With the financial system in the West blowing up in their faces, regulators there are doing their best to deflect responsibility. Much has been said about the impersonal forces that have been responsible for the crisis—global imbalances, the global “savings glut”, China’s pegging the yuan, greedy bankers, the bubble in the housing market. The story is well-known—large capital inflows to the US lowered interest rates, fuelled a boom in mortgage lending, a reduction in loan standards, and financial innovations that produced an unsustainable explosion of credit. Bankers added to the problem by adding unsustainable leverage and complex derivatives. This view of the crisis, Ross Levine points out, conveniently lets regulators off the hook.
Levine points to five policies in the US that were responsible for the crisis. These were: Securities and Exchange Commission (SEC) policies towards credit rating agencies; Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps; SEC and Federal Reserve policies concerning over-the- counter derivatives; SEC policies towards the consolidated supervision of major investment banks; and, government policies towards two housing finance entities, Fannie Mae and Freddie Mac. SEC is the US stock market regulator and the Federal Reserve is the US central bank.
It’s surprising that at a time when the big investment banks are being investigated, the rating agencies are not being scrutinized. The conflict of interest between rating agencies and the fact that they get their fees from the clients they rate is well known. Levine approvingly quotes a Moody’s vice-president, who said: “We obviously cannot ask payment for rating a bond. To do so would attach a price to the process, and we could not escape the charge, which would undoubtedly come, that our ratings are for sale.” But that was in 1957, in a different age.
The author says the argument that rating agencies have a reputation to protect does not really hold water, because ratings have been made compulsory and because users of ratings cannot sue the agencies. Writes Levine, “The banks associated with creating structured financial products would first pay the rating agencies for guidance on how to package the securities to get high ratings and then pay the rating agencies to rate the resultant products. The short-run profits from these activities were mind bogglingly large and made the future losses from the inevitable loss of reputational capital irrelevant.” He points out that the operating margin at Moody’s between 2003 and 2007 averaged 53%, compared with 36% and 30% for Microsoft Corp. and Google Inc. respectively.
The inability to regulate credit default swaps (CDS), which is essentially a type of insurance on somebody else’s credit, is well known. Unlike insurance policies, CDS allows punters to take out insurance on assets not belonging to them. It’s like taking out an insurance on a slum burning down—you then have an incentive to try and make it happen. Levine points to a Fed decision that allowed banks to reduce their reserves if they used CDS and alleges that it maintained this policy despite growing risks. Levine says that despite high-profile problems with derivatives such as the default of Orange County, SEC and the Fed squashed all attempts that sought more transparency in over-the-counter derivatives.
The paper lists three specific policies that allowed investment banks to reduce their capital and increase leverage, while at the same time reducing supervision. Levine points out that “SEC had only seven people to examine the parent companies of the investment banks, which controlled over $4 trillion in assets”.
And finally, the paper documents how the US government pressured the government-sponsored housing finance companies (GSEs) Fannie Mae and Freddie Mac to lend to low-income groups, which encouraged them to go in for subprime mortgages. Generous lobbying by the GSEs, who were making hefty profits, also helped.
To cut a long story short, policymakers everywhere will do well to go through this paper before they decide to “liberalize” their financial systems.
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