When the investment banking industry heaps praise on the Federal Reserve for creativity and statesmanship in stretching its traditional mandates in the recent financial market turbulence, it’s time for ordinary people to fasten their seat belts and hang on to their wallets. The Fed-brokered acquisition by JP Morgan Chase of Bear Stearns and its assumption of $29 billion in assets of questionable value, along with opening its discount window to non-bank as well as bank borrowing secured by potentially tainted collateral (“trash for cash”), has enormous implications for global financial intermediation. It is now apparent that governments in the future are likely to participate in bailing-out individual financial firms to stem financial turmoil, whether or not they are banks. In the process, taxpayers will be exposed to significant losses associated with individual financial intermediaries whose collapse is thought to pose a danger to the financial system – not to mention the slippery slope toward bailing out systemically-important nonfinancial companies in the automotive, airline and other sectors whose businesses have been wrecked by market shocks.
In the United States, the ongoing bailouts of financial firms that now cover both banks and nonbanks are likely to exceed the taxpayer cost of the S&L crisis of the 1980s which, after substantial recoveries, cost them about $150 billion – roughly 2.5% of GDP at the time. That crisis was triggered by a sharp increase in US short-term interest rates, which imperiled most of America’s poorly regulated mortgage-finance institutions. The government had to step in as a deposit guarantor of those institutions, and eventually restructured or liquidated them. This time, the crisis comes from a massive loss of confidence in the surge of collateralized mortgage obligations and other structured financial instruments created in recent years – often highly complex bonds collateralized by bundled mortgages known to contain some amount of risky, sub-prime obligations likely to be worth less than their face value. Since investors don’t know for sure that they are immune to such losses, the rational thing to do is to run – flooding the market with sellers and robbing it of buyers – this despite the fact that in the end default rates may not in fact by large enough to impact the bulk of the outstanding debt obligations. The result is an extended liquidity panic that is now about a year old. Unlike the S&L crisis of the 1980s, however, this one is occurring in the global capital markets – which are ostensibly not guaranteed by the government – rather than in insured and regulated banks and mortgage lending institutions.
This shift of financial flows from regulated depository institutions to the free, open and global financial marketplace has been one of the most positive developments in finance during the past twenty years. It has led to more competition, more efficient asset pricing, more granular risk allocation, more transparency in most financial markets and lower cost of capital. Today, the market capitalization of all the world’s stocks and bonds exceeds $100 trillion, several times the combined amount of all the world’s bank deposits. Along with the efficiency and innovation, however, has come a degree of fragility that few market participants or outside observers recognized as the new edifice was being constructed.
One source of fragility is heavy concentration in global financial intermediation. The principal market intermediaries – those who created, packaged and distributed the securitized mortgage loans and many other structured investment vehicles – are two dozen or so publicly-traded financial service giants that have positioned themselves at the center of global financial flows, where they collectively dominate transactions. These financial colossi underwrite, distribute and trade securities of all types, simultaneously manage families of funds including in-house hedge funds and private equity portfolios, and often serve as principal investors, prime brokers and M&A advisers. They generate transactions imaginatively and aggressively, with the objective of selling their holdings to others as quickly as possible after pocketing fees and trading profits. Theirs is a highly competitive, mark-to-market business. It is also a risky one, which is extremely prone to herd-like behavior. In a business totally founded on confidence, erosion of that confidence almost always starts a death-spiral. When things go wrong, all are affected at the same time and in the same direction because all are involved in the same markets. Losses and write-offs are inevitable, the share prices of the financial giants collapse, and market liquidity seizes-up for a time and threatens real harm to the economy.
This is what happened in 1990 after the collapse of the junk-bond and LBO markets, in 1998 after the Russian debt default and the collapse of Long Term Capital Management, and in 2000 after the dot-com bubble. It happened again this time and – given recent bailouts and in the absence of effective public policy changes – will happen again next time as well. While shareholders of bank-affiliated and independent broker-dealers have already taken massive losses, many of those involved in creating today’s financial mess have taken enormous financial rewards off the table, leading to a widespread perception of “privatization of gains and socialization of risks.” Since this situation is politically unsustainable, it’s inevitable that there will be a significant regulatory response. This will include calls for structural remedies, such as a modern version of the 1930’s era US separation of commercial and investment banking. After all, less than a decade following the 1999 repeal of the Glass-Steagall provisions of the Banking Act of 1933, every major American credit institution – backed by deposit insurance and access to “too big to fail” support – was caught in the biggest financial crisis since Great Depression of the 1930s.
But functional separation of business lines and recreation of Glass-Steagall typebarriers has turned to be irrelevant in the current crisis and therefore in any new efforts at global financial regulation. As long as financial intermediaries (whether they are banks, broker-dealers, hedge funds or major asset managers) are considered too big, too complex or too interconnected to fail, they are now likely to be supported at public expense, either through support of their liabilities or support of their assets. Members of the general public will pay, either through public expenditures, derailed monetary policy and higher inflation that favors debtors, or bearing risk for which they not compensated. Whether or not there is formal “lender of last resort” support from the public, the Bear Stearns and “trash for cash” experience shows that the key intermediaries (even mid-size broker-dealers) are so integral to the functioning of the global financial system that they too have to be saved from failure – a contingent liability that the government and taxpayers have implicitly assumed in the interests of increasing market competition and financial efficiency. The result is an acute form of “moral hazard” in which the gains from successful short-term risk-taking are allocated in large measure to the employees of the firms involved, but losses (even after the collapse of financial share-prices and firm recapitalizations) have to be absorbed to a significant extent by the general public – in effect, socialization of risk and privatization of returns.
Socializing risk gives the public the right to regulate those who benefit from public support, and greater regulation will certainly come. One hopes that the massive shareholder losses we have already seen among financial institutions, and those yet to come, will lead to better corporate governance among financial firms and in turn a better balance between risks and rewards – self-correction that serves the interests of the shareholder and the taxpayer alike. In the hyper-competitive financial market that will soon reappear, however, market discipline is unlikely to be sufficient and in any case will dissipate in plenty of time for the next crisis. So regulatory pressure will have to focus on the interrelated issues of solvency (of institutions) and liquidity (of both institutions and instruments).
In the matter of solvency, for bank-based firms the issue is already addressed in the Basel 2 banking reforms now being implemented, and these will be revisited in the light of recent events. It will include strengthened incentives to recognise the underlying sources of risk and how it is modeled, and review the treatment of key securitisation exposures and off balance sheet commitments. It will also have to monitor procyclicality inherent in the Basel 2 capital adequacy standards and more generally the countercyclical properties of prudential policies.
Basel 2, as reformed, will also be extended to pure investment banks, the so-called monoline firms of which only four global players remain- Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley. Some may come under revised Basel 2 solvency standards by combining with commercial banking organizations, and comparable solvency requirements will be extended to any that remain independent. To deflect likely constraints on their core business models centered around the aggressive use of leverage, these firms and their lobbyists are busy making the case that they already meet Basel 2 standards under the oversight of the Securities and Exchange Commission. They argue that they meet Basel 2’s 4% Tier 1 risk-adjusted shareholder equity capital requirement, and that the fact that they systematically mark their assets to market while banks rely on loan-loss reserves and subordinated debt is likely to satisfy Basel 2’s 4% Tier 2 capital requirement as well – thereby already exceeding the required 8% Basel 2 combined ratio. Whether the latter is in fact the case, and whether the remaining investment banks meet Basel 2 requirements or the 10% ratio applicable to US banks, awaits better disclosure of the market values of their exposures.
Such argumentation, intended to execute an end-run around increased regulation and convince the regulators that meeting their prudential requirements is no big deal, is unlikely to work. Now that they have availed themselves of Federal Reserve support (and with former Bear Stearns people arguing that the firm never would have failed if the Fed’s bailout of the industry has come sooner), the investment banks inevitably will be absorbed into whatever regulatory net applies to commercial banks – whether that involves enhanced capital requirements and leverage constraints or new standards designed to deal with liquidity disruption in times of stress. They will also be subject to regulation designed to combat borrower fraud and force improved due diligence on the part of debt originators and wholesale financial intermediaries, which may well include mandatory retention of specified lending exposure and debt tranches for the duration of the underlying loans. All wholesale financial intermediaries will be under pressure review whether the structure and effectiveness of risk management in their operations are commensurate with the risks they run in their business models.
In the matter of liquidity of financial instruments, there will be a great deal of discussion about transparency in the structure of financial instruments, common templates in securities design, disclosure and approaches to valuation – possibly leading to significant migration of over-the-counter transaction onto organized exchanges, eliminating counterparty risk in the process but sacrificing some degree of innovation and substantial sources of earnings for wholesale intermediaries. This includes the market for credit derivatives, which has undoubtedly improved granularity in risk allocation but has encountered major problems in transparency and counterparty exposures of its own. And it has not prevented herding in times of severe credit stress.
As always, the objective of forthcoming regulatory change will be to improve stability of the financial system with minimum efficiency losses. Since measurement of the latter is highly problematic while instability shows up only after it’s too late, the issue involves balancing the unmeasurable against the unknowable – and sometimes involves overregulation or underregulation. In the process, the remaining full-service investment banks – themselves arguably the product of regulatory reaction to financial disaster in 1933 – may well go by the boards, disappearing into commercial bank-based financial conglomerates or fundamentally transforming their business models. But since financial conglomerates themselves usually trade at a discount from sum-of-the-parts valuations, this would be a loss to the global financial architecture.