The Howling Hole in Treasury Secretary Paulson’s Proposals for Regulatory Reform

US Treasury Secretary Henry Paulson proposes that the Federal Reserve be given powers it does not have today, to demand information from/inspect the books of /impose constraints on the behaviour of – the primary dealer-brokers (that is, investment banks), for as long as the Fed is providing these investment banks with money through open market operations (via the Term Securities Lending Facility (TSLF) ) or at the Fed discount window (through the Primary Dealer Credit Facility(PDCF)). Once the investment banks stop suckling at the Federal Reserve nipple, however, the new supervisory/regulatory role of the Fed vis-a-vis the investment banks would shrivel and the ancien regime would re-emerge more or less intact.

This proposal is a recipe for increasing financial instability. The times when the Fed comes to the rescue of stricken investment banks is when the bad investments made during the most recent period of financial excess come home to roost. These are the times that the fundamental worsening in the financial prospects of this sector is amplified by liquidity crises and crunches. Systemically important financial markets (like the interbank market, the ABCP markets, other ABS markets and wholesale capital markets across the board) dry up as lack of trust and confidence, fear and panic replace euphoria, hubris, over-confidence and master-of-the-universe-syndrome. Under those circumstances there is never any objection from the afflicted private financial enterprises to the Fed asking awkward questions and sticking its nose in the books, as long as the central bank is willing to take assets off their books at prices well above what could be realised in an impaired, inefficient, free market. Beggars can’t be choosers.

But the information gathered by the Fed during the bad times in this way is of no use whatsoever, unless it can be used to restrain the behaviour of the investment banks and of other highly leveraged financial institutions (including regular, deposit-taking commercial banks) over and above what has been possible in the past.

Financial crashes and crises are prepared and nurtured during the financial booms that precede them. Unless a way can be found to restrain financial booms, limiting the damage caused by financial busts will have the highly undesirable side effect of increasing the attractiveness to the private financial sector of engaging in behaviour likely to result in even more extreme booms and busts in the future.

This is true when the Fed extends its lender of last resort (LLR) role to a new set of counterparties, as it did when it created the PDCF for the investment banks. This is also true when the Fed extends it market maker of last resort (MMLR) role to a new set of counterparties, as it did when it created the TSLF for primary dealers (investment banks). There has to be something to counteract the perverse effect of increasing the incentives for excessive risk taking by highly leveraged financial institutions (HLFI) inherent in the expansion of the Fed’s LLR and MMLR role, even if the securities that are accepted as collateral at the discount window or in OMOs (or bought outright, in the not too distant future) are priced punitively.

As Avinash Persaud notes in his recent blog: ” …the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.” This is the singular weakness in all proposals for expanding the role of the LLR (either through widening the scope of the eligible collateral and of the eligible counterparties or for extending the maturities at which LLR operations are conducted).

The importance of this point cannot be over-emphasized: asymmetric regulation during bad times, in exchange for financial largesse by the Fed, as proposed by Treasury Secretary Paulson, is a recipe for exacerbating the financial excesses that occur during cyclical booms.

Proposals for expanding the role of the central bank to include that of market maker of last resort, as advocated by Anne Sibert and myself (see also S&B) ) , suffer from the same asymmetry. Our market maker of last resort is a buyer of last resort of illiquid mortgage backed-securities (MBS) during bad times, when markets have become disorderly and illiquid. It is not complemented by the Fed as seller of last resort of MBS in liquid markets during good times. The problem is that, during good times, markets are orderly and liquid. However, even orderly and liquid markets can be driven by bubbles rather than just by fundamentals.

Disorderly and illiquid markets can be identified a lot more easily than orderly and liquid (that is, technically efficient) markets that are afflicted by speculative bubbles and are therefore socially inefficient, because they provide the wrong price signals to private and public agents. In addition, the ordinary instruments of monetary policy (increases in the policy rate) are poor instruments for dampening let alone puncturing asset bubbles: blunt and ineffective if used modestly; blunt and damaging the wrong parts of the economy when used aggressively.

Clearly, the liquidity management instruments that can be effective during a liquidity crunch (expanding the set of eligible collateral, counterparties and maturities in OMOs and at the discount window) are by definition powerless when markets are liquid, orderly and technically efficient: increases in the supply if inside assets (financial instruments that are in zero net supply) in orderly, liquid and efficient markets will not have any effect.

What is to be done? Clearly, the prospect of the Fed going through the books of individual investment banks and other HLFIs during goods times and bad times is not a happy one. Central planning was tried. It failed because it was not incentive-compatible. Hayek was right. So we don’t want the Fed (or anyone else) to micromanage the business strategy and investment decisions of investment banks or other HLFIs.

The only alternative is to fall back on the broadest possible credit controls, based on simple rules of thumb. Let me give a few examples:

  1. Regulatory capital adequacy requirements should apply to all highly leveraged financial institutions. Just to get around the obvious wheeze of the treasury department of a bicycle manufacturer being turned into a de-facto financial intermediary, the capital adequacy requirements should be applied to any highly leveraged institutions, whatever its label. This will capture commercial banks, investment banks, hedge funds, assorted investment funds, private equity funds – the lot. Whether you are a highly leveraged institution (HLI) depends on whether you pass the HLI ‘duck test’, if the economic substance of your on-balance sheet and off-balance-sheet activities suggests that you have a high ratio of debt to equity, you are a HLI.
  2. Regulatory capital adequacy requirements should be counter-cyclical – they should be raised (by the central bank) during periods of boom and lowered during periods of bust. This will also help remedy one of the problems with the Basel I and II Accords.
  3. There should be regulatory leverage ceiling for all highly leveraged institutions. This ceiling should again be varied countercyclically by the central bank: the ceiling will be lower during booms and higher during busts.
  4. There should be regulatory maximum liquidity ratios (say ratio of liquid assets net of liquid liabilities to total assets) for all HLIs. This ratio should again be varied countercyclically by the central bank.
  5. Maximum loan-to-value ratios for all collateralised borrowing (including mortgages). Again, these ceilings should be raised during a slump and lowered during a boom.
  6. Maximum aggregate loan to annual income ratios for households. These ceilings too should be varied countercyclically. This obviously requires considerable information sharing by lenders, but it may be possible to do this without encouraging anti-competitive collusive behaviour among lenders.

My examples are not meant to be exhaustive, just illustrative. They share the feature that they don’t have Fed staff crawling through the darkened corridors of investment banks at night. They require verification that the various credit ceilings are respected, of course. But the ceilings themselves are varied according to macroeconomic conditions, not firm-specific circumstances.

The US regulatory system for the financial sector is a mess. The argument that having 5 Federal agencies supervising/regulating the banking sector was a good thing because it built in redundancy (five pairs of eyes, ears and noses are better than one) turns out to be wrong. No-one was in charge. No-one was responsible. Everybody assumed the other fellow would be checking on the obvious things nobody ended up checking on. Reform and consolidation are overdue.

But the specific proposal for dealing with investment banks and other highly leveraged institutions is deeply flawed, and would end up increasing financial instability by limiting the downside during a credit bust without restraining the perceived up-side during a credit boom. The only way to prevent really bad times is to stop the good times from getting out of hand. Crude, unsophisticated credit ceilings of the kind I have outlined could do the job.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website