The disastrous meltdown of structured securitization represents a dual failure of market discipline and government supervision. At every stage of the securitization process, incentive conflicts tempted private and government supervisors to short-cut and outsource duties of due diligence that they owed not only to one another, but to customers, investors, and taxpayers.
When commissions and other fees for service are paid upfront, managers and line employees of firms that originate, securitize, rate, or insure loans fear that they are passing up short-run income whenever they nix a questionable deal. At the same time, accountants, appraisers, and even government supervisors know that they can win business from competing enterprises in the short run by establishing a reputation for not challenging a troubled client’s dodgy representations about asset values or assessing its efforts to transfer risks off balance sheet as conscientiously as a third party might suppose.
For government supervisors, incentive conflicts trace principally to short horizons, clientele influence, and pressure to support the expansion of homeownership for low-income households. As credit spreads increased in 2007-08, these incentive conflicts led authorities to temporize by adopting policies that risked allowing the depth and duration of the crisis to increase. Ignoring the lessons of the S&L Mess, Federal Reserve press releases (e.g., that of March 16, 2008) and speeches by Chairman Bernanke and New York Federal Reserve President Geithner repeatedly misframed the difficulties that highly leveraged and short-funded institutions faced in rolling over their debt as evidencing a shortfall in aggregate market liquidity rather than volatile and widespread concerns about the individual solvency of troubled institutions.The following passage typifies the way Fed officials interpreted the crisis before September 2008:
“In this environment, banks have faced several different types of liquidity and funding challenges. They have been called on to fund a range of different contingent liquidity and credit commitments, as is typically the case in crises. The substantial impairment of securitization and syndication markets has been an additional challenge because it has reduced banks’ access to liquidity and their capacity to move assets off balance sheets. As the market value of many securities has declined, and investors have reduced their willingness to finance more risky assets, liquidity conditions have eroded further. In response,, even the strongest institutions have become much more cautious, building up large cushions of liquidity, bringing down leverage and reducing financing for their leveraged counterparties.
This paper attributes the ongoing financial crisis instead to economic and political difficulties of monitoring and controlling the production and distribution of safety-net subsidies. Crisis pressures will not relent until access to safety-net subsidies has been capped and managers and authorities acting together find a way to quell doubts about the future viability of institutions known to be struggling with outsized losses. This can be done in the short run by temporarily nationalizing zombie firms and by producing and publicizing convincing forensic evidence that their insolvency has been repaired.
The paper goes on to argue that, to reduce the threat of future crises, the critical task is not to reform the architecture of financial regulation, but to repair defects in the incentive structure under which private and government supervisors manage a nation’s financial safety net. As explained in earlier research, a country’s financial safety net is a multidimensional policy scheme whose mission is to balance the costs and benefits generated by: (1) protecting financial-institution customers from being blindsided by insolvencies; (2) limiting aggressive risk-taking by financial firms; (3) preventing and controlling damage from runs; (4) detecting and resolving insolvent institutions; and (5) allocating across society whatever losses occur when an insolvent institution is closed. Unless the safety net is backed up by solid crisis planning, cumulative extensions of the safety net are apt to result in less frequent but more devastating crises. This is because the more effective a nation’s safety net becomes, the less likely it is that regulatory personnel will have prior hands-on experience in coping with the severity of crisis pressures.
Proposals that would redesign regulatory instruments (such as risk-based capital requirements) or rearrange bureaucratic responsibilities for administering particular elements of the safety (by merging two or three related agencies or expanding the mission of the Federal Reserve) without remedying the incentive conflicts that reward the mismanagement of safety-net resources will postpone rather than promote genuine reform. Genuine reform entails making financial-institution managers and federal regulators jointly responsible for conscientiously estimating and controlling in a timely manner the safety-net consequences of emerging financial contracts and institutional forms.
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26 Yale J. on Reg. ___ (forthcoming Summer 2009)