Will the “Economic Growth, Regulatory Relief, and Consumer Protection Act” Cause A Repeat Crisis?
Note: Edited on November 6th.
Judging by recent headlines, you might think that the enactment of S. 2155, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” (Pub. Law 115–174) means the door’s now open to a repeat of the crisis in 2007–2009. It’s hard to imagine how. In what follows, I’ll first offer a brief account of why we had a banking crisis, and then explain why there doesn’t seem to be anything in the “Economic Growth, Regulatory Relief, and Consumer Protection Act” that will make that happen again.
Why a Crisis?
A 2012 Federal Reserve Bank of Philadelphia study by Cordell, Huang and Williams showed why structured finance collateralized debt obligations (CDOs) were the products at the heart of the last crisis. Figure 1 in that study shows how structured finance CDO tranches, the French word for “slices,” and a reference to securities that entitle the investor to “slices” of the incoming payment streams, relate to the underlying residential mortgage backed securities (MBS) or home equity line MBS tranches. Table 11 shows how those products caused so much damage, as they estimate that the average amount of the total volume that was written off equaled 65 percent. Table 12 shows that average write-downs for the Senior AAA equaled 55 percent, for the Junior AAA tranche equaled 80 percent, and for all other tranches equaled 90 percent or more.
The study points out on page 23 that the largest structured finance CDO dealers, such as Citigroup (and also the investment banks Merrill Lynch, Morgan Stanley and UBS) retained some of the highest rated, “super senior” tranches (others dealers, like Deutsche Bank and Goldman Sachs, distributed the associated risks elsewhere, to the bond “insurers,” like AIG). A related study by Erel, Nadauld and Stulz calls this the “securitization byproduct” effect, as they present evidence and explain why banks that securitize assets would also retain the highest rated tranches.
In addition, I show in a recent working paper that after the Recourse Rule lowered capital requirements for highly rated, private label tranches, the largest, securitizing banks on average increased their holdings of those tranches, until the crisis. That was a demand effect. In the paper, I also highlight how the 2003–2004 “Capital Treatment of Consolidated Asset-Backed Commercial Paper Program (ABCP) Assets” rule could also have stimulated the supply of CDOs, since it lowered capital requirements for assets in ABCP programs as Acharya, Schnabel and Suarez pointed out in a recent paper.
Accepting that as the story behind the banking crisis, based on annual SIFMA data on outstanding CDOs originated in the U.S., the graph below plots the fraction of all CDOs that were structured finance CDOs, or collateralized loan obligations (CLOs), which are backed by commercial loans, from 1989–2017:
Total volume outstanding for all CDOs did not exceed $100 billion until 1999, peaked at $1.05 trillion in 2007 and at the end of 2017 stood at $701.8 billion. If anything, structured finance CDOs are on the way out as the volume at the end of 2017 stood at $106.7 billion, or under 20 percent of the entire market, and a far cry from end-2007 when volume stood at $583.1 billion. Meanwhile, CLO volume outstanding at the end of 2017 stood at an all-time high of $528.3 billion, equal to 75.3 percent of the entire market.
(Here, it’s also worth pointing out that while CLOs were the original CDOs, they originally had simple tranche structures; pages 68–72 of the Financial Crisis Inquiry Commission Report observes that the idea for CDOs with the more complicated tranche structures examined in the Cordell, Huang and Williams’s study came from the Resolution Trust Corporation (RTC), created after the S&L Crisis. The RTC was attempting to offload some of the debt back into the market, and chapter 16 of the FDIC’s report on the Savings and Loan Crisis, starting on p. 405 discusses how the RTC came up with the idea of offering a greater variety of seniorities to attract customers. See also Table 1. 16–1 on p. 412.)
The “Economic Growth, Regulatory Relief, and Consumer Protection Act”
With that background in mind, as I mentioned in a recent post concerning S. 2155, predecessor to the “Economic Growth, Regulatory Relief, and Consumer Protection Act,” aims to address small bank regulatory burdens, in part by simplifying capital requirements; after all in a post last year, I showed that by the end of 2016, nearly 25 percent of all bank regulatory restrictions embodied in the Code of Federal Regulations came from capital requirements. That likely came from Basel III, rather than Dodd-Frank, which in Section 606 merely called for changing the language for bank holding companies to being “well capitalized.”
While I don’t yet see any seeds of a future crisis emanating from the language, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” has some positive and negative features. For example:
1) Section 201 proposes that “community banks,” defined as those with under $10 billion in total assets, have a leverage ratio equal to about 8 to 10 percent of total assets; the leverage ratio, in general, eliminates potential incentives for banks to hold highly rated tranches the way the Recourse Rule’s risk based capital requirements did for the largest, securitizing banks in the years before the crisis. So while you sometimes hear people say the leverage ratio “encourages” risk-taking, you can say the same for complex, risk-based capital requirements, like those found in the Recourse Rule. Overall, the taxpayer might like Section 201, since, at least for community banks, it tends to direct them to fund with less short-term, run-prone funding, and community banks were probably already doing this, so they likely won’t mind either. That said, a co-author and I found that the benefits of going to a 15 percent leverage ratio for all banks (small and large), generally equal or exceed the costs, so taxpayers who worry about another banking crisis might like this idea even more.
2) Section 205 calls for smaller banks that report bi-annually, rather than quarterly, to reduce the amount of information they submit when filling out the call reports. To see why that’s important, I showed in a post last year how call report forms (and the instructions explaining how to fill out the forms) have been growing in line with the growing regulatory burden. Having to report information for a growing form, quarterly, would tend to increase compliance costs. The largest banks, which want to remain dominant in their market, will like this, since the relatively higher compliance costs will keep smaller competitors out. The smallest banks that have no aspirations of competing directly with larger banks will also like this, since they will spend less time filling out information and more time on banking activities. At the same time, since banks in general facing greater regulatory burdens can pass off at least some of the costs onto customers, consumers of large bank services may not like this, while consumers of small bank services might like this.
3) Section 214 limits the application of the higher 150 percent risk-weight, implying a 12 percent capital requirement, for Highly Volatile Commercial Real Estate (HVCRE) that followed from the U.S. implementation of Basel III to only those loans that are deemed acquisition, development, or construction (ADC) loans. While the change seems narrow in scope, lowering capital requirements is not the way to foster financial stability. So taxpayers who worry about the next banking crisis might not like the general direction of the policy change. Also, as I’ve recently discussed, wading into debates over the specifics of capital adequacy standards may not be the best use of time for members of Congress, unless it concerns the broader debate over risk-based capital requirements vs. the leverage ratio.
4) Section 401 calls for raising the dollar thresholds for firms subject to enhanced supervision. That would only be a good thing if bank size was explicitly the cause of the last crisis. But as I detailed above, the last crisis was more about greater reliance on securitized banking, driven by regulation, which only a handful commercial bank holding companies like Citigroup, were involved in creating. Customers at the largest banks might not like this, since that means higher costs arising from the regulatory burden facing them will remain in place, and these banks can then pass on the costs to their customers.
5) Section 402 calls for eliminating reserves from the leverage ratio, which effectively turns the simple leverage ratio into a risk-based capital ratio, albeit a very simple one. While this provision does not likely bear the seeds of a crisis, I have been thinking for some time, that the combination of the Federal Reserve paying interest on reserves to banks, while at the same time classifying bank reserves in the 0 risk-weight category (meaning such assets have no capital requirements) creates incentives for banks to hold greater reserves, just as the Recourse Rule could have encouraged larger, securitizing banks to hold greater highly-rated, private label securitization tranches. Just think, prior to the interest on reserves rule, banks had little reason to hold substantial excess reserves, since they had the same capital treatment as U.S. Treasuries, but paid no interest. But after the rule, they now do have a reason to hold more reserves. If you only had the leverage ratio in place, then you might expect banks to hold fewer reserves, even with the interest on reserves rule; that could be yet another reason to like the simple leverage ratio. Overall, taxpayers who worry about another banking crisis might not like the general direction of this provision, but I cannot see this as a cause of a future crisis. Then again, crises are more about the unknown unknowns than the known unknowns.
Conclusion
In a speech in March 2018, former FDIC Vice Chairman Thomas Hoenig asked “why shouldn’t a capital ratio of 10 percent equity to total assets be the minimum standard for every bank wishing to operate in the United States?” That’s a great question. While I have yet to see a good reason why a 10 percent (or 15 percent) leverage ratio shouldn’t be implemented for all banks, the answer to the question is simply that the politics of banking in the U.S. prevent this from happening.
