Oversight and Regulation of Financial Institutions

Oversight & Regulation of Financial Institutions

In the article entitled "How Financial Oversight Failed & What it May Portend for the Future of Regulation," economist Richard J. Herring identifies the government policies he believes contributed to the current financial crisis. These policies include:

Credit rating outsourcing.

Government housing.

The call for investment banks to form holding companies.

Basel I and Basel II minimum capital requirements.

After describing the policies and the financial repercussions of each in detail, Herring presents three arguments in favor of the policies, followed by three refutations of these arguments. From there, Herring goes on to address the principal/agent problems surrounding the financial crisis in both the private and public sectors, and then concludes with the description of two incentive plans -- contingent capital and resolution policy -- he believes will encourage "greater market discipline" (Herring, 2010).

Regarding credit rating outsourcing, Herring argues that outsourcing caused a "regulatory-induced increase in the demand for highly rated assets . . . [of] investment grade or higher" (Herring, 2010). The result of this demand was an imposed pressure on credit rating organizations (CROs) to rate institutions more liberally than they otherwise might have been inclined to. An institution whose credit rating would at one time have been rated average or slightly below average, was then being rated as slightly above average, which in turn skewed the perception of the institution's stability or lack thereof, resulting in a rapid decline credit rating standards. It is here that Herring puts forth his thesis statement: "What began as an attempt to improve the supervision of credit risk ultimately had the unintended consequence of exposing the financial system to a devastating credit shock" (Herring, 2010).

Regarding the government housing policy, Herring argues that imposed requirement for Fannie Mae and Freddie Mac to provide affordable housing options for even the poorest Americans resulting in heightened for low-interest government loans, thereby placing pressure on banks to meet the demand for low interest -- and in some cases no interest -- loans. Add to this the emergence of "Fair Lending Best Practices Agreements" in 1994, and it was suddenly possible for low-income families to purchase to homes they would otherwise never have been able to afford -- and in reality, could not afford. Says Herring of the government housing policy:

A series of presumably well-intentioned government programs to meet the housing aspirations of poor Americans (albeit, by compelling other entities to subsidize the loans) led to a huge decline in the quality of mortgages issued in America. Rather than helping poor Americans to buy housing they could not afford by subsidizing down-payments, (which would have had to be reflected as an expenditure on the Federal budget) Congress and two Administrations chose to make it possible for lower income Americans to become very highly leveraged, which, of course, left them highly vulnerable to any decline in their own incomes or any fall in housing prices. The only way such lending could have been sustainable was to project a high rate of growth in housing prices into the indefinite future, an assumption that now looks hopelessly naive, but was widespread. Thus government housing policy intended to help the poor led to a personal catastrophe for many of the intended beneficiaries and a financial crisis that quickly became global. (Herring, 2010)

Meanwhile, investment banks responded to the European-imposed pressure to form holding companies by pushing for the Securities Exchange Commission (SEC) to be recognized as equivalent to the Federal Reserve as a regulatory body. Unfortunately, the SEC had neither the necessary experience or even the interest in assuming responsibility for investment bank regulations, hence the widespread failure of the SEC a regulatory entity.

And finally, Herring argues that the imposition of minimum capital requirements as dictated by Basel I and Basel II statutes resulted in "shadow banking systems" as a way of increasing credit-worthy perception. Essentially, Herring argues the following:

These government prudential policies that were intended to make the system safer have, in fact, made it more vulnerable to crisis. Would some other approach be more productive? Some experts would insist that policy should be directed at getting incentives right, but that turns out to be harder than one might expect. (Herring, 2010)

Nonetheless, avid proponents of Basel I and Basel II argue that the current financial crisis could have been avoided if Basel II had been implemented sooner. Pillar 1, they say, would have required the support of back-up capital for young and developing financial institutions, while Pillar 2 would have required more than the minimum capital of certain struggling institutions. Herring discounts the first claim by citing that 2004 policy already required back up capital -- a requirement that proved ineffective in restrain[ing] Citi from sponsoring seven Structured Investment Vehicles, more than any other institution" (Herring, 2010). Similarly, Herring discounts the second claim by that

Britain's widely-admired Financial Services Authority authorized Northern Rock to adopt the Internal-Ratings-Based Approach to setting its capital requirements, which reduced its capital requirements by 30%. The FSA did not ask Northern Rock to set aside more capital because of its precarious liquidity position. Instead it permitted the bank to pay out the excess capital to its shareholders just weeks before it had to be taken over by the government. (Herring, 2010).

One final argument put forth by Basel I and Basel II supporters is that Pillar 3 would have encouraged full-disclosure of market practices and thereby encouraged great market discipline; a claim Herring discredits by saying it was full-disclosure that led to the widespread bailouts of the last decade, providing evidence that full-disclosure has little to no effect on market discipline.

The problem, Herring argues, is that the so-called "incentives" for practicing market discipline actually encourage financial institutions to take excessive risks. Herring also argues that if an institution is guaranteed to be protected from loss with tax-payer bailouts, there is nothing to deter one from excessive risk behavior.