All the Regulation in the World Won’t Stop the Next Crash

During a recent chat with staff and clients at Vested’s New York headquarters, the subject of financial regulation came up more than once. It was natural enough under the circumstances. The gathering occurred on the one-year anniversary of Silicon Valley Bank’s failure. Some present expressed hope that more vigilant and stricter regulation could prevent future such failures and more important, prevent future financial panics and crashes. Others were more skeptical. This month’s essay expands on that conversation.

Here are the three principal conclusions: 

1) It is in the nature of finance that it swings from unsustainable highs to frightening lows.

2) The only regulation that could significantly smooth out such swings would make banking entirely unprofitable and steal from the economy the great spur to growth that finance provides.

3) A best defense against huge losses, such as markets suffered in 2008-09, would come less from heavy regulation than from the application of prudent banking practice and that regulation perversely may discourage such practice.

The adventure of the Silicon Valley Bank (SVB) is instructive. It failed for three reasons, two of which regulation all but ignored and one of which it actually encouraged. SVB had a remarkably un-diversified deposit base. It was concentrated on large depositors in a narrow range of businesses and spread over a small geographic area. SVB also had a less than well diversified asset base, heavily skewed toward holdings of U.S. treasury bonds. Regulators never voiced an opinion on the lack of deposit or asset diversification, though prudent banking practice would have advised heavily against either. Meanwhile, regulators, clearly obsessed with credit risk, positively encouraged the heavy emphasis on treasury bonds by giving those holdings a special place in the regulatory structure. Though treasuries are safe credits, default is not the only form of risk. That became clear when the Federal Reserve (Fed) raised interest rates to fight inflation, and SVB’s treasury holdings suffered huge paper losses. Once the close circle of depositors found out about those losses they ran to withdraw their deposits, forcing the bank to sell assets and suffer realized losses not just paper ones.

These particulars bring out much of the more general problem with an over-reliance on regulation. One is that the rules, as with everything legal, tend to deal with the catastrophe that occasioned their writing, like generals always fighting the last war. The crash of 2008-09 had to do with poor credit quality, so the rules written after it (in the Dodd-Frank financial reform legislation) took that focus. They all but ignored issues such as diversification and the interest rate risk that brought down SVB. But that is not all. Even if the rules could cover several kinds of risks, they could not keep up with how incredibly adaptable finance is. Take the present pressure regulators place on banks to avoid credit risks. Banks in response have curtailed lending to riskier credits. But because risky borrowers still want funds and will pay relatively high rates to get them, new institutions and practices have arisen to fill the gap left by the constrained banks. In this switch, a so-called “shadow banking system” has taken considerable business from conventional banks, especially smaller regional banks. The system has the same risk. It is just that its epicenter has moved.

Similarly, the regulations put in place after the 2008-09 crisis in the Dodd-Frank financial reform legislation have a focus on real estate, which lay at the center of that crisis. The banks accordingly are loath to extend themselves into this area. But they also want profits and so have turned to high return so-called leveraged loans to riskier corporate borrowers. These are no less risky than real estate, but regulators are not focused on them because they had no rale in the 2008-09 crisis. Depending on how one measures, these so-called leverage loans have grown some 7-10 percent a year since the financial reform legislation revamped financial regulation and bank incentives. Today, such risky lending exceeds $3.5 trillion. Again, risks have simply shifted, not disappeared.

Nor can regulations effectively stop the tendency for the financial system to go to extremes. This problem develops because past lending successes, presumably in good economic times, increase flows of profits to financial firms with which they can enlarge the capital base and accordingly extend more loans and investments. As that lending increases profits and likely also raises the value of financial assets, this capital base rises still higher, encouraging still more lending. The system effectively builds on itself. Indeed, the rising base all but impels financial managers to lend more and so take on more risk. If prudence holds bankers back, they can come under pressure from shareholders for missing profit opportunities. Indeed, the regulations, because they claim to have imposed safeguards, make this shareholder pressure to dispense with prudence that much more intense. Those complaining could say that the prudence is excessive or that risk is contained because the firm is fully compliant with all regulations. The person voicing prudence could lose his or her job.  As Citibank’s CEO said at the time of the 2008-09 crash, “as long as the music is playing you must get up to dance.” 

On a still more fundamental level is the inherent risk in the business of finance. The great complexities of modern finance can obscure this underlying nature, but it is nonetheless unavoidable. To see why, consider the two basic functions banks and finance generally have in the economy: 1) They offer depository service to businesses and individuals in support essential day-to-day payments.  2) To bear the cost of that function and turn a profit, they lend out a large portion of those deposits at interest to individuals and businesses.  In this they become an essential asset to economic expansion and development.

The process creates prosperity, but a simple illustration can demonstrate how much risk is involved. Say, for example, administration and interest paid on deposits cost banks 5 percent of the total amount involved. If they lend all the money out at interest and charge the borrowers, say 8 percent, they would enjoy a margin of three percentage points over cost. If any more than 3 percent of their borrowers failed to pay, they would struggle to meet obligations to their depositors. The 8 percent capital requirement set by the Bank for International Settlements (BIS) in Basel, Switzerland would protect them in such an event. But even a minor recession could easily create troubled loans well in excess of 8.0 percent, and a major recession could drive up the problem loans to well over 10-20 percent. The banks, in other words, are always at risk of collapse. Much higher capital requirements would be safer, but they also would make banking less than profitable and at the same time, deny economies financing for ventures that ultimately drive growth and prosperity, which no doubt is why BIS and the American regulators go no higher. 

Of course, modern finance is much more complex and sophisticated than this example. Banks have loan loss provisions on top of the capital demanded by custom and regulations. Deposit flows also make the calculations more complex than portrayed here. Loan covenants can protect the flows of repayments even if borrowers go bankrupt. Other institutions have different practices. Investment banks help larger firms borrow by selling their bond issues to other investors. Private equity and venture capital firms use their own funds to support new ventures and also enhance their ability to extend more to business by themselves borrowing from banks and elsewhere in the financial system. Complex practices and even more complex financial instruments support these structures. But at base, all behave much like the above, admittedly simplistic picture of the banks. The nature of all this business creates and existential risks for them, even if only a relatively small portion of their borrowers fail.

It is a complex business that demands a balance of risk and safety. Regulations certainly have a role to play, but they cannot be the only answer. The point here is not to argue for or against regulations. Rather it is to point out that the quest for safety can run counter to the economy’s need to take risk and so gather its full potential. The point here is also to highlight how regulations cannot offer even limited safety and certainly not the security they claim for themselves. Indeed, in some ways they may thwart more effective ways to moderate finance’s boom-bust nature.

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