John Duca, Deputy President of the Dallas Fed, spoke to PEFM in Balliol College on October 9 on macroprudential policy and the financial crisis. In his presentation Duca challenged the Rogov and Reinhart thesis that crises are caused by excessive build-ups of debt, arguing that crises are much more related to real estate booms and busts. These in turn were generated by massive relaxation of regulatory requirements in the period up to the crisis.
Duca argued that price trends in the US commercial and residential real estate markets are usually distinct, but unusually they were both booming in the run up to the crisis. He ascribed this to not only the well-known pervasiveness of low interest rates but, as importantly, the marked reduction in prudential requirements, as enforced through the risk-weighting on capital requirements, and the regulatory environment more generally. There was an underappreciation of the risks, particularly the tail risks, with no recognition of inter-connectedness. There was an illusion that mortgage-backed securities (MBS) were safe.
Until around 2000, the US financial system was regulated through a series of provisions largely enacted after the Great Depression. In 2000 it became possible to protect MBS through credit-default swaps; the market took when, under the Commodities Futures Modernization Act, derivatives contracts were to be honored before regular contracts in bankruptcy. As regards sub-prime mortgages, investors thought they were getting short term investment grade assets, when in fact they were getting junk. In 2004 capital requirements on banks were 8%, but risk-weights on bank holdings of MBS were slashed, so that the effective rate became just 1.6%. Issuances of MBS soared into the stratosphere.
Meanwhile, Fannie Mae and Freddie Mac (F&F) could buy some sub-prime debt. Banks could invest in F&F, first with 4% risk-weight, then 1.6%. Minimum loan to value ratios fell from 12% to zero: people were buying houses with no money down. Commercial real estate capital requirements also fell from 8% to 1.6% in 2004. Again, risk correlation was ignored. As the crisis started, for the first time since the Great Depression there was a fall in the value of assets—but liabilities remained. With the debt overhang increasing, it became very hard for the macroeconomy to recover. House price increases had been used to finance consumption. With the ability to borrow against housing worth slashed, consumption fell. Collateral values fell, and foreclosures rose, undermining the capital positions of banks and non-banks. The magnitude of the initial losses was not as great as the effect of uncertainty, as CDS were not issued through clearing houses. There was a big increase in bond spreads over US TBs, and a collapse in the stock market. Overall, a perfect storm.
Since then there has been a focus on risk at the macro level. It has been expounded by Adair Turner and others that lending rates do not take externalities (ie the cost of failures) into account. So, imbalances must be prevented before they occur. In the US, Dodd-Frank was a comprehensive attempt to address identified financial sector weaknesses; in Europe there has been a swathe of regulation: the Fourth Capital Requirements Directive (CRDIV), the Resolution and Restructuring Directive (RRD) and the harmonized implementation of Basel 3. Higher, and better-defined capital requirements, stress tests, limitations on risk taking in securities markets (the Volcker rule), liquidity ratios, and macroprudential ceilings on risk-taking (such as minimum LTV ratios) all serve to safeguard financial stability. Some countries have gone further, for instance through high minimum risk weights (Belgium, Sweden, Norway) or floors on loan deposit ratios (Norway). Additionally, there are capital requirements on SIFIs, or sectoral capital requirements (Switzerland) or cyclical macroprudential surcharges (Switzerland).
Nevertheless, capital may appear to be there when it is not. Stress tests are designed to avoid banks gaming the system, and to identify tail risks, and avoid banks delaying loan recognition., to avoid the “bk letter” approach to regulation. The US has a 5% retention ratio on all securitized loans, and limitations on the types of assets that can be securitized. If debt service ratios exceed 43% the bank is liable to additional requirements. In Europe there has been a tightening on the classes of assets eligible for financing with covered bonds (Spain). There are also limits on borrowers, regarding collateral, capacity, and character. Thus, there is in a sense a triple coverage, with a view that it is hard for the banks to game all three.
Liquidity ratios play a newly significant role—the aim being that they should reduce the risk of fire sales. LOLR tools have been markedly refined, including through term auction facilities, long run discount loans, primary dealer facilities and dollar swap lines (US), funding for lending scheme (UK) and a long term refinance facility (ECB). The credit market easing has involved central banks buying commercial paper: the Fed bought all commercial paper coming to the market for five weeks, ending holding 20% of the market. There was overall a 90% fall in the size of the market. The risk was not of the corporates, but of the other paper holders.
F&F raised fees on refinancing. The Treasury said one could not increase the value of a loan in a refinancing if the LTV as over 80%. Heat maps, and other visual aids now help diagnosis.
Overall there has ben a kitchen sink approach to reforms. Adjusting regulations, perhaps excessively, has been burdensome for small banks. The four largest banks had 54% of the assets after the GFC, now 47%. Only one of the ten largest banks in the world is American.Capital surcharges are dampening the growth of the largest institutions. There is maybe a shift towards the securities markets, but this does not necessarily mean that risks are reduced. There is regulatory arbitrage: the regulations cover only a part of the system, and business is shifting to the unregulated part.
$ ½ trillion left the money markets in the three weeks after the failure of Lehmans. The money market funds had committed to make their depositors whole so the institutional funds wanted to be the first out. For the future one needs floating net asset values. There are now also living will for SIBs.
In the next crisis US regulators will not be so nimble, so they have to be more proactive to stop a crisis. This may indeed involve dampening growth. The monetary authority has to act on short term monetary goals. If there is a single financial stability authority, it should recognize that there is a single system that it needs to work within. In the UK, monetary and financial stability policies have been brought within the same institution., with overlapping officials at the Bank of England between the monetary policy committee and the financial policy committee. In a crisis one expects that they will coordinate closely together.
Charles Enoch (Director, PEFM, St Antony's College, Oxford)
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