“It's a Wonderful Life” On Regulatory Policy: The Real Risk

Not addressing systemic risk

Focusing on the wrong institutions may lead regulators and policy analysts to ignore the greatest risk to banks.  This second failing of regulatory and policy focus has serious implications beyond just the resources they are wasting.  Bank runs represent the source of the greatest risk that arises from the maturity mismatch.  They are far more serious systemically than any bank’s trades.  It is, after all, a bank run that threatens Bailey Building and Loan.  George tries to explain that to customers of Bailey Building and Loan.

Perhaps both policy discussions and regulatory initiatives should focus on the maturity mismatch.  Put simply, it is the greatest risk in banking and is far more likely to result in a financial crisis than any particular bank’s investment.  US policy wonks and regulators seem to have outsourced the entire issue to those negotiating the Basel III rules. 

Regulators and policy analysts should be trying to figure out how to assist banks in hedging the maturity mismatch.  US regulators seem to be doing exactly the opposite.  Remember, ultimately, it is only the ability to produce cash that saves Bailey Building and Loan.

Once one focuses on the real issue of the liquidity squeezes that create financial crises, TARP is neither the only nor the most important government program implemented during the financial crisis.  The government's Transaction Account Guarantee (TAG) as the name implies involved guaranteeing deposits.   As anyone at all familiar with American banking regulation knows, the FDIC guarantee of deposits was a primary response to bank runs during the depression.  What was different about the Transaction Account Guarantee program was it guaranteed all deposits rather than those below a limit.

A WALL STREET JOURNAL article published the day after Christmas discussed deposit guarantees. It focused on one of the issues deposit guarantees implemented during the financial crisis created.  As the article's title, “Small Banks to Depositors: Trust Us: Dec.31 Expiration of FDIC's Unlimited Guarantee Drives a Scramble to AllayCustomers' Concerns,” implies, runs remain a problem for small banks.  In fact, the primary argument that small banks make for continuing the guarantees is that they cannot compete for deposits without the guarantees.  They fear that if the guarantees are ended, they will experience runs as depositors shift their money to larger banks.

The article clearly demonstrated that maturity mismatches characteristic of banks are still the major systemic risk.  That risk is most immediate and threatening not at large banks but among small banks.  Instead of addressing that risk directly, regulators are off tilting at windmills.  Hedging and even proprietary trading do not create maturity mismatches.  In fact, when done appropriately they mitigate the risk introduced by maturity mismatches.

Probably nothing illustrates the confusion better than how one of the small banks is trying to encourage depositors not to withdraw their deposits.  The article quotes Keith Costello, chief executive of Broward Bank of Commerce. "We are telling our customers that we have a loan portfolio that has no nonperforming loans, which is a very clear statement that our bank is very solvent, very safe and very secure."  

Under mark-to-market accounting, what matters is not whether the loan is performing or not.  Market value and liquidity are what determines the solvency of an organization.  Performing loans do not necessarily meet the liquidity requirements that can be created by a run.  When a run occurs, performing loans may have to be sold at distressed prices in order to meet emergency liquidity requirements.

The systemic risk that this creates was highlighted in a WALL STREET JOURNAL article on December 30, 2012 (“Gauging the Guidance That ModelsGive the Fed”).  The article describes how the Fed uses various models of the economy and the financial system to predict the future course of the economy.  Those predictions are then used to determine what the appropriate Fed policy is.

It goes on to note the limitations of the model with the following quote: “But here is the problem: The models are deeply flawed. They failed to foresee the financial crisis in 2008 and have tended to overestimate the strength of the economy for several years.”  The article is not being at all alarmist.  As it notes, “Of course, no model or human can perfectly predict the future.” 

The problem is not that the models are less than perfect.  From the perspective of regulatory policy, the problem arises from the sources of the gaps in how they read and project the economy.   “One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works.”  This is a pretty explicit statement that their models are not a useful tool in directing regulatory policy, and that their models do not reflect the risks that can arise from misguided regulation.

It goes on to make those risks rather explicit.  “The models have formulas that predict how many pennies an investor will spend for every $1 increase in his stock-market portfolio or how much less banks might lend if interest rates go up half a percentage point. But they haven't predicted the vulnerability of banks to a financial panic or how that vulnerability affects the broader economy [emphasis added].”  In short, a principal Fed policy tool provides the Fed with information that has a big blind spot.  That blind spot relates to the greatest source of systemic risk arising from the financial system.  One can call that risk bank runs, liquidity squeezes, financial markets freezes or financial panics.  They should be the primary focus of regulation.