The credit crunch of 2007-2008 shares many similarities in terms of causes with the Depression Era and wave of bank failures which took place in the United States in the 1920’s. It would appear that legislative responses made by the government of President F.D. Roosevelt are finding resonance with today’s legis-lators, in particular a reintroduction of an updated form of the Glass-Steagall Act of 1933. This article suggests that legislative intervention in financial markets may be premature and counterproductive; the state, acting through regulators, has a poor record in matters of supervision and oversight.
The causes of the banking crises of the 1920’s in the United States were numerous and despite the passing of time, remain contentious amongst academics, legislators and policy makers. Keynesians tend to argue that lower aggregate expenditure at that time, exacerbated by sharp retrenchment by the Federal Reserve (the Fed) at precisely the time when it should have been stepping in to make up for a collapse in demand, dragged the economy down to a lower equilibrium, resulting in turn in unemployment and a further driving down of demand within the economy. This constituted a vicious circle which, at its most severe point, led to an unemployment rate of 25%, which was even higher in some agriculture-oriented states. At the international level there was a corresponding collapse in global trade, which again negatively impacted upon the domestic US economy. Historians of this era tend to locate the start of the Depression in October 29, 1929 with the collapse in stock market prices. However, in addition to Federal Reserve inaction there were other factors at play in the lead-up to the Depression. These included a rapid expansion of credit in the 1920’s and the overreaction to this by the Fed in the 1930’s, and the consequent credit crunch. During this period prudent lending criteria gave way to more scientific methods for evaluating risk. Regarding the former, lenders focused upon the so-called ‘3 C’s’ of lending: character (the personal characteristics, honesty, previous reliability of the borrower), capacity (the borrower’s ability to service interest payments from existing income, and the stability of that income over the life of the loan) and capital (the amount which the borrower was able to contribute to the venture from his or her own resources). The new scientific methods focused instead upon a quantitative analysis of the borrower’s balance sheet and profit and loss account, prioritised over whether or not the borrower was known to the lender or had a track record of successfully servicing previous loans. This problem of over-supply of credit was exacerbated by ‘over-banking’, or the provision of too many licenses to financial institutions at state level. States tended to stipulate low capital requirements and deposit safety nets which subsidised entry into the market, and protected incompetent bankers. The banking system was also fragmented at state level, undercapitalised, and over-burdened with risk resulting from previous imprudent lending decisions.
With regard to investment business during the 1920’s, commercial banks conducted themselves through two broad forms of organisation. First, some banks chose to conduct securities business, including underwriting of new issues, through internal securities departments. Second, other banks elected to establish legally separate affiliates with their own boards of directors. Academics who have studied these alter-native structures have discovered that the former attracted higher risk premiums in their activities as sophisticated investors discounted the greater likelihood of conflicts of interest arising when lending and underwriting were provided within the same organisation. In other words, if there was a possibi-lity that a bank had a vested interest, for example it was providing underwriting services in respect of a new share issue in respect of which it was also advising its private clients, then investors would either refrain from participating in the issue, or would seek independent advice, or would simply require a greater premium for taking on this risk.
A monetarist perspective on the chaos.
Monetarists including Milton Friedman have contended that the Depression and associated wave of bank failures were principally a consequence of policy errors by the Fed. Speci-fically, in response to the earlier over-supply of credit in the 1920’s, the Fed embarked upon a steep monetary contraction in the few years following 1929. Friedman has suggested that whilst the stock market crash of 1929 would have triggered a recession, this should have been a ‘run of the mill’ downturn: it was the decision of the Fed to tighten the money supply at exactly the wrong time which turned a recession into a depression. Friedman noted how large banks were allowed to fail, producing a panic which turned into runs on banks, which were already facing borrower defaults on a scale they were undercapitalised to deal with. If the Fed had made emergency liquidity available to the banks and maintained the stock of money in circulation, the Depression may have been avoided. Instead, Secretary Mellon of the Fed saw a moral dimension to allowing banks to fail. His view was that the weak would be driven out, and depositors would have to work harder to escape from their difficulties. In other words, the crisis would have morally beneficial consequences. A final major school of thought regarding causes of the Depression is the Austrian School. This line of economic reasoning shares much of the monetarist analysis but with the added dimension of locating economic crises not in mathematical methodologies alone, although of course these are useful tools, but instead by perceiving economic cycles as principally the outcome of human activities and choices which cannot, by definition, be predicted within binding and universal statistical or empirical frameworks.
A legislative response: the importance of being seen to be doing something.
The principal legislative response to the Depression and bank failures was the Glass-Steagall Act of 1933. President Roosevelt had concluded that the failures specifically, and the wider economic collapse more generally, had been caused in part by a chaotic regulatory framework, particularly the phenomenon of overbanking which had predominated in the 1920’s. The main consequence of the Act was a formal division between commercial banking and investment banking: a firewall was to be constructed between the two activities, which prohibited funds from the former being used in the activities of the latter. Legislators were concerned that banks had been using depositor funds to purchase speculative assets contrary to the prudent criteria of the depositors themselves who had not even consented to their funds being used in this way. At first appearance Glass-Steagall appeared to have been an effective and targeted piece of legislation. However, several academics, including Kroszner and Rajan (1997), have contended that the Act was in fact unnecessary, being premised upon an assumption that sophisticated investors were not able to work out for themselves the risk of a conflict of interest and either withdraw their funds or demand a higher risk premium. It had been these higher demands by depo-sitors and investors which led banks to demerge their activities and provide investment advice through separately incorporated affiliates in the late 1920’s: Glass-Steagall was intended to convey the impression that ‘something was being done’ within the political arena, when the reality was that participants in the marketplace were already well aware of the possibility of the sort of conflicts of interest which the Act was aimed at curtailing.
2007-2008: banking system fragility revisited
The causes of the 2007-2008 credit crunch are similar to those which brought about the Depression in the US in the 1920’s. For example it is now widely conceded by policy makers, including those in today’s Fed, that credit had been kept cheap for too long. There also existed speculative bubbles in asset prices of which most policy makers were aware. It has been suggested that politicians colluded in the creation of this bubble and actively encouraged it; if voters believed that their wealth was increasing, they would be more willing to borrow, to spend, and to look favourably upon those very politicians, which had created this fortuitous state of affairs. It is perhaps a paradox that the US President who eventually repealed Glass-Steagall was not a ‘freewheeling free market’ Republican, but instead a Democrat President, Bill Clinton. One of the reasons for the repeal was a belief that banking had become so globalised, and the services provided so diverse and overlapping, that it no longer made practical sense to maintain the artificial division stipulated by Glass-Steagall. The destination of much of this cheap credit was the sub-prime housing market; loans were made to individuals who lacked any of the ‘3 C’s’ of lending which characterised prudent banking in the US in the 1920’s. Stability of income was not an issue, the overriding assumption made by lenders that the collateral underpinning the loan transaction, the property itself, would never fall in value, at least not in the medium term. These loans were subsequently shifted ‘off balance sheet’ via the process of securitisation. Mortgage payments were bundled up and sold to investors in the form of bonds (mortgage-backed securities) issued by special purpose vehicles (shell companies with legal identities separate from the banks themselves). Ratings agencies failed to appreciate the risk implicit in these bonds, making the same assumption as the original lenders as to the value stability of the underlying collateral. These bonds were not, as urban myth now suggests, toxic at the time of issue; bad loans had of course been ‘mixed’ with good ones but the overall securitised packages were largely sound and less risky than now being suggested, but more risky than was thought at the time by either the ratings agencies or investors. The bonds only became toxic when borrowers started losing their jobs and then their homes, creating an oversupply of properties, which in turn drove down prices. As financial institutions came to fear which among their number were holding undisclosed toxic assets, so they became unwilling to lend to each other. Interbank lending at this time witnessed interest rates peak and then plateau as banks finally refuse to lend to each other at all. Undercapitalised banks soon ran out of capital, now denied access to the traditional source from which they could replenish it.
State response: a giant must tread carefully.
The immediate response of governments to the crisis was to inject liquidity into the interbank market, principally through open market purchases of securities, combined with the taking of majority shareholdings in distressed financial institutions. Banks were instructed to recapitalise their balance sheets either by taking in more deposits, by retaining earnings, by seeking out strategic investments from sovereign wealth funds, or by share issues. But at the same time politicians, concerned about the wider economic recession, demanded that they increase lending to small and medium size enterprises: in other words, to use the same capital twice and in contradictory ways, simply put. The approach of legislators to the credit crunch appears to comprise a three-pronged strategy. First, banks will be forced to hold more of their capital in risk-free assets. In this way the prolife-ration of leveraging which took place prior to the crunch and which some policy makers contend exacerbated it, will be reduced or at least calmed. Counter-cyclical buffers are to be estab-lished: capital retained during good times, which can then be used during market downturns. Second, a newer updated version of Glass-Steagall will be reintroduced; banks will be legally obliged to separate off the deposit taking role from their investment banking activities, sometimes erroneously and derogatively termed ‘casino banking’. Third, regulators will have increased powers of oversight and invest-igation, and will be tasked with being more proactive than was previously the case. The implicit rationale seems to be that free and unregulated markets brought the global banking system to its present parlous position, and that the state should actively intervene to prevent its reoccurrence. Each of these elements should appeal to those who say that ‘something must be done’, as was said by politicians during the 1920’s Depression, but each may have unintended and negative consequences.
Capital adequacy rules: making specific provision against unquantifiable risk?
Basle III, the latest set of recommendations made by the Basle Committee intended to stabilise the international banking system, harmonize standards of regulation, and buttress banks’ abilities to withstand future shocks, has largely been constructed upon the previous attempt at achieving these goals, Basle II. The recommendations continue the previous preoccupation with weighting of types of risk, and the allocation of capital against it. In this regard it suffers from the previous failing to acknowledge that risk is not a static phenomenon: just as toxic assets did not start life as toxic but became so when the property market collapsed, all assets, including sovereign bonds, constantly change their characteristics as markets, economics, and politics around them change. Compliance costs, audit, and regulatory intrusiveness presents a potentially heavy burden to an industry which is slowly emerging from the chaos which it itself helped bring about. Basle III also stipulates two conservative, again potentially burdensome, liquidity buffer requirements for financial institutions. The liquidity coverage ratio is aimed at ensuring that banks have sufficient high quality liquid assets such as gilts and treasuries, to withstand a thirty day panic, run, or exogenous shock. The presently evolving net stable funding ratio is intended to reduce funding mismatches of the variety which broke a number of large financial institutions during the credit crunch of 20007-2008 as a consequence of over-reliance upon short-term borrowing in the interbank market. Neither ratio will prevent a bank failure: instead both may result in banks bleeding to death (at the expense of stakeholders’ funds) over a longer time period than might otherwise have been the case.
In the context of the Basle III enhanced capital adequacy rules, these may result in the sort of regulatory arbitrage, which characterised Basle I and II. To work, the policy relies upon an accurate measurement of risk but since the financial industry is constantly creating new products and services, any broad or even narrow risk clas-sifications will always have to be taken with a ‘pinch of salt’. How can capital, whether in terms of share capital or depositors’ funds, be accurately allocated against classes of risk which themselves are incapable of accurate measurement? The requirement may also adver-sely affect borrowers, particularly small to medium size enterprises upon which economic activity depends. If a greater part of capital is tied up according to new statutory rules, banks will be forced to ‘sweat’ their reduced resource through a mix of higher marginal interest rates, facility fees, and greater collateral for loans. As with Glass Steagall, this new policy implicitly assumes that investors are unable to gauge risk or to discover for themselves the trading activity of financial institutions in which they invest. The reality is that owners of the overwhelming shares in banks are institutional investors such as pension funds and sovereign wealth funds; they have the power to demand information and to limit or refrain from involvement or investment entirely should they take the view that a financial institution is being unnecessarily and dangerously risk-hungry. These investors, just as the investors of the 1920’s, are not in need of ‘protection’ by the state, utilising taxpayers’ funds to bail them out when losses result from their own poor decision-making. Such a costly policy has recently been characterised as the privatisation of profits, and the socialisation of losses, generating hostility from pressure groups, the media, and society as a whole.
Glass-Steagall is dead: long live Glass Steagall.
The reintroduction of a form of Glass-Steagall may have the unintended consequence of reducing financial innovation in the global capital markets. During the recent deluge of criticism of banks there has developed a perception that complex financial instruments such as derivatives and securitised products are inherently destabilising, opaque in terms of risk, and tend to over-leverage the international financial system. These criticisms may in part be fair, but one of the principal functions of these products is to redistribute risk from those who do not want it, such as commodity producers or processors or companies trading in different currencies, to those willing to take it on in return for a payment, a premium. Risk redistribution is a fundamental aspect of financial innovation and its potential for improving the lot of developing economies should not be underestimated. For example, securitisation enables third world producers to ‘sell’ risk across geographical borders, piercing the ‘sovereign ceiling’ in the process. It also enables provi-ders of insurance, for example along the San Andreas Fault, to bundle up part of their (earthquake) risk and sell it to those who are willing to bear it, in the form of Catastrophe bonds. The conduct of regulators during the recent credit crisis was poor; they did not lack powers to prevent it, but instead failed to exercise these powers effectively. The principal problem with regulators is that they have nothing to win or lose from their decisions or omissions: they are not true stakeholders and accordingly have no incentive to ‘keep an eye on the shop’. Whilst traders and financial engineers across the global financial sector have lost their jobs in their hundreds of thousands the regulators, having confessed to their errors, their omissions to act, and their failures to see the warning signs of the looming credit crunch (for example, the drifting up of rates in the interbank market), have remained largely immune from justifiable political or public opprobrium. Indeed, many regulators have seen increases in staffing levels and, paradoxically, a continuance of bonuses. At best regulators may be criticised for having power but without responsibility or social (as opposed to political) accountability; to extend their already adequate statutory weaponry would appear unnecessary.
Restoring a battered reputation.
In terms of marketing and communication strategies, financial institutions now need to prioritise transparency, not necessarily with regulators but instead with other financial institutions (in the interbank market), institutional investors, and ratings agencies. The principal reason for the drying-up of interbank lending during the credit crunch was lack of trust; despite governmental demands for greater transparency, the location of so-called toxic assets still remains elusive, weighing down on the cost of capital supplied across the sector. Banks need to be more transparent, utilising tried and tested techniques such as rolling road shows to institutional investors, as part of this new dialogue. There also needs to be much greater communication with stakeholders through the medium of the internet; to disclose the existing cost of capital on a regular basis can only enhance investor trust, lowering the cost as a consequence, ceteris paribus. It will also give a valuable liquidity signal to regulators, presaging imminent crises. If the state continues pouring taxpayer (bail-out) funds into an environment where opacity persists, it will not encourage openness; after all, if banks can receive funding anyway, then why should they be transparent? In this regard government provision of liquidity has the perverse effect of delaying a market-led recovery based upon mutual trust between financial institutions. Problem loans could also be transferred to separate (consolidated) vehicles, and graded according to riskiness (for example, whether there has been default in interest payment for three months, six months, or whether there has been a total default on principal); dedicated workout specialists should be allocated to the task of improving this part of the bank’s business. Again, this degree of transparency and proactivity will be significant step along the road to restoring trust. The justified charge of greed also needs to be addressed by making deliberation processes of remuneration committees publically available, and ensuring that such committees are more balanced in their composition between ‘insiders’ and ‘outsiders’. Instead of the awarding of bonuses which have pre-
viously not been adequately related to performance, reward should only be given for promotion of organic growth within banks, and not for bringing about short-term blips in share prices. Contracts should be reviewed annually against rigorous performance targets. There is also nothing clever about expan-ding a bank by acquisition: stakeholders should have enhanced advance voting rights on deals which significantly expand the size of a business, and its debts. Lastly, stakeholders need to be more empowered through statute, for example in terms of enhanced voting rights, ability to demand ad hoc information, and to recall the board at short notice, but must also shoulder much of the blame for what happened during the recent credit crunch. As owners of the banks in which they invested, they failed in discharging their oversight responsibilities. If governments underwrite the existing banking system, premised on the mistaken belief that some banks are just ‘too big to fail’, then stakeholders will have little reason to exercise due diligence or supervision: this is the moral hazard argument writ large. They should also take a greater role in appointment of senior personnel via involvement in appointments committees. Regarding the issue of enhanced powers for regulators this should be resisted by banks and stakeholders alike. The state, when acting through regulators, has a poor record in matters of supervision, and invariably its own political agenda to pursue. Recent criticism of the banking industry has been a useful distraction from the real under-lying problems of sovereign debt and state profligacy which developed in the years preceding the recent crisis; markets are at their most creative and dynamic when state intervention is kept to a minimum and stakeholder activism and supervision, and acceptance of res-ponsibility and blame, predominates.
About the author
Simon D. Norton is a Lecturer in the Law and Practice relating to Banking and Capital Markets at Cardiff Business School, Cardiff University. He has published in the areas of corporate governance, securitisation, and the role of the state in tax reform. Prior to taking up his present academic position he worked in the swaps division of a major
Japanese finance house. His current research includes reform of the global financial system with reference to Basle III, and the impact of lending activities of financial institutions upon the natural environment, with particular reference to the Equator Principles.
1. Kroszner, R.S. and Rajan, R.G. (1997). Organization structure and credibility: Evidence from commercial bank securities activities before the Glass-Steagall Act. Journal of Monetary Economics 39: 475-516.