Recent proposals to limit “too-big-to-fail” miss the main cause of the credit crisis. In fact, it is not sheer size that is the problem, it is the lack of information. Like the 911 commission is showing, failures to share intelligence across different agencies, as well as a lack of intelligence, overall, led to the shortcomings in our knowledge about financial risks that necessitated bailouts. Will size restrictions help? Not if we don’t have better information.
Historically, size limitations have hindered U.S. banking and cause more crises than they have prevented. The U.S. banking system was built on the basis of unit banking (limiting banks to a single office) and state chartering, both of which reduced bank diversification abilities and resulted in repeated crises in the early 1800s. The national charter removed some of the uncertainties in the system, but still did not allow banks to grow large enough to properly diversify in the late 1800s, leading to more financial crisis. Into the early 1900s and through the thrift crisis, the story was the same: size restrictions hinder banking industry performance and cause crises.
Innovative products caused the crisis. Those innovative products, it can be argued, were traded in small quantities (even though they were leveraged) and therefore were not judged to be systemic. In fact, while every large crisis is – by definition – systemic (after all, all financial institutions exist in the context of a financial system), the root cause is asymmetric information – where a shock to asset values leads investors to exit the market, absent information on the distribution of the shock.
In short, not enough was known and shared among regulatory authorities about innovative products. A council of regulators can help with the sharing part, but not if there is nothing to share. Hence, regulatory agencies need to gather and make available (to themselves) market data for innovative product areas that was not available at the time of the crisis.
The reason that regulators did not have that information, quite honestly, is equal parts cost and interest. The cost of market data on new products is prohibitive to performing research on risks to the financial system. For instance, while working with a regulatory agency in 2006-7 to research mezzanine RMBS CDOs with Intex, the astronomical cost forced us to use only part of the data package. Performance data on individual mortgages is priced similarly.
Hence, great economies could be had by requiring producers of data resources on products affecting regulated financial institutions to give the regulators a single free subscription. The marginal (additional) cost to the data providers would be slight, and the regulatory gains from doing so huge. (just perform a back-of-the-envelope audit of data costs at regulatory agencies and you will be astounded by the potential cost savings, even from merely removing duplication.)
Moreover, memorializing such a requirement in a new law is necessary because it is not just the cost, but the legal status of regulators that has prevented them from data access. Even with Intex , regulatory attorneys had to argue that the agency was a QIB (qualified institutional buyer) before they could legally buy the data. While this particular agency could make a convoluted legal argument, other regulatory agencies who could not, cannot legally buy the data even if they have sufficient budget. The industry already addresses needs for trading position and counterparty data collection and reporting similarly. For instance, DTCC counterparty reports contained the information necessary to understand CDS risk exposures – once the regulatory agencies finally thought to ask DTC for a data feed.
Such a requirement — to gather and make available to regulatory agencies (and themselves) market data for innovative product areas that was not available to regulators at the time of the crisis – would give regulatory agencies a crucial advantage over Wall Street, which is what regulators really need to do their jobs.
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: firstname.lastname@example.org; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.