Most of the leverage built by financial firms between 2004 and 2007 was either done through regulatory arbitrage or was the result of lax regulation. Commercial banks added over $700 billion to their off-balance-sheet leverage by providing under-capitalised guarantees to structured purpose vehicles (conduits) that themselves had hardly any capital. Regulators allowed this, even though a similar leverage game brought down Enron. Once the Securities Exchange Commission (SEC) lifted its net capitalisation rule in 2004, investment banks ramped up their exposure to sub-prime mortgages. In no time these banks drove up their debt-to-equity ratios from 22:1 to 33:1.
Markets could be deemed inefficient in all this if they had the relevant information, but made a mistake in not using it. But many activities through which the financial sector built up leverage, such as conduits and over-the-counter exposures, were not visible to investors. In contrast, these activities wereor should have beenvisible to regulators.
The low price of credit risk of financials until 2007, coinciding with the rising path of their leverage, implied that the hidden trajectory of expected taxpayer losses was exploding. Put simply, profits were being privatised and risks socialised. It was regulation, not markets, that allowed this to happen.
Regulation is supposed to fix market failures. But regulation also reduces market discipline. Thus, when regulators deem a bank well-capitalised, the onus is on regulators that this be right. Markets may not have the incentive to gather this information, nor possess the details of regulatory supervision that led to such an assessment. Conversely, when regulation allows itself to be arbitraged, the financial sector becomes more opaque, exposing markets to unexpected outcomes.
When such adverse outcomes materialised in the first eight months of 2007, market learned fairly quickly. By then, Countrywide had fallen, Bear Stearns had to bail out hedge funds invested in the US subprime assets, and indices tracking such assets were declining day by day. When BNP Paribas declared on August 8 that there was no market for subprime assets in its hedge funds, it became clear to investors that the entire financial sector had made a one-way bet on the economy. Investors realised that the seemingly well-capitalised financial institutions were in fact significantly more levered, no matter what their regulatory capitals looked like.
Since that day of rude awakening, markets have given hell to weak players and rewarded strong ones. Financials with the worst balance sheets have fallen, and the next in line have been punished severely. In fact, only the relatively stringent stress tests conducted earlier this year have restored markets confidence in regulatory endorsements of financial stability.
Alan Greenspan, the former Federal Reserve chairman, acknowledged that he made a mistake in trusting that free markets could regulate themselves. The underlying assumption is itself questionable. The financial sectorso heavily regulated and partly guaranteed since 1930sis not exactly a free market, is it
Recently, the G20 also blamed the reckless excesses of the banking sector for the mess we are in. While there might be a grain of truth to this, there is also a sense in which these excesses are consistent with the efficiency of markets. If government guarantees are offered gratis to the private sector, competition leads to their fullest exploitation. If regulators legitimise the shadow banking world, then profit-maximising bankers avoid capital requirements through off-balance-sheet transactions. If money is being thrown at insolvent firms without any strings attached, these firms procrastinate on capital issuances and continue paying bonuses and dividends.
Hence, compared to 1930s, the current job of rewriting regulation is tougher. We need to address regulatory failures in addition to market failures. Will we restrict the scope of government-sponsored enterprises Will we stop rebating deposit insurance premiums to banks in good times Will we bring capital requirements of off-balance-sheet activities in line with on-balance-sheet ones Will central bank lines of credit be made contingent on solvency criteria, like the private lines of credit And will regulatory supervision be held accountable by requiring that they produce public reports on the strengths and weaknesses of banks they invigilate
To attribute this crisis to a failure of efficient markets is to miss its most important lesson: That poor regulation, with its incentive and information distortions, can also destabilise markets.
The author is a professor of finance at New York Universitys Stern School of Business