Guest post by Chris Whalen of Institutional Risk Analytics
"My dear sir, the Treasury order is popular with the people everywhere I have passed. But all the speculators, and those largely indebted, want more paper. The more it depreciates the easier they can pay their debts… Check the paper mania and the republic is safe and your administration must end in triumph."
President Andrew Jackson writing to President
Martin Van Buren regarding the Specie Circular
Last week the financial markets received a wake-up call courtesy of our former PruSec colleague Mike Mayo, now of Caylon, who appropriately suggested that Citigroup (NYSE:C) may be required to start recognizing the impairment of some $10 billion in deferred tax assets in its Q4 earnings. The good folks at C responded as only bank IR flaks can, saying that they did not know where Mayo came up with his estimate.
Unlike most of the inhabitants of Wall Street, who barely read the first page of earnings press releases, Mike actually reads Ks and Qs. For example, on Page 10 on the most recent Form 10-Q filed by C, you will see a fascinating discussion of the "TAX BENEFITS PRESERVATION PLAN" implemented by C managers to prevent a write-down of these icky intangibles, an accounting event that would seriously impair the capital of the Queen of the Zombie Dance Party.
Likewise on Page 21 of the last Form 10-K for C, you will see a very concise discussion of the composition of C deferred tax assets and also a good discussion of the IRS rules regarding the longevity of same. Just be glad that you are not the audit partner who must sign-off on C's 2009 annual report. Can't wait to read that document.
As IRA co-founder Chris Whalen told Gretchen Morgenson of the New York Times on Sunday regarding C: "They are hoping that a combination of bank assistance and maximizing revenue and buying time will let them survive. When I look at the whole picture, Citigroup is in the process of resolution. I continue to believe the equity is worth zero and that the company will have to go to bondholders for some kind of money to make the bank stable."
Just in case you missed our well-deserved kudos for Mike Mayo on CNBC's Fast Money on Friday, click hear. The segments starts about 4:00 into the show.
And now to our feature. In this issue of The IRA, we present the views of our friend and mentor Ed Kane of Boston College, who argues that the problem with the financial regulatory framework is not the law, regulation nor even the regulators, but rather the confluence of poorly aligned incentives and financial innovation.
THE IMPORTANCE OF MONITORING AND MITIGATING THE SAFETY-NET CONSEQUENCES OF REGULATION-INDUCED INNOVATION
Edward J. Kane
James F. Cleary Professor in Finance
October 29, 2009
With respect to any crisis, accountability for top government officials is a negative function of their "ability" to sell their own particular "account" of the time line of crisis and recovery. To a greater or lesser extent, official narratives are self-serving cover stories designed to heap credit on their authors and the institutions they lead, while shifting the blame for financial and macroeconomic turmoil into someone else's territory.
The plausibility of the key elements in a cover story is sustained by a combination of mischaracterization, distortion, and distraction. A particularly useful tool is post hoc ergo propter hoc argumentation. This kind of argument starts by associating the absence of crisis in the past with something or someone that departed the scene shortly before the crisis emerged. For example, one might argue: first, that the US didn't experience a full-fledged financial crisis until after Alan Greenspan or Paul Volcker had left the Fed; and second, that the absence of one or the other's seasoned leadership explains why the turmoil developed and why it degenerated into a disaster.
Obviously, that particular narrative would not serve the purposes of officials whose handling of financial turmoil is being questioned today. By casting them as overmatched rookies, this story offers them no credit and considerable blame. What incumbent officials want is a story that portrays them as overcoming odds as fearful as those faced by Horatius (and his brave colleagues Lartius and Herminius) at a bridge whose crossing would have allowed the most important country in the world (in their time, Rome) to be invaded by a deep depression. To avoid invidious comparisons with their predecessors, the story officials might choose could attribute the turmoil to weaknesses in the policy environment that previous officials (perhaps even Greenspan himself) might have mistakenly embraced.
The cover story that I perceive to be making the rounds in DC today concerns how large financial institutions made themselves too difficult to fail and unwind (TDFU). To evaluate this story, I propose to answer two questions. Is it reasonable to pin the blame for the crisis on the Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLBA), which abandoned the longstanding regulatory strategy of trying to keep banking, securities, and insurance firms from offering one another's signature products? Would repealing GLBA and breaking up TDFU firms in the US help to mitigate the frequency or depth of future crises? My answer to both questions is no.
The financial crisis of 2007-2009 is the product of a regulation-induced short-cutting and near elimination of private counterparty incentives to perform adequate due diligence along the chain of transactions traversed in securitizing and re-securitizing risky loans (Kane, 2009a). The GLBA did make it easier for institutions to make themselves more difficult to fail and unwind. But it did not cause due-diligence incentives to break down in lending and securitization, nor did it cause borrowers and lenders to overleverage themselves. Still, the three phenomena share a common cause. Excessive risk-taking, regulation-induced innovation, and the lobbying pressure that led to the GLBA trace to subsidies to risk-taking that are protected by the political and economic challenges of monitoring and policing the safety-net consequences of regulation-induced innovation. These challenges and the limited liability that their stockholders and counterparties enjoy make it easy for clever managers of large institutions to extract implicit subsidies to leveraged risk-taking from national safety nets (Kane, 2009b). The trick is to probe exogenous advances in information, communications, and financial-contracting technologies for opportunities to fashion products and organizational structures that book traditional business in innovative and nontransparent ways.
In the US, the de jure barriers between the banking, securities, and insurance industries that the GLBA finally eliminated had by 1999 become loophole-riddled remnants of their original selves. They provided no more protection for contemporary citizens than the scattered fragments of ancient city walls that tourists admire in ancient European cities today. In Europe, city fathers stopped maintaining these walls for good reason. Technological innovations in weaponry and ordinance prevented the benefits of repairing them from covering the costs. In a similar manner, blasts from the ever-improving artillery and munitions of regulation-induced innovation destroyed the effectiveness of Glass-Steagall and Bank Holding Company Act barriers to cross-industry operation. Fresh blasts will destroy them again if Congress decides to resurrect them.
In a world of gargantuan and footloose financial institutions, re-erecting federal barriers to cross-industry competition in the US will change the country or state in which particular risk exposures are booked, but it will not lower the danger of future crises. What it would do is to distract Congress, regulatory personnel, and the news media from addressing the need to repair the defects in supervisory incentives that fostered the short-cutting and outsourcing of due diligence at every stage of the derivatives creation and securitization process.
To fix defects in supervision, securitization systems need doses of better ethics and better incentives all along the transactions chain. This requires that financial institutions be discouraged from abusing the benefits of safety-net support and that government supervisors be made specifically accountable for delivering and pricing safety-net benefits fairly and efficiently. This can be done through changes in top officials' oaths of office, changes in the ways that they are required to measure their performance, changes in financial-institution reporting responsibilities, changes in compensation structures, and changes in the kinds of securities institutions have to issue.
I. Original Purposes and Declining Effectiveness of Exclusionary Laws
The Glass-Steagall and Bank Holding Company Acts are exclusionary laws. Their purpose is to compartmentalize the activities of differently chartered firms so as to avoid potentially crippling concentrations of risk in individual financial firms and to constrain opportunities for multiproduct firms to take advantage of naïve customers. Intuitively, the GLBA may be characterized as lowering and regularizing the cost of cross-industry operations. It removed the need to spend resources on getting around restrictions on what banks may do and on what kinds of differently chartered (i.e., "nonbanking") corporations may own a bank. Proponents of traditional compartmentalization policies had supposed that carefully restricting reciprocal entry into bank and nonbank financial activities could protect society from three kinds of potential harm (Saunders and Walter, 1994, pp. 134-135). Microeconomically, proponents sought to assure a wider range of financial-services competition by lessening opportunities for banks to engage in the practice of coercively tying sales of financial products that might be purchased from a nonbank (such as securities underwriting) to sales of a product (such as loans) in which a bank might enjoy a degree of monopoly power. Macroeconomically, proponents sought to limit opportunities for banks to expand their risk taking into activities that might destabilize their earnings sufficiently to disrupt financial markets by increasing the risk of widespread bank failures. Distributionally, proponents sought to protect taxpayers from the possibility of suddenly being handed a large bill for resolving bank insolvencies. The current crisis amply demonstrates that outsized costs can be shifted to taxpayers when institutional risk taking is effectively subsidized by mispricing and undersupervising loss exposures booked by institutions able to count on safety-net support.
The stubborn survival of compartmentalization strategies in the U.S. traced far more to the workings of money politics than to the pursuit of these societywide benefits. The GLBA passed because, as loopholes expanded and proliferated in piecemeal fashion, the political contributions that supported the compartmentalized regulatory regime dwindled and finally fell below the threshold value that opponents were prepared to offer to eliminate what was left of the scheme.
Regulatory Competition and Regulation-Induced Competition
Regulation-induced innovation accepts rules, but attacks mechanisms for enforcing them. The loopholes it opened in compartmentalization laws not only reduced their value to the sectoral interests that sponsored them, it increased the number and complexity of definitional issues that supervisory authorities had to investigate and defend. As distance-related communications and transportation costs moved closer and closer to zero, jurisdiction-changing innovations in financial contracting and organizational form rendered laws designed to compartmentalize the banking, securities and insurance industries increasingly irrelevant and difficult to enforce. In the years leading up to the passage of the GLBA, US courts became clogged with cases requiring judges to rule on whether or not an innovative contract, corporate structure, or cross-institutional delivery system had successfully moved a bank, securities firm, or insurance company beyond the prescribed reach of a particular law or regulator (see, for example, Anderson, 1993; Sivon, 1992; Turner, 1993).
As national markets became highly connected and products developed more and more potential substitutes, compartmentalization strategies quickly became riddled with loopholes. Regulators and legislatures in different jurisdictions competed eagerly with one another for regulatory domain and seemed all too willing to accept as tribute a mere fraction of the incremental value that the loopholes they create generate for the firms that use them.
Banking practices and market environments differ markedly over time and space. Much of this variation is driven by an irreconcilable tension between adjustments in regulation or supervision and loophole-seeking avoidance activity undertaken to make regulatory interference less burdensome. Regulation begets avoidance activity, and avoidance eventually begets some form of re-regulation. Regulatory adjustments, problems, and market events unfold and mutate as part of alternating sequences in which either regulation spawns new forms of avoidance (RA sequences) or the growing effectiveness of particular avoidance activities calls for innovative re-regulation (AR sequences). Adapting regulatory protocols to innovative avoidance activity is an endless task. Each and every piece of regulatory re-engineering kicks off a series of RA sequences. Inevitably, the range, size, and speed of regulation-induced innovation outpaces the vision and disciplinary powers that regulatory authorities can bring to bear. The current crisis tells us that, in recent years across the chain of adjustments by regulators and regulated institutions, risk-taking incentives became more and more dangerously misaligned with societal interests. But this process began long before GLBA was enacted.
In the face of foreign (especially European Union) regulatory competition, the ease of locating viable loopholes and the resource costs of adjudicating the permissibility of creative product-line and organizational transformations make it foolish to try to roll back the clock. A strategy of formally walling off the parts of a complex financial firm that formally enjoy safety-net support is unenforceable today. Realistically, the societal benefits compartmentalization could achieve in the 1930s have for years had to be pursued in other ways. Most other developed countries acted far earlier than the US to allow domestic and foreign banks to sell insurance and securities products and permitted either direct or indirect cross-industry ownership of bank, securities, and insurance organizations (Borio and Filosa, 1994; Hough, 1991; Posner, 2009). Rebuilding cross-industry barriers in the US will make safety-net exposures less transparent and serve foreign interest by intensifying incentives for TDFU firms to undertake activities in these countries through foreign subsidiaries.
II. Strategies That Might Reduce Safety-Net Subsidies To TDFU Institutions
It pays multinational financial conglomerates and national champion banks to make themselves harder and harder to supervise. This means that policymakers' root problem is not how to make TDFU firms smaller or less complicated, or even how to make them more transparent and easier to fail and unwind (although that would be helpful). The root problem is how to design and manage national safety nets so that they do not deliver subsidies to firms when they expand their political clout, organizational complexity, and risk taking in clever ways. This means not only improving the operation of the US safety net, but also improving the ways that the US net links up with nets operated by other countries.
Large US financial firms operate in a regime of multiple regulators. The absence of cross-country agreements for sharing resolution costs in the event of a multinational firm's insolvency encourages incentive-conflicted regulatory competition. Ambiguity about which country's taxpayers can be saddled with the bill for safety-net losses reduces accountability for supervisory and regulatory mistakes. It incentivizes regulators in different countries to compete aggressively for footloose financial-institution capital and employment. It also encourages officials to blame not themselves but foreign regulators if and when the risky business they have competed for falls into distress.
To be effective, programs of regulatory reform must address the sources of the agency costs that intensified problems in industry risk taking and in government insolvency detection and crisis management. To confront these issues squarely, Congress and the Administration must focus beyond mere adjustments in form and bureaucratic structure to force a re-evaluation of the information produced and the particular contracts under which private financial managers and government officials operate. A mitigatable source of incentive conflict in industry risk taking and loss generation is the limited liability that stockholders enjoy. The less capital they have invested in the firm, the more valuable safety-net support becomes to them and their counterparties.
Incentive conflict in government is rooted in two circumstances. First, top government officials have horizons much shorter than the taxpayers they formally serve. Second, taxpayers are not their only principals. Different principals differ in at least four important ways: in their understanding of the duties officials owe them; in their ability to influence policy decisions as they are being made; in their ability to appreciate the consequences of alternative policy decisions; and in their ability to offer rewards for bending policy in the directions they prefer. The result is that officials feel disproportionately accountable to residents of sectors that make themselves particularly well-informed and politically powerful.
Improving Incentives in the Private Sector
If they want to help safety-net managers to serve taxpayers better, Congress must task large institutions with making safety-net loss exposures in their firms easier to detect and cheaper to resolve. Detection can be improved by developing explicit metrics for measuring the value of safety-net support at individual institutions and requiring safety-net beneficiaries to use these metrics to estimate the value of their safety-net support and report this value at regular intervals to their principal supervisor.
Although still provisional, researchers have developed a number of metrics for the value of safety-net support. Carbo, Kane, and Rodriguez (2009) estimate the value of safety-net support from data on a banking organization's stock price. Baker and McArthur (2009) extract estimates from a firm's credit spread. Hart and Zingales (2009) focus on the price of credit default swaps. Huang, Zhou, and Zhu (2009) use stock price, credit spreads, and credit default swap data simultaneously. If the analytical resources of the world's central banks and largest institutions can be incentivized to attack this estimation problem on a massive scale, the confidence intervals that practitioners have to build around the various point estimates should decline rapidly in the future.
It would also be helpful to require financial firms to plan for the downside. To my knowledge, Richard Herring and Jacopo Carmassi (2009) were the first to propose that managers be required to prepare and file with their principal regulator a standby plan with which to handle their firm's bankruptcy and be obliged to test, update, and refile this plan on a regular basis. The existence of an up-to-date corporate "living will" would make the threat of putting an insolvent institution into receivership or conservatorship more credible because it would lower the costs of executing the threat. Having a benchmark winding-up scheme in place would also make it much easier for authorities both to wipe out the claims of stockholders and to negotiate haircuts for uninsured creditors as the moment of takeover approached.
Explicitly planning for liquidation or break-up is one way of making insolvencies cheaper to handle. Another way is to re-establish some form of extended liability for owners of financial-institution stock. Extended stockholder liability makes stockholders of a liquidating firm responsible for covering a layer of corporate losses beyond the value of the capital previously accumulated at the corporate level. Several now-industrialized countries (including the UK, the US and Canada) imposed extended liability on bank shares when their safety nets and private contacting environments were less well-developed.
Extended liability increases transparency, counterparty disciplinary rights, and regulatory accountability at the same time. It increases transparency by transforming movements in the stock price of publicly traded banks into a clearer signal of institutional strength or weakness. Extended liability means that a supervisor's right to liquidate an insolvent commercial or investment bank would carry with it a right to collect specified amounts of additional funds from the personal or corporate assets of every stockholder. As compared to limited-liability shareholding, deterrency is enhanced by stockholders' duty to pony up additional funds if (but only if) managers and regulators allow the bank to become so insolvent that it passes into liquidation. Stock markets would imbed the value of this contingency into the price of each TDFU firm's shares and traders could fashion derivative instruments that capture various tranches of the loss exposure it entails. The value of the contingency would be negligible for institutions that were performing well and adequately supporting their risk with paid-in corporate capital. However, the insurer's claim on off-balance-sheet stockholder resources would become increasingly valuable whenever a TDFU firm began to take poorly supported risks or to slide into financial distress. By increasing the sensitivity of TDFU stock prices to changes in earning power and earnings volatility, extended liability would encourage information-revealing stockholder doubt about the viability of troubled institutions in advance of their final slide into complete economic insolvency. Because doubts would emerge gradually, these "runs" on an institution's stock would be far less catastrophic than the sudden meltdowns that inattentive regulators allowed Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers to experience in 2008.
A sustained sell-off by worried stockholders would increase the quality of counterparty and regulatory supervision by helping safety-net managers to identify institutions that deserve increased supervisory attention long before the enterprise-contributed capital of these institutions could become exhausted. The idea is to create a pool of contingent private capital that would be drawn inescapably onto an institution's balance sheet when and as it firsts falls into distress. Mark Flannery's proposal for contingent capital certificates (2009) would do this very well if an appropriate market-based trigger for forcing the debt-to-equity conversions can be found. Sharp declines in the price of a financial institution's stock could reinforce regulator-initiated triggers if large financial firms were required to issue extended-liability stock.
Improving Incentives in Government
Requiring private institutions to prepare a regulator-certified unwinding plan and to estimate the value of their safety-net support would sharpen the missions of micro- and macro-prudential regulators. Besides verifying estimates of the value of safety-net support supplied by institutions under their purview, regulators could be further tasked with establishing, publicizing, and testing periodically a benchmark market-mimicking scheme for insolvency management.
While authorities would be free to deviate from their benchmark plan in an actual crisis, they would be obliged to explain why they are doing so. To help them to put crisis-management plans into operation more promptly, I would also require them to aggregate the estimates of safety-net subsidies that individual institutions produce. Each micro-prudential regulator would consolidate these estimates in ways that would track over time the aggregate value of safety-net benefits for firms they supervise. I would ask the Treasury, the Fed, the Office of the Comptroller, the Securities and Exchange Commission, the FDIC, credit-union regulators, and the Office of Thrift Supervision (if it survives) to use these estimates and other relevant data to construct independent estimates of the evolving value of safety-net subsidies to the financial sector as a whole.
Obviously, these reforms would make the jobs of top regulators more difficult. For this reason, Congress would be well advised to raise the salaries of these officials. However, to lengthen the horizons of safety-net managers, the raise should be as deferred compensation that would have to be forfeited if a crisis occurred within three or five years of their leaving office. This would have the further benefit of making new appointees more cognizant of unresolved problems that his or her predecessor might be leaving behind. To discourage elected officials from trying to win special treatment for firms that contribute money to their campaigns, it would be useful to require that regulatory personnel report promptly and fully on interactions with elected officials that occur outside the public eye.
Congress could further sharpen monitoring and loss-control responsibilities by establishing schemes in which private and governmental monitors could hold one another financially responsible for the quality of their work. For example, Congress has proposed that safety-net managers be required to move trading in over-the-counter derivatives and other securities to clearinghouses or exchanges when and as their volume becomes large enough to pose material safety-net consequences. This duty would be strengthened if deposit insurers were made to reinsure with private parties the coverage they provide to OTC market makers in derivative instruments. This could be done either by writing credit default swaps or by transacting directly in reinsurance markets.
III. Summary Implications
It is important to recognize that the current financial crisis is rooted in the economic and political difficulties of monitoring and controlling the production and distribution of safety-net subsidies. Regulation-induced innovation by financial firms seeks relentlessly to outstrip the monitoring technology and the administrative focus that supervisory personnel use in controlling institutional risk-taking. Exclusionary laws and rigid capital regulation encourage rather than control regulatory arbitrage over time.
To reduce the threat of future crises, the pressing task is not to rework bureaucratic patterns of financial regulation, but to repair defects in the incentive structure under which private and government supervisors manage a nation's financial safety net. The mission of these managers 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 (Kane, 2001). 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. 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.
Redesigning regulatory schemes and relocating bureaucratic responsibilities for different features of the safety net will not by itself do much to slow processes of regulatory arbitrage. This can only be done by making financial-institution managers and federal regulators accountable for estimating and controlling in a timely manner the safety-net consequences of transformative financial contracts and institutional structures.
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