Restoring Financial Stability: How to Repair a Failed System

October 30, 2009 at 6:06 am

Restoring Financial Stability is the best book I’ve read on the crisis so far. It is filled with valuable data. It covers many different aspects of the situation. And, for the most part, it is even handed in its criticisms, never resorting to the many highly biased political explanations. But from my perspective it falls short on several counts.

Most importantly, this crisis was clearly a supply driven phenomena. It’s not as though the demand for housing drove up the price of financing – quite the opposite. A worldwide excess of short-term funding drove up the price of assets. Gladly, the book does not resort to the trite argument that the Fed inflated the money supply by lowering short-term interest rates following the 2002 recession, as M2/GDP fails to convincingly confirm much if any monetary inflation. Instead, the book unfortunately makes no account of the source of this funding whatsoever. It never even crosses its radar screen. I would say that misses the forest from the trees!

The book also fails to put the US financial system and it’s regulations into the proper context. In a world awash in short-term funding, banks strove to borrow and lend this capital within the confines of their limited equity and capital adequacy requirements. They did this by logically raising additional equity off-balance sheet to take advantage of segmenting capital markets and by selling risky tranches of debt with high equity requirements to outside investors. In addition to lending, banks also earn profits by holding duration risk – it’s the raison d’être for banking. Banks clearly compared spreads to the equity requirements for each tranche and chose to hold tranches with the highest return. Logically designed regulation led them to hold the least risky, AAA, tranches. Public market valuations supported these decisions.

The book argues that banks thwarted capital adequacy requirements. In one instance it cited the mere fact that banks held less risky AAA securities with logically lower regulatory capital adequacy requirements as proof that banks engaged in regulatory arbitrage (e.g. figure 2.3). That surely does not make the case. It claims banks used off balance sheet SIVs to avoid capital adequacy requirements but it is careful to never definitively accounts for the combination of capital held both on and off balance sheet. Instead, the authors claim capital adequacy requirements for liquidity enhancement alone would have allowed banks to hold one tenth the capital requirement on-balance sheet, but to make that narrow argument, one would have to be referring only to the capital used to derive FDIC premiums (a side issue) and not capital adequacy requirements essential to the core argument. Regardless, others have calculated that banks would have needed to hold 12 to 15% equity vs. the pittance required by regulators for AAA rated (mortgage) securities. To suggest that regulatory arbitrage and not regulations themselves is the source of the problem requires showing dramatic examples of arbitrage which the book never does without resorting to the kinds of gimmicks described above.

Regulations require banks to hold 4 to 8% equity against loans. They also allow investors to buy equity with 50% margin. The chief way to reduce capital requirements is to tranche loans, sell off the risky first-loss equity-heavy tranches and then lend money to the buyer of these tranches. The book makes virtually no account of this. At the same time, bank regulation and margin requirements are long standing and time tested. Bank regulators, rating agencies and capital markets are sophisticated; it’s not as though banks operated without these institutions largely recognizing the critical issues. Perhaps regulators could have plugged this hole but it would have had repercussions elsewhere and the resulting equity requirements are not dissimilar to those imposed on Freddie and Fannie. In part, regulations have been politically designed to encourage home ownership at the expense of increased financial stability. Again, an analysis of this core issue is simply unaddressed by the book.

Thin equity requirements are built on a long-standing underlying regulatory assumption that financial risk is predominately unsystematic. Ratings that turn the collateralized tails of B tranches into A tranches are consistent with this view. The book presents public market prices of tranches that are not substantially inconsistent with this view. To argue that banks were undercapitalized, especially in light of the fact that they were not undercapitalized relative to their worldwide counterparts, is to challenge this underlying regulatory assumption. But to make this argument one must present historical evidence that this assumption is in fact mistaken. The book never raises the issue directly nor does it present any evidence. The argument must also show the cost-benefit of the holding more equity against the benefit of increased protection from 50 year storms or simply that we should have left available short-term debt un-invested, something, I doubt which has ever been done. It might well be the case that we should risk the capital rather than letting it sit idle and suffer the occasional consequences. On page 136, the authors concede that “…to avoid systematic risk the capital requirements may be too imposing…” This critical topic, perhaps the very core of the debate, warrants far more than a sentence! Again, it’s off the radar screen.

One solution is to insist that homeowners hold 20% equity. That clearly shifts the risk from financial institutions and investors to homeowners, perhaps the group least able, financially, to bear that risk. Homeowners logically sold that risk to investors, including the US-quasi owned Freddie and Fannie, who appear to have under-priced that risk relative to historical standards. If prices are low, why shouldn’t homeowners sell off this risk and if they logically do, why don’t they (i.e. taxpayers) benefit, all things considered? Again, these core tradeoffs are unaddressed by the book’s analysis.

As an aside, I would also contend that many of the book’s arguments are sloppy. Take the argument on compensation as an example. The book shows evidence that the compensation of financial sector CEOs was more skewed toward equity ownership relative to other sectors, that it was surprisingly well linked to market valuations and that it generated appropriately wide dispersion between top and bottom performers. It goes on to cites, without details, one countervailing study that claims financial sector compensation was 20% less correlated to market valuations than other sectors. From that evidence it argues that compensation was improperly designed. That might be true but the evidence presented surely does not convincingly support that conclusions. If anything, a tighter link would have driven more compensation into 2003 when markets rebounded outside the control of company managers. Further, public markets clearly rewarded risk-taking. The book also simply ignores the large volume of liberal academic studies denying the link between stock market valuations and shareholder designed compensation structures that align incentives to share prices with managerial behavior. Without any reference to this literature, academia has now widely concluded that bonuses largely paid as shares that vested over time over-incented managerial behavior (i.e. risk-taking). Even if the book’s argument on compensation is accurate, it’s superficial at best. In general, my complaint with the logic is that it largely fails to address the significance of the null hypotheses and in many cases the same data could be used to argue the opposite conclusion.

Lastly, I would contend that if we had implemented every single one of the book’s recommendations it would have had very little effect on the current situation. Capital would have had to have sat idle or been diverted from other more successful endeavors. It seems unlikely that precious capital would have or should have simply sat idle to protect against 50 year storms. And had other endeavors been more logical, capital should have and would have flowed to them assuming regulations were consistently applied. The problem lies in the fact that a surplus of short-term financing existed relative to the available investment opportunities, opportunities that are always, by their very nature, long-term. And further, that relative to this expanded supply, the equity available to underwrite the resulting duration risk was, logically, in short supply. The supply of short-term debt relative to the equity available to underwrite this risk is more than merely a matter of relative price. Japanese and Swiss interest rates, for example, have demonstrated that risk adverse short-term investors are largely insensitive to returns so changing relative returns will not covert debt into equity in order to adjust the mix. Again, the book makes no argument why increased regulations, changes to incentive structures or any other of its recommendations in part or in whole would have altered this market imbalance. At “best”, it would have left short-term capital underinvested or consumed. More likely, it would have reduced returns to equity and may have exacerbated this imbalance. Again, this core issue is unaddressed by the book. Instead, cries of, “Too much debt!” (i.e. not enough equity) and, “Too little regulation!” implicitly assume as their starting point that regulation can correct this imbalance (or at least divert it from our financial infrastructure; that consuming rather than investing this surplus would be better for society in the long run; or that it would be wiser to let some other economy invest this capital. All seem unlikely.

Comments

Baara says

October 30, 2009 at 4:13 am

I read this book immediately after I finished Cooper’s The Origin of Financial Crises which was highly recommended by the usually trustworthy Economist. For several reasons, Restoring Financial Stability (RFS) is the best book on the current crisis by a long ways. I am shocked that there is only one Amazon review so far.

RFS is neither dumbed-down nor overly complex. Anyone who reads the Wall Street Journal or Financial Times will easily grasp the material covered and the language being used. The sources cited for the individual essays are predominately articles from academic journals but the authors of RFS do a nice job of summarizing the important points from these articles rather than assuming the reader is familiar with the sources. I am a history major and had no trouble following the authors.

You do not need to be interested in the solutions proposed in order to buy the book. The policy recommendations are brief and follow the much more important background information covering the causes and progression of the financial meltdown.

The book is especially worth reading because of its refreshing objectivity. It is not a political book or an anti-capitalism book. It tells the story of self-interested actors altering their behavior according to the incentives before them. The book focuses on these incentives and how they might be adjusted in order to achieve the same ends without the risk of harmful macroeconomic effects.
Linda says

October 30, 2009 at 6:06 am

Restoring Financial Stability is the best book I’ve read on the crisis so far. It is filled with valuable data. It covers many different aspects of the situation. And, for the most part, it is even handed in its criticisms, never resorting to the many highly biased political explanations. But from my perspective it falls short on several counts.

Most importantly, this crisis was clearly a supply driven phenomena. It’s not as though the demand for housing drove up the price of financing – quite the opposite. A worldwide excess of short-term funding drove up the price of assets. Gladly, the book does not resort to the trite argument that the Fed inflated the money supply by lowering short-term interest rates following the 2002 recession, as M2/GDP fails to convincingly confirm much if any monetary inflation. Instead, the book unfortunately makes no account of the source of this funding whatsoever. It never even crosses its radar screen. I would say that misses the forest from the trees!

The book also fails to put the US financial system and it’s regulations into the proper context. In a world awash in short-term funding, banks strove to borrow and lend this capital within the confines of their limited equity and capital adequacy requirements. They did this by logically raising additional equity off-balance sheet to take advantage of segmenting capital markets and by selling risky tranches of debt with high equity requirements to outside investors. In addition to lending, banks also earn profits by holding duration risk – it’s the raison d’être for banking. Banks clearly compared spreads to the equity requirements for each tranche and chose to hold tranches with the highest return. Logically designed regulation led them to hold the least risky, AAA, tranches. Public market valuations supported these decisions.

The book argues that banks thwarted capital adequacy requirements. In one instance it cited the mere fact that banks held less risky AAA securities with logically lower regulatory capital adequacy requirements as proof that banks engaged in regulatory arbitrage (e.g. figure 2.3). That surely does not make the case. It claims banks used off balance sheet SIVs to avoid capital adequacy requirements but it is careful to never definitively accounts for the combination of capital held both on and off balance sheet. Instead, the authors claim capital adequacy requirements for liquidity enhancement alone would have allowed banks to hold one tenth the capital requirement on-balance sheet, but to make that narrow argument, one would have to be referring only to the capital used to derive FDIC premiums (a side issue) and not capital adequacy requirements essential to the core argument. Regardless, others have calculated that banks would have needed to hold 12 to 15% equity vs. the pittance required by regulators for AAA rated (mortgage) securities. To suggest that regulatory arbitrage and not regulations themselves is the source of the problem requires showing dramatic examples of arbitrage which the book never does without resorting to the kinds of gimmicks described above.

Regulations require banks to hold 4 to 8% equity against loans. They also allow investors to buy equity with 50% margin. The chief way to reduce capital requirements is to tranche loans, sell off the risky first-loss equity-heavy tranches and then lend money to the buyer of these tranches. The book makes virtually no account of this. At the same time, bank regulation and margin requirements are long standing and time tested. Bank regulators, rating agencies and capital markets are sophisticated; it’s not as though banks operated without these institutions largely recognizing the critical issues. Perhaps regulators could have plugged this hole but it would have had repercussions elsewhere and the resulting equity requirements are not dissimilar to those imposed on Freddie and Fannie. In part, regulations have been politically designed to encourage home ownership at the expense of increased financial stability. Again, an analysis of this core issue is simply unaddressed by the book.

Thin equity requirements are built on a long-standing underlying regulatory assumption that financial risk is predominately unsystematic. Ratings that turn the collateralized tails of B tranches into A tranches are consistent with this view. The book presents public market prices of tranches that are not substantially inconsistent with this view. To argue that banks were undercapitalized, especially in light of the fact that they were not undercapitalized relative to their worldwide counterparts, is to challenge this underlying regulatory assumption. But to make this argument one must present historical evidence that this assumption is in fact mistaken. The book never raises the issue directly nor does it present any evidence. The argument must also show the cost-benefit of the holding more equity against the benefit of increased protection from 50 year storms or simply that we should have left available short-term debt un-invested, something, I doubt which has ever been done. It might well be the case that we should risk the capital rather than letting it sit idle and suffer the occasional consequences. On page 136, the authors concede that “…to avoid systematic risk the capital requirements may be too imposing…” This critical topic, perhaps the very core of the debate, warrants far more than a sentence! Again, it’s off the radar screen.

One solution is to insist that homeowners hold 20% equity. That clearly shifts the risk from financial institutions and investors to homeowners, perhaps the group least able, financially, to bear that risk. Homeowners logically sold that risk to investors, including the US-quasi owned Freddie and Fannie, who appear to have under-priced that risk relative to historical standards. If prices are low, why shouldn’t homeowners sell off this risk and if they logically do, why don’t they (i.e. taxpayers) benefit, all things considered? Again, these core tradeoffs are unaddressed by the book’s analysis.

As an aside, I would also contend that many of the book’s arguments are sloppy. Take the argument on compensation as an example. The book shows evidence that the compensation of financial sector CEOs was more skewed toward equity ownership relative to other sectors, that it was surprisingly well linked to market valuations and that it generated appropriately wide dispersion between top and bottom performers. It goes on to cites, without details, one countervailing study that claims financial sector compensation was 20% less correlated to market valuations than other sectors. From that evidence it argues that compensation was improperly designed. That might be true but the evidence presented surely does not convincingly support that conclusions. If anything, a tighter link would have driven more compensation into 2003 when markets rebounded outside the control of company managers. Further, public markets clearly rewarded risk-taking. The book also simply ignores the large volume of liberal academic studies denying the link between stock market valuations and shareholder designed compensation structures that align incentives to share prices with managerial behavior. Without any reference to this literature, academia has now widely concluded that bonuses largely paid as shares that vested over time over-incented managerial behavior (i.e. risk-taking). Even if the book’s argument on compensation is accurate, it’s superficial at best. In general, my complaint with the logic is that it largely fails to address the significance of the null hypotheses and in many cases the same data could be used to argue the opposite conclusion.

Lastly, I would contend that if we had implemented every single one of the book’s recommendations it would have had very little effect on the current situation. Capital would have had to have sat idle or been diverted from other more successful endeavors. It seems unlikely that precious capital would have or should have simply sat idle to protect against 50 year storms. And had other endeavors been more logical, capital should have and would have flowed to them assuming regulations were consistently applied. The problem lies in the fact that a surplus of short-term financing existed relative to the available investment opportunities, opportunities that are always, by their very nature, long-term. And further, that relative to this expanded supply, the equity available to underwrite the resulting duration risk was, logically, in short supply. The supply of short-term debt relative to the equity available to underwrite this risk is more than merely a matter of relative price. Japanese and Swiss interest rates, for example, have demonstrated that risk adverse short-term investors are largely insensitive to returns so changing relative returns will not covert debt into equity in order to adjust the mix. Again, the book makes no argument why increased regulations, changes to incentive structures or any other of its recommendations in part or in whole would have altered this market imbalance. At “best”, it would have left short-term capital underinvested or consumed. More likely, it would have reduced returns to equity and may have exacerbated this imbalance. Again, this core issue is unaddressed by the book. Instead, cries of, “Too much debt!” (i.e. not enough equity) and, “Too little regulation!” implicitly assume as their starting point that regulation can correct this imbalance (or at least divert it from our financial infrastructure; that consuming rather than investing this surplus would be better for society in the long run; or that it would be wiser to let some other economy invest this capital. All seem unlikely.
Anonymous says

October 30, 2009 at 8:09 am

NYU Stern has put together a tremendous, comprehensive and timely guide to the ongoing financial crisis. The book superbly summarizes the roots of the crisis, the scale of the problems across the financial sector and possible public policy solutions in a clear and non-partisan manner. This is a volume that I hope finds its way to the desks of every policy maker and politician – both in the US and abroad. I would also strongly recommend this to everyone involved in banking or finance (including, and perhaps particularly, financial journalists).

For those interested in the text’s contents, Stern has a fantastic site featuring on-line resources including video of the book-launch conference and executive summaries of each of the book’s chapters ( http://whitepapers.stern.nyu.edu/home.html )

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