Abstract
This chapter argues that, since the 1980s, moral hazard has encouraged excessive indebtedness and contributed to greater leniency from regulators and financial gatekeepers towards systemic banks. Examining the rise of the “too big to fail” (TBTF) banking behemoths, we question how moral hazard came to dominate banking culture and how the developing financial innovation in and after the 1980s combined with that culture to accelerate the growth and pre-eminence of the mega-bank. We explore how financial gatekeepers—US regulators, credit rating agencies (CRAs), and the Federal Reserve—became “lenient partners” (or “sweeteners”) that enabled and accelerated the growth of the financial services sector. We propose various reforms dealing with TBTF banks, CRAs, US regulators, and the indebtedness of American citizens.
Keywords
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- 1.
Disintermediation means bank customers directly engage in financial activities without the guidance and support of—and without paying fees to—intermediary financial institutions, such as banks and savings and loan associations.
- 2.
Securitisation is the process of collecting and transforming individually illiquid assets into a pool of collateral supporting the issuance of senior and subordinated debt and equity interests. Common examples of securitisation include mortgage-backed securities (MBS), and asset-backed securities (ABS) secured by, for example, credit card account receivables.
- 3.
Moral hazard occurs when one entity takes greater than proportionate risks because another entity bears or is made to bear the cost of those risks. In this chapter, moral hazard primarily refers to a specific situation, namely, that of US systemic banks, which take excessive risks because they are confident they will not be allowed to fail in case of severe financial distress. See Rowell and Connelly (2012) for a study of the term “moral hazard”.
- 4.
Systemic risk is the possibility that an event at a bank or company level could trigger the collapse of the economy.
- 5.
We focus exclusively on the US economic and financial system because consumer credit, structured finance products, excessive leverage, and the TBTF phenomenon emerged and developed dramatically in the US before spreading, to a lesser extent, to other developed countries.
- 6.
Federal Deposit Insurance Corporation (FDIC 1997, 248). The FDIC’s Annual Report for 1950 indicated that it was “the intent of the Corporation to use this authority sparingly”.
- 7.
The consequence of hypergrowth strategies was the increasing concentration in the financial sector. This remains a major challenge of the re-globalization era. James Busumtwi-Sam provides a striking illustration in Chap. 5, showing that remittance flows are in the hands of a very small group of international money transfer operators.
- 8.
- 9.
The purchase of the ‘bad loans’ and the assumption of control represented a new response to a failing bank. Prior to the CINB crisis, the FDIC had three options: liquidate the bank and pay insured depositors (only), arrange for an acquiring bank to assume the liabilities (and thus protect uninsured depositors), or directly inject funds.
- 10.
See https://www.federalreservehistory.org/essays/failure_of_continental_illinois and Carrington (1984).
- 11.
See statement of Richard Michalek, US Senate, Permanent Subcommittee on Investigations, Hearing on Wall Street and the Financial Crisis: The Role of Credit Rating Agencies , 23 April 2010, p. 44: Senator Levin: “OK. And then, what does [IBG-YBG] mean?” Richard Michalek: “IBG-YBG was explained to me to mean”, “I’ll be gone, you’ll be gone. So why are you making life difficult right now over this particular comment?” […] “When it was originally told to me, I did not realize how that thinking really was driving much of what was going on, actually”. Senator Levin: “Short-term thinking”. Mr. Michalek: “Short term, get this deal done, get this quarter closed, get this bonus booked, because I do not know whether or not my group is going to be here at the end of next quarter, so I have to think of this next bonus”.
- 12.
For a scathing description of a battle for power exemplifying the then-current shift in cultures, see Auletta (1985).
- 13.
It is worth noting that abundant liquidity on US capital markets was (and is still) partly driven by capital flows from China. See http://www.cnbc.com/2014/09/17/why-chinese-money-is-flooding-american-markets.html
- 14.
- 15.
The importance of a “third party risk assessor” grew in proportion with the development of securitisation. See below.
- 16.
For a more exhaustive analysis of the role played by the main CRAs, namely, Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s), and Standard & Poor’s (S&P), see below.
- 17.
In July 2007, Chuck Prince (then CEO of Citigroup) said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. See Nakamoto and Wighton (2007).
- 18.
Here, our analysis is partly in line with Laurent Dobuzinskis’ chapter on regulatory failure.
- 19.
Here, we briefly mention the FRB as regulator. Below, we will refer to it as monetary policy maker.
- 20.
The “go along to get along” culture combines well with the “if it ain’t broke, don’t fix it” rubric in the developing “revolving door” environment, where mid-level regulators and “deal-level” employees at the CRAs were eager to maintain favour with potential future employers offering significantly greater financial rewards.
- 21.
For a comprehensive overview of the byzantine US regulation and supervision of financial institutions, see Mason (2015).
- 22.
Regulatory capture is an illustration of government failure that occurs when a regulatory body promotes the financial or political interests of the firms or groups it is charged with regulating. Nobel Prize winner George Stigler developed such arguments in various research works; for example, see Stigler (1964, 1971).
- 23.
In the early 1990s, there was already a consensus that financial services spurred economic development. See King and Levine (1993).
- 24.
SEC . 1992. Exclusion from the Definition of Investment Company for Structured Financings. Investment Company Act Release No. 19105. November 19 [57 FR 56248 (Nov. 27, 1992)].
- 25.
Often used in determining regulatory capital and when posting collateral, such a deduction is referred to as a “haircut”.
- 26.
In 1975, the SEC introduced the concept of NRSRO for the purpose of categorizing debt as investment grade (or not) when calculating broker-dealer capital.
- 27.
SEC . 2001. Marketability of Asset-Backed Securities Issued by Special Purpose Vehicles. No-Action Letter. July 13.
- 28.
Federal Register. Part II, Securities and Exchange Commission, 17 CFR Parts 210, 228, et al.—Asset-Backed Securities; Final Rule, Vol. 70 (5), January 7, 2005, Rules and Regulations, p. 1510.
- 29.
For an overview of the Dodd-Frank Act and its capacity to prevent future financial crises, see Murdock (2011).
- 30.
We have very reliable sources indicating that the SEC itself asked the Ford Motor Credit Company LLC to submit a request for a no-action letter on the day that Rule 436(g) was to have been suspended (i.e., the day after President Obama signed the Dodd-Frank Act). The rationale was that the Dodd-Frank provision was poorly thought out and would have caused enormous damage, so the SEC had to be proactive.
- 31.
For additional post-crisis analysis of SFAS 140, see Barth and Landsman (2010).
- 32.
Since 1991, federal banking regulators have been expected to take PCA to identify and address capital deficiencies at banks to minimize losses to the deposit insurance fund (DIF). PCA includes different types of penalties. A critically undercapitalized FDIC-regulated institution would be required to be taken into receivership by the FDIC.
- 33.
As a refresher, when securities are traded through a recognized and sufficiently capitalized “exchange”, the counterparties are in fact each trading with the exchange, which then bears some of the risk of non-performance by the contracting parties. Exchange members typically pay fees and post margin (collateral) to the exchange to finance administration and to ensure sufficient capital is available to assume the relatively rare failures of the trading members.
- 34.
Post-crisis, ISDA developed “Determination Committees” (“DCs”) to hear and determine transaction disputes from contracting counterparties. According to ISDA, the “DCs” consist of 15 member institutions, 10 of which are voting swap dealer members and 5 are voting non-dealer members. The majority of disputes involve whether or not a payment-triggering “credit event” has occurred under a credit default swap transaction. All participants using ISDA documentation contractually agree to adhere to the rulings of the DCs. But as with every other ISDA agreement, recourse for any member who disputes an outcome under the ISDA document is limited to judicial resolution in a court willing to take jurisdiction. ISDA itself has no power of enforcement. See ISDA (2012).
- 35.
Credit ratings were first released by John Moody in 1909. The success of these credit risk indicators in the US enabled new entrants (Poor’s, Standard Statistics, and Fitch) to compete with Moody’s firm in the 1920s. Since Poor’s and Standard Statistics merged to form Standard & Poor’s (S&P) in 1941, the credit rating industry has been dominated by these three agencies. See Sinclair (2005) for an overview.
- 36.
In 2013, in order to reduce the conflicts of interest inherent to the credit rating business, the European Commission “explored the appropriateness of, and ways to, support a European public credit rating agency”. However, this project has not materialized so far. See Regulation (EU) No. 462/2013 of the European Parliament and of the Council of 21 May 2013 amending Regulation (EC) No. 1060/2009, para. 43.
- 37.
The through-the-cycle methodology “places low weight on short-term credit shocks and thereby reduces rating volatility” (Moody’s 2003b).
- 38.
Moody’s rated less than 5000 structured finance securities in 1994 vs. more than 86,000 in 2007 (Moody’s 2008, 2).
- 39.
A rating affirmation letter is a letter that affirms the rating of the subject obligation as of such and such date is X. These letters may be requested in connection with a secondary market transaction or in connection with a change in control of a noteholder. A rating confirmation letter is akin to a “no-action” letter issued by a regulator and states that in light of some proposed action, such action “in and of itself” will not result in the reduction of the rating currently outstanding.
- 40.
One possible answer: the CRAs are not selling their expertise, they are selling their ratings and buying market share from their competitors. See US Senate (2010).
- 41.
- 42.
Our critical view of the action performed by the Federal Reserve complements those developed by Laurent Dobuzinskis and Ted Cohn in this volume.
- 43.
Alan Greenspan served as Chairman of the Federal Reserve from 1987 to 2006. He was succeeded by Ben Bernanke.
- 44.
Core inflation is generally calculated using the consumer price index (CPI).
- 45.
Even with respect to the core inflation standard, interest rates were too low. The federal funds rate minus inflation differential declined from 2.3 percentage points during 1986–1995 to 1.2 percentage points during 1996–2005 and 0.9 percentage point during 2006–2015.
- 46.
Total assets of the Federal Reserve System soared from $900 billion in August 2008 (i.e., a few weeks prior to the collapse of Lehman Brothers) to $4.4 trillion in August 2014 (Federal Reserve data).
- 47.
The FOMC (Federal Open Market Committee) is the branch of the Federal Reserve Board that determines the direction of monetary policy.
- 48.
- 49.
This fear of jeopardizing one’s own short-term compensation (even when the action disproportionately threatens long-term returns) represents one critical facet of the culture steeped in moral hazard. The cognitive biases attending decisions involving immediate and future realized values, when combined with secondary incentives in the behaviour of sell-side analysts and traders operating in a “zero sum” trading environment, significantly contribute to less than economically optimal outcomes and amplify the swing of the regulate-deregulate pendulum.
- 50.
A bail-in is an alternative to bailouts of failing banks where investors and in the extreme, depositors, take a loss rather than governments and taxpayers.
- 51.
- 52.
Pay As You Earn, or PAYE federal student loan repayment plans adjust the monthly amount due on the loan according to the income level of the borrower, adjusted for certain necessary expenditures. The term of the plan is typically 20 or 25 years, with the federal government paying to the private lender the unpaid interest and principal otherwise coming due on the loan. However, at the end of the 25 years, any remaining balance on the loan(s) is forgiven (but, subject to contrary subsequent legislation, the forgiven amount is recognized as taxable income to the borrower in the year of forgiveness). See Federal Register. 34 CFR Parts 685. 209 and 221.
- 53.
IRR, or internal rate of return, is that implicit rate of return on investment from a stream of cashflows. The lender is effectively guaranteed a return of its capital at the 10-year treasury rate. The government’s cost of funds, assuming some payments are made by the student-borrower, is necessarily less than the 10-year treasury rate. The lender agreeing to forego the subsidy would effectively be sharing the risk of return on the student’s education.
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Gaillard, N., Michalek, R.J. (2019). How and Why Moral Hazard Has Distorted Financial Regulation. In: Hira, A., Gaillard, N., Cohn, T. (eds) The Failure of Financial Regulation. International Political Economy Series. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-05680-3_4
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