A major focus of the Obama proposals to redesign the regulatory system is to bring all the major financial institutions that were implicated in the current financial crisis (or might be implicated in the next one) under regulation. These include hedge funds, investment banks and mortgage companies, which have been only loosely regulated.

The general presumption seems to be that if all the major categories of firms are regulated, with clear lines of regulatory responsibility, all should be well. But will it?

A major focus of the Obama proposals to redesign the regulatory system is to bring all the major financial institutions that were implicated in the current financial crisis (or might be implicated in the next one) under regulation. These include hedge funds, investment banks and mortgage companies, which have been only loosely regulated.

The general presumption seems to be that if all the major categories of firms are regulated, with clear lines of regulatory responsibility, all should be well. But will it?

There should be some unease about this presumption, because major banks and thrifts subject to extensive regulation were nonetheless caught up in the crisis. The Citibank and Bank of America holding companies were regulated by the Federal Reserve; the banks themselves were regulated by the Comptroller of the Currency (OCC); and WaMu, IndyMac and Countrywide were regulated by the Office of Thrift Supervision (OTS).

The plan is to shift major responsibility for regulating all systemically important firms to the Federal Reserve, which is the most trusted of the agencies. However, the major cause of regulatory failure during the period leading up to the crisis was the same for the Fed as for OCC and OTS: They all lacked a critical regulatory tool.

Financial crises arise out of the interaction of a major external event with a financial system that happens to be extraordinarily vulnerable to that event. In the savings-and-loan crisis of the 1980s, the external event was the interest-rate explosion that arose out of efforts to dampen the inflation. The vulnerability was the unbalanced portfolios of the savings-and-loan industry, which financed home loans carrying fixed rates for long terms, with short-term deposits. Because of the imbalance, their interest cost rose sharply with rising market interest rates, but their interest income changed very little. The circumstances generating the S&L crisis are very unlikely ever to be repeated because systemic vulnerability to an interest-rate shock has been largely eliminated.

In the current crisis, the external event was housing prices rising at an unsustainable rate — termed a "bubble" because at some point it must burst. The vulnerability was the incentive created by the bubble to generate income by ignoring the risks associated with the inevitable bursting of the bubble. Here is a much-oversimplified illustration for a firm I call "A," which is a composite of many.

During the bubble period, lender A could originate $1 billion of home loans every month on which it made $75 million. Since it took five months to sell these loans, A always had an unsold inventory of $5 billion. These highly profitable loans maintained their value so long as home prices continued to rise. The month that home prices dropped, however, the value of these loans fell by 20 percent; A incurred a $1 billion loss on its inventory; and it shut down. The loss was absorbed by its creditors. …CONTINUED

Looking backwards, during the 40 months A was operating, it generated $3 billion of "income" for its owners and managers. I put the word "income" in quotes because, while it constituted income in a legal sense, about a third of it should have been allocated to a reserve for future losses. Had A done that, it would have survived the shock of the house-price decline. If every firm had done the same, there would have been no crisis.

But the incentive system is strongly biased against reserving. For most firms, it makes more financial sense to ignore the risk, pay out all the revenue as income as it is received, and go broke when the bubble bursts. If it bursts after a short period, reserving would cost them, and if it runs for a long time, the firm can withdraw an obscene amount of money that, barring fraud or other illegalities, the ultimate losers (including taxpayers) can’t take away. Even our tax system discourages reserving, since the amounts reserved would be taxed as income.

While the system is no longer vulnerable to an interest-rate shock, it will remain vulnerable to bubbles in the housing market or elsewhere. There is no plausible compensation system that would change this. The search for one is a useless digression.

For the reconstituted regulatory system to prevent bubble-generated financial crises, it must have the authority and know-how to impose and enforce a system of mandatory reserving. Such systems now apply only to firms chartered as insurance companies, including mortgage insurers, which are regulated at the state level. If a mortgage insurer had insured the loans originated by A in my example, its risk would have been very similar, but in contrast to A, it would have placed half of every premium dollar it collected into a contingency reserve.

Most of the knowledge and experience required to apply such systems to other financial firms is currently in state regulatory agencies. This provides an ironic perspective on the Obama plan proposal that the federal government take over the regulation of insurance companies from the states.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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