Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  The central bankers from the two countries implemented the idea that the risks of bank assets varied by developing a new risk-based bank capital system. This system assigned risk weights to four buckets of assets; the weights were then multiplied by the total assets in each category. The risk-weighted amounts were summed into a single measure of risk-weighted assets, which were then divided into two different kinds of capital: Tier 1 (essentially common equity and retained earnings) and Tier 2 (Tier 1 capital plus preferred stock, subordinated debt, and a limited amount of loan-loss reserves).

  The net result was a system requiring banks to have capital equal to or exceeding two risk-adjusted capital ratios, 4 percent for Tier I capital and 8 percent for Tier II capital. These two standards were subsequently adopted in the late 1980s by other advanced countries whose central banks belonged to the Basel Committee on Banking Supervision, an exclusive club of central bankers who regularly meet in Basel, Switzerland to discuss common bank supervisory problems and challenges.

  The Basel standards, as they have come to be known, may have looked good in principle (how could one object to the notion that different bank assets carried different kinds of risks?), but on closer inspection in practice they proved highly problematic, to put it charitably. At bottom, the problem was that the risk weights not only were arbitrary but flawed.

  Under the new system, including subsequent refinements, a bank’s investments in the government bonds of each other’s countries (later expanded to the debt of over 30 countries belonging to what some have called the rich countries club, the Organization for Economic Cooperation and Development, or OECD) had no risk weight. This meant that not only did banks need no capital to support these investments, but that banks essentially were given the green light to load up on these securities, a consequence that would prove especially disastrous for European banks after the U.S. financial crisis spread across the Atlantic. When various European governments ran into severe financial troubles (Cyprus, Greece, Italy, Spain, Portugal, Iceland, and Ireland), so did their countries’ leading banks which had been encouraged by the Basel risk weights to buy their debts (though surely the governments also applied some arm twisting to accomplish this goal as well).

  The Basel system also assigned a 100 percent risk weight to most all loans, except for residential mortgages, which were assigned a 50 percent risk weight, a compromise to bring the German regulators on board (who, like their American counterparts, oversaw many financial institutions devoted largely to mortgage lending). In retrospect that decision gave another bad green light to banks on both sides of the Atlantic to load up on securities backed by mortgages, including the toxic subprime mortgages that later almost sank the world’s financial system.

  In the mid-1990s, the Basel rules were updated to take account of various critiques, and even then the central banks couldn’t stop fiddling, and they initiated toward the end of the century a nearly decade-long process of further updating. That process was almost complete toward the end of the 2000s and then the financial crisis struck. In the post-crisis atmosphere, the central bankers got religion and substantially increased the minimum levels of capital required of banks, adding another 1 to 2.5 percentage points of additional risk-weighted capital for the largest, most complex banks deemed to be “systemically important.” But worried about causing banks and their lenders too much disruption, the committee delayed the effective date for its higher standards for roughly another decade (nonetheless, at this writing, most large U.S. banks already comply with the higher requirements).

  Throughout this evolution, the Basel standards grew increasingly complex, in part because banks complained that the rules were too rigid and did not take account of their own internal risk models and controls, an argument the Basel Committee appeared to accept until the financial crisis struck. The post-crisis rules leave less discretion for banks, but still run into the hundreds of pages, requiring an army of internal staff and outside lawyers and consultants to help banks comply (in their growing complexity, the Basel rules share much in common with the Volcker rule, adopted in the United States after the crisis, and discussed in detail in the next section).25

  It didn’t have to be this way. Early into the Basel regime, the SFRC, among others, began criticizing the rules, at first for their arbitrariness and for ignoring a fundamental proposition in financial economics: that risks should not be measured by individual asset classes, but on the basis of entire asset portfolios, since the ups and downs of the values of loans, securities, and other bank assets can offset each other (or amplify risk in certain cases). As the Basel rules grew more complex, the SFRC statements criticized the Basel Committee and its rules for complexity, too. In their place, the SFRC recommended that bank regulators return to simple minimum leverage ratios (the standard capital-to-asset ratios without any risk weights), supplemented by a minimum amount of subordinated debt (long-term uninsured debt that cannot be withdrawn on demand), expressed as a percent of assets. The Basel rules allowed subordinated debt to count on a voluntary basis as part of a bank’s Tier 2 capital ratio, but the rules did not require it. The SFRC viewed subordinated debt as a way for bond investors who only had downside risk to monitor bank managers for excessive risk taking. An additional advantage is that the price on such debt, or conversely its interest rate, would serve as a market-based warning signal for regulators to help implement SEIR.

  Except for the FDIC, which pressed for a minimum 6 percent leverage ratio to backstop the Basel standards for U.S banks, U.S. bank regulators never considered abandoning the Basel risk-weighting regime or mandating a minimum subordinated debt ratio, even after the financial crisis. However, since the crisis, there have been various calls for essentially replacing the capital ratios in Basel with a minimum leverage ratio, although some proposals have more than that as an objective: setting minimum capital thresholds so high, at least for the largest banks, that they will be forced to break up. This is the main objective of the Brown–Vitter bill introduced in the Congress in 2013 that, if passed, would establish a minimum capital ratio of 15 percent of assets for banks with assets over $500 billion. One academic study proposes an even more ambitious target: a 30 percent capital-to-asset minimum.26 The Basel committee, meanwhile, with a clear vested interest in maintaining its complicated risk-based system, concedes the role for a simple leverage ratio as a backup—but at a paltry 3 percent of assets.

  The desire to break up the largest banks is understandable because in the midst of the financial crisis, the federal government, over two administrations (George W. Bush and Barack Obama), injected government funds as capital in the nine largest banks (and many other smaller ones) to keep them from failing. In addition, the government supported certain nonbanks, including direct capital injections into the nation’s largest insurer, AIG, the two government-sponsored housing entities, Fannie Mae and Freddie Mac, and even in two of the big three domestic auto companies (General Motors and Chrysler). Putting aside the fact that the government since has been nearly paid back for the hundreds of billions in emergency funding,27 the fact that the investments were made rankles political leaders and voters in both political parties, especially at a time when such largesse was not available to smaller Main Street businesses, and to millions of individual homeowners who lost their homes after the plunge in housing prices put them under water with mortgage balances greater than the values of the houses.

  Aside from its unfairness, the rescue of the largest banks—especially all of the uninsured creditors—creates the moral hazard that vigilant enforcement of capital standards and supervision is designed to offset. The Dodd–Frank Act contains various provisions designed to prevent reoccurrences of this “too-big-to-fail” problem, but no one knows whether they will work or if regulators will faithfully carry out the law until the provisions are tested by the next financial crisis.

  Meanwhile, there is no consensus among economists about the adequacy of the too-big-to-fail parts of Dodd–Frank or about the appropriat
e level of capital for banks going forward. But one thing financial economists agree on is that without sufficient capital, banks and securities firms will not have an adequate cushion against future losses nor proper incentives for avoiding the risks that can lead to such losses. The failure to pay heed to this simple insight caused misery for many businesses and individuals alike.

  The Glass–Steagall Debate

  Much of the legal and regulatory framework governing the financial industry—banks in particular—was established in the wake of the Depression: Federal deposit insurance, securities regulation, and strengthened bank regulation all occurred in 1933 and 1934; several years later, the creation of institutions to facilitate residential mortgage lending (which, among other things, led to the 30-year mortgage) and regulation of the mutual fund industry.

  One of the signature pieces of legislation enacted in 1933 was the Glass–Steagall Act, which divorced commercial banking (mainly the business of taking deposits and lending them out to businesses and individuals) from underwriting securities (purchasing securities from firms wanting to go public or sell more shares, or from firms and governments wanting to issue debt, and then reselling those securities to the public).

  The conventional wisdom is that Glass–Steagall—named after its two main sponsors, Senator Carter Glass and Representative Henry Steagall—responded to findings in a famous congressional investigation of the 1929 stock market crash (headed by Senate counsel Fernand Pecora) that banks had misled customers about the value of securities they sold. For their sins, the banks were punished by having securities underwriting taken away from them.

  While it is certainly true that some banks engaged in deception, that sort of misdeed was addressed in the Securities Acts of 1933 and 1934, which enacted new disclosure requirements for companies seeking to go public and those that remained publicly held. This legislation applied to all securities firms, and would have applied to banks selling securities had they been permitted to continue doing so.

  But much like the Volcker rule that was adopted in the wake of the 2007–2008 financial crisis, the Glass–Steagall Act was principally a way for Congress and the public (to the extent it followed such matters) to punish banks during a period when many of them had failed and when some had behaved improperly. But as subsequent economic research has shown, there was no evidence that banks’ underwriting of securities contributed to the massive numbers of bank failures, nor any logical reason why Congress could not have applied their new securities protections to banks had they not been outlawed from underwriting securities (the prohibition was not complete, since it did not apply to bank underwriting of federal or municipal general obligation bonds, or to state-chartered banks that did not belong to the Federal Reserve system).28

  In short, there was little economic evidence (some would say none) in support of Glass–Steagall, and I have been unable to find many economists who favored it, even at the time. Indeed, as time went on, those banking scholars (including me, in my PhD dissertation, later published as a book) who studied the Act noted that it began and continued as an artificial legal barrier to competition from banks to standalone investment banks in the underwriting of securities.29 In this respect, the Act was little different from other forms of economic regulation that were later dismantled, although Glass–Steagall did not impose price controls of any sort; that job was left to other Depression-era legislation that put limits on the interest banks could pay their depositors, a restriction that was eventually lifted in the 1980s.

  In any event, the Glass–Steagall Act stayed on the books for more than 60 years, despite many efforts to repeal it. Banks that began lobbying for financial reform legislation in the 1980s to repeal or scale back the Act consistently ran into a fierce wall of resistance from the securities industry, which obviously did not want additional competition from banks. The two sides of the debate, through their political contributions and lobbying activities, made for gridlock in the banking committees in the Congress, and so large-scale financial reform was not in the cards.

  Bank regulators, specifically the Federal Reserve, were more receptive to the need for competition in securities underwriting. So, beginning in the late 1980s and extending well into the next decade, the Fed began to expand the percentage of overall activity that bank affiliates could devote to underwriting corporate securities. The Fed did this under another exception to Glass–Steagall’s broad prohibitions: Bank affiliates that were not primarily engaged in underwriting could underwrite otherwise impermissible securities (mainly corporate debt and equity) to a limited degree.

  Eventually, so much securities underwriting by banking affiliates was going on that by the end of the 1990s, Congress was ready to throw in the towel and to dismantle Glass–Steagall altogether through enactment of the Gramm–Leach–Bliley Act of 1999 (GLBA). As a result, Glass–Steagall essentially died not with a bang but a whimper, although the process was significantly accelerated by Citigroup’s purchase of Travelers Insurance. Citigroup would have had to substantially reorganize, or even abandon the Travelers acquisition, had GLBA not passed Congress. Citigroup wanted to be the first to test the commercial viability of the financial supermarket model, in which a single financial services holding company would own subsidiaries in multiple lines of financial activity—banking, insurance, and securities—and seek to cross-sell customers the services provided by each of the subsidiaries, while realizing efficiencies (or economies of scope) in consolidating all these financial activities under one roof. I can’t say that economists were decisive in convincing Congress to enact GLBA, but a steady stream of economic scholarship over the roughly two decades before supporting the repeal of Glass–Steagall certainly didn’t hurt the effort.

  In any event, the full-service financial supermarket model that Citigroup wanted to test was a flop. Several years after getting the green light to put the model together from Congress, Citigroup began unraveling it, principally by selling off Travelers. JP Morgan Chase (a large bank that was the product of a merger of two large banks before it) and others tried a less ambitious version of the supermarket idea—combining commercial and investment banking, the very combination prohibited by Glass–Steagall—and at this writing still seem committed to it.

  However these experiments in financial market models turn out is a sideshow compared to the renewed debate since the financial crisis of 2007–2008 over the wisdom of sticking with GLBA or returning in some fashion to the Glass–Steagall world. Although the issue was little more than a footnote during the initial congressional deliberations of financial reform legislation after the financial crisis, the securities activities of banks began to attract much greater congressional attention in 2010, after Scott Brown was elected to fill the Massachusetts Senate seat long occupied by Senator Ted Kennedy, who died early in that year (Brown later was defeated in 2012 by Senator Elizabeth Warren, an advocate of Glass–Steagall, who developed the idea and campaigned, successfully, for the creation of a separate federal consumer financial products safety commission).

  At that time, the financial reform law that was to become the Dodd–Frank Act of 2010 was still making its way through Congress. To jump-start that process and to regain some political momentum behind its passage, the Obama administration turned to the chairman of its Economic Advisory Board, Paul Volcker (see following box), one of the most distinguished public servants in economic policy making of the previous half century, who up to then had more of a titular than an actual policy making function in the administration.

  Volcker has long been a believer that banks should stick to their knitting, namely taking in deposits and lending them out, and should not branch out to engage in other activities, especially those related to underwriting securities, or even worse in his view, betting on asset price movements—what has come to be known as “proprietary trading. Apparently not believing there was sufficient support then for repealing GLBA in its entirety, Volcker urged Obama and, in turn, Congress to implement what on the surfac
e seemed to be a simple, second-best solution: Simply ban banks from engaging in proprietary trading. The president embraced the idea, quickly naming the idea the Volcker rule and urged its inclusion in the financial reform legislation. By that time, public sentiment had turned on the large banks, and so the president’s idea was an easy sell at least to the Democrats in Congress, who ultimately voted for Dodd–Frank (then newly elected Senator Brown was one of only three Republican Senators to vote for the bill).

  Paul Volcker: A Giant Among Economists

  When the economic history of the twentieth and early twenty-first centuries is written, no figure will stand taller, figuratively and literally, than Paul Volcker. Although he never gained the economists’ union card, the PhD, his private sector and public experience, combined with his formal training in the subject at Princeton and Harvard, put him at the top ranks of the profession.30

  Volcker is best known for leading the Federal Reserve from 1979 to 1987 during one of the most difficult economic times of the past century—with the exception of the Depression and the financial crisis of 2007–2008. Nominated for the Fed chairmanship by President Jimmy Carter when annual inflation was nearing double digits while the economy was suffering from recession—a deadly combination often referred to as stagflation—Volcker put his emphasis on fighting the former, which eventually laid the foundation for curing the latter.

  It took guts, a man with giant convictions, and a giant personality to ward off the many attacks he got for wringing inflation out of the economy, which he and his Fed colleagues eventually did. Volcker was greatly aided along the way by President Reagan, whose administration never wavered in its support of the Fed’s tight monetary policy as a way of slaying inflation, even as the unemployment rate climbed over 10 percent in 1982. Once hitting that peak, however, the unemployment rate declined rapidly as the fiscal stimulus of the 1980 tax cuts took hold and the economy came roaring back (though not without an unprecedented, at the time, increase in federal budget deficits).