the financial crisis, and then consider whether the Dodd-Frank Act or the pending Basel III Accord will pave the way for greater financial stability.
I'll start by considering the underlying causes of the financial crisis, which is commonly attributed to "market failure." At the outset, it should be noted that with the exception of AIG, most insurance companies and many small and mid-sized banks weathered the storm without requiring any federal assistance. It was the leading securities firms and largest commercial banks that required the preponderance of bailouts. Accordingly, they should be the focus of any reforms.
That said, what went wrong to produce the worst crisis since the Great Depression? I contend there are several common attributes of financial institutions that became troubled.
First, virtually all of them held a high percentage of "toxic assets" on their books. In an environment of low interest rates and narrow margins, investors sought assets that offered attractive yields, and these institutions were eager to provide securitized mortgages and other structured products that boosted their fee incomes. While the respective institutions off-loaded most of what they structured, they held on to some senior tranches, believing they were secure. However, they failed to appreciate that the securitization process, which had worked very well for over two decades, became tainted when underwriting standards by firms that originated the home mortgages deteriorated during the housing boom.
Second, firms involved in securitization needed to expand their balance sheets and sought to boost overall profitability via financial leverage. Large investment banks increased debt levels to 30-40 times equity capital with the tacit blessing of the SEC. This was partially in response to international competitors gearing balance sheets and partially due to the fact that investment bank holding companies were not regulated. Credit ratings were the only effective deterrent to aggressive use of leverage and rating agency models failed to detect the outsized risk.
In the case of commercial banks, balance sheet leverage was lower due to mandatory reserve requirements; but some created off-balance sheet entities such as special investment vehicles (SIVs) as a way to increase leverage. The Federal Reserve, which had oversight responsibilities for the banks, permitted them to do so.
Third, many troubled institutions financed long-term holdings with short-term borrowings. The recipe for disaster was the value of their assets plummeted when the housing bubble burst, and the impact was magnified by the need to de-lever their balance sheets quickly. In many instances, financial institutions were forced to sell their higher-quality assets at fire sale prices when credit lines were cut or when depositors withdrew funds. The crisis became systemic when banks were no longer willing to accept counter-party risk.
In short, the severity of the 2008 financial crisis stems from the process of securitization breaking down when leading securities firms and commercial banks had taken on too much debt. While the managements of these institutions committed serious errors in judgment, the various regulatory bodies including the SEC and Federal Reserve along with the ratings agencies were also complicit. In this respect, the crisis is the culmination not only of market failure, but also of regulatory failure and flawed government policies that were designed to increase home ownership to those who could not afford them.
Against this backdrop, the Dodd-Frank Act was passed in 2010 to rectify the problems that were encountered and to strengthen the financial system. The approach taken was very comprehensive, and many of the goals seem laudatory:
The main problem with Dodd-Frank, however, is its complexity: The Act contains 849 pages of legislation and several thousand more pages in subsequent rule making documentation. In most instances, the devil is in the details, and many parts of the bill are still being worked on. A case in point is the controversy over the Volcker rule, which is designed to prevent banks from trading securities for their own account. Today, three years after the Act was passed, hammering out a rule has proved so complex that the final version may not come out until later this year.
Others question whether Dodd-Frank deals effectively with the problem of "Too Big To Fail." Dodd-Frank grants the FDIC a special new power called the resolution authority, which allows the government to run a bridge company for a failed firm, with losses put on shareholders and creditors rather than taxpayers. In this respect, it provides legal cover for the government to assume obligations of troubled institutions that did not exist before.
However, skeptics question whether this provision will deter managements from taking on excess risks to boost profitability. If anything, the U.S. banking system has become more highly concentrated in the past five years, with the ten largest banks now controlling over one half of all deposits. When financial institutions become this large, some observers contend they operate as if they have an implicit government guarantee. Accordingly, some observers favor breaking up the largest institutions.
My own assessment is that it is impossible to know ahead of time how effective Dodd-Frank will be once it is fully implemented. One concern is that it could result in "regulatory overload" that does not achieve greater financial stability. For this reason, I prefer better regulatory enforcement to more rules and regulations.
Compared to the Dodd-Frank Act, the Basel III proposal is a more targeted approach: The rules are directed at improving the capital adequacy and the liquidity of global financial institutions. With respect to capital, Basel III would place greater focus on common equity, where the minimum requirement would be 7% of risk-based assets including capital buffers. The liquidity coverage ratio (LCR) will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario. Minimum Net Sufficient Funding Ratios (NSFR) would attempt to force banks to fund illiquid assets with longer-term funding.
Basel III, nonetheless, it is not without controversy: Indeed, some bankers have pressed U.S. officials to lessen the burden on small banks and avoid penalizing real-estate lending on grounds it would curtail housing activity just when it is beginning to recover. Others believe higher capital ratios will prove harmful for Europe, where banks fall well short of the proposed guidelines. According to a recent European Banking Authority report, for example, the aggregate European banking sector needs about 338 billion euros of additional equity capital to comply with the rules.
My own assessment is the 2008 financial crisis demonstrated many financial institutions in the U.S. and Europe lacked adequate capital to deal with shocks from the real estate sector or from several European sovereigns. Accordingly, I support raising capital requirements for banks and find the argument that Thomas Hoenig, Director of the FDIC, has made to be worth considering: He favors using tangible equity and total assets to compute capital adequacy on grounds this measure is more conservative and credible. The decision to assign lower capital charges to sovereign debt, for example, has been called into question when exposure to troubled sovereigns was the root of the euro-zone crisis. Also, for those who claim higher capital requirements would have harmful side effects on economic activity, my response is that the phase-in period lasting through 2019 seems more than adequate.
To conclude, the principal factor that made the 2008 financial crisis so severe was the excess leverage in the financial system. The over-riding goal of the financial system should be to ensure the process of intermediation between savers and investors is conducted prudently. This can be achieved by requiring financial institutions to maintain capital levels that are adequate to meet stressed conditions, while supervisory and regulatory bodies do their jobs more effectively.