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US Financial Crisis: A Story of Smart Bankers and Laid Back Regulators?

“The regulatory apparatus in the US was 100 years behind the financial innovation, that was at the root of the crisis.”1

– Nilekani M. Nandan, Co-Chairman, Infosys Technologies Ltd.

Joseph E. Stiglitz, the Nobel Prize-winning economist, believes that financial crises are not an unusual phenomenon. However, he suggests that those countries which have strong regulatory frameworks are not exposed to financial crises. He and his allies, with similar opinion, argue that in safeguarding the interests of citizens, the governments have to ensure that such crises are averted by having a strong administrative frame work to oversee the functions of all participants in economic activity – prevention is better than cure. When prevention is not possible, they say, damage must be minimised by timely and appropriate measures.

It is debatable as to what or who caused the US financial crisis, which speedily became a global financial crisis. While some attribute it to greed of the bankers, many others feel that deregulation is the real culprit. It is worth noting that US has had almost three decades of deregulation.2 However, history suggests that every step that was taken towards deregulation was done to amend some flaw in the existing system.

Post-financial crisis, the role of the regulators in the crisis is being questioned. In view of the laissez faire mechanism of US, it is arguable if the regulators even had a role to play and if they were expected to, then where did they go wrong. At the same time, the role of the investment bankers in precipitating the US financial crisis is also under scrutiny.

US: Role of Regulators and Investment BankersAs of October 2008, the proposed bailout of the Wall Street by the US government was a whooping $1.6

trillion3 . The tax payers, whose money is used to bailout the greed of the investment bankers, are confounded over the necessity and effectiveness of the bailout plan. They question why losses should be socialised, when profits are privatised. Further, they feel that if at all the government should intervene; it must anticipate and try to avert the crisis by taking appropriate measures, thus ascertaining the role of regulators in a country’s economy.

In the US, regulation in the financial services industry does exist but is highly complicated. There are many federal and state agencies, which are involved in the system (Exhibit I). Though these agencies have different agendas, many a time, a particular financial services firm is accountable to one or more of the agencies.

1 In an interview with NDTV Profit, “Just Books”, telecast on November 30th 20082 Barney Frank, “Why America needs little less laissez-faire”, http://www.ft.com/cms/s/0/d001b2c6-c20a-11dc-8fba-0000779fd2ac.html, January 13th 2008 3

Stiglitz E. Joseph, “Financial Crisis”, http://www.economist.com/debate/days/view/225, October 17th 2008

This case study was written by Vandana Jayakumar under the direction of Saradhi Kumar Gonela, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

© 2009, IBSCDC.No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

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Exhibit I

Main Federal Agencies and State Agencies of the USAgency Role/Activities

The Federal Deposit Insurance Corporation (FDIC)

The Federal Reserve

Ginnie Mae

Main banking regulator of the US

• Generally referred to as ‘The Fed’

• Has regulatory powers over the banking system and the financial markets of the US

• Acts as the ‘lender of last resort’ to the US banking system

• Operates the monetary policy of the country by setting key interest rates and adjusting the overall supply of money and credit

• Has great power in its hands as it can influence economic growth and inflation.

• Wholly-owned corporation of the federal government

• It ensures timely payment of principal and interest on those mortgages which have been insured or guaranteed by the federal government

• These mortgages are bundled into Mortgage-Backed Securities (MBS)4 by the approved

NASDAQ

The New York Stock Exchange

Office of Thrift Supervision (OTS) associations.

Main venue for trading stocks in the US.

It is a federal agency, which regulates thrifts and savings

Securities and Exchange Commission (SEC) • A department of the federal government

• The main regulatory body which monitors the securities markets in the US

• It enforces the law with regard to securities trading

• In a way it polices the Wall Street.

The Securities Investor Protection Corporation (SIPC)

It reimburses the investors when their brokerage firms become insolvent.

Treasury Department • Its activities include tax collection, debt management, bank regulation, currency and coinage, financial management for the federal government and advising on economic and financial policy

• Plays a pivotal role within the federal government and the US economy.

Source: Compiled by the author from http://f inancecareers.about.com/od/regulatorsandexchanges/ Regulators_Exchanges_and_Industry_Organizations.htm

4 MBS is a type of asset-backed security which is secured by one or more mortgages

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Despite the presence of so many federal and state agencies to oversee and regulate the economy of US, a financial crisis so magnanimous, took place. There were accusations and mud slinging not only against the regulators for their inaction but also against the investment bankers for plunging the world into the financial crisis through irrational and unjustifiable assimilation of debts, based on housing market and related financial derivatives. The American philosophy of laissez faire was itself under attack for precipitating the crisis. However, in the midst of financial crisis, the benefits of laissez faire, which manifested in the form of deregulations, cannot be ignored.

Though, deregulation is being suspected as one of the prime reasons for the crisis, it definitely helped in economic growth. As a deregulation initiative, in early 1970s, the Bretton-Woods system5 of fixed exchange rates was replaced by floating currencies. As a consequence of the floating exchange rates, capital controls were abolished in the US and the UK. With the markets becoming free, credit controls were also abandoned. Growth in investment banking in America, which was an outcome of deregulation, contributed to the prosperity of an average American, by making mortgage loans easier for homebuyers. The number of Americans who owned a house steadily rose, more and more lenders started entering the home loan market. In the 1970s and the 1980s, though there was a fear of high consumer demand affecting inflation and trade deficit, US seemed to be experiencing good times. Inflation was under control due to the technological change of the 1990s and the Indian and Chinese impact in the early 2000s. At the same time, external trade deficit was easy to finance on account of the liberalised capital markets and free flow of capital from the savings of Asia. The financial industry kept flourishing and its share in the American stock market rose to 23.5% in 2007 (Exhibit II).

Exhibit IIUS Financial Sector

Market capitalisation as % of total

25

20

15

10

5

0 1980 ’85 ’90 ’95 2000 ’05 ’08

Source: “Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730 October 16th 2008

5 After the Second World War, the Bretton-Woods system of fixed exchange rates was instituted. According to this system, capital could not flow freely between countries due to exchange controls.

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As the financial industry was flourishing so was investment banking. With the relaxation in the regulatory controls, hectic financial innovation took place. These innovations were very successful and they bestowed lots of benefits. Freedom to innovate greatly increased the wealth of American economy, in particular and the global economy, in general. Hence, the role of the investment bankers in making the society prosperous cannot be denied. Typically, the activities of an investment banker included advising their clients on financial issues, issuance of bonds, suggesting and executing strategies involved in business alliances and managing the sale of company’s stock to the public. They helped in directing capital to the companies from all over the globe. At the highest levels, the investment bankers were very significant people in shaping the economy of the world and particularly a capitalistic economy like US.

Amidst prolific investment banking, there was failure on the part of the government to live up to its responsibilities through its regulatory authority. The regulations were unable to keep pace with financial innovation despite cooperation between the regulators and bankers. Ironically, by the time regulators could comprehend the complexities of financial instruments, brainchildren of investment bankers, they did irreversible damage to the global economy.

History suggests that there has been strong relationship between the regulatory bodies and the bankers. There have been many instances when the bankers were made regulators. President Franklin D. Roosevelt appointed Joseph Kennedy, a successful stock speculator, as the first chairman of SEC, which was created during the Great Depression. On being questioned as to why he appointed a stock speculator as the chairman, the President quipped, “Set a thief to catch a thief.”6 Similarly, during the reign of President Bill Clinton, Robert Rubin, earlier the chief of Goldman Sachs became the Treasury Secretary. William Donaldson, one of the chairmen of the SEC, was also a veteran Wall Street executive. Latest example is of Henry M. Paulson (Paulson), a high profile executive of Goldman Sachs, who was appointed Treasury Secretary. Paulson took over as the Treasury Chief when the current account deficit of the US stood at more than $800 billion7 . Paulson, being an admired figure in the Wall Street, it was believed that he would be able to efficiently handle the financial stress.

The people of the Wall Street were entrusted with regulatory responsibilities, for their financial and economic experience, with an assumption that when such people go on to be on the regulators side, they are better equipped at handling the regulatory bodies. However, sometimes they failed to see the larger interests of the economy in supporting their erstwhile investors and colleagues. There were occasions when the regulators and the investment bankers worked in close cooperation as they had parallel interests.

For instance, in 2004, a major decision was taken by the regulators after a plea from big investment banks of US. One of the banks which led the charge was Goldman Sachs, headed by Paulson (who became the Treasury Secretary 2 years later). The plea was to exempt the brokerage units of the banks from an old regulation which limited the amount of debt that the brokerage units could take on. Despite scepticism on the regulators side, the plea was heard and the rule was changed. The decision was made in favour of the investment banks as there were industry complaints about excessive regulation and growing competition from overseas. This exemption benefitted the regulators as well. The earlier laws did not give the SEC a clear view of the parent companies of the banks. In exchange for relaxed capital rules, the banks allowed the commission to examine the books of their parent companies and their subsidiaries. However, in taking this decision, the regulators could not foresee the consequences.

The implications of the new rule were very favourable for the investment bankers as the exemption made available billions of dollars to them. Paradoxically, these dollars had been held in reserve till then as a shock absorber against the losses on their investments. The exemption enabled the principal company to invest these funds in the fast growing market of complex financial instruments such as MBS and credit derivatives. The new rule was exploited by the banks to such an extent that leverage ratio (a measurement of how much a firm borrows as compared to its total assets) of the investment firms sharply rose. For instance, at one point of time, the leverage ratio of Bear Stearns was 33:188 i.e., for every dollar of equity it had $33 of debt. Needless to mention the side effects of the new regulation that have culminated in the bankruptcy of Wall Street firms when faced the financial meltdown. Had the relaxation not been granted, billions of unregulated investments could not have been possible and on the safe side, banks would have had cushion to face the turmoil.

6 Labaton Stephen, “How U.S. regulators laid the groundwork for disaster”, http://www.iht.com/articles/2008/10/03/business/03sec.php?page=3, October 3rd 2008 7

“Paulson’s Progress”, http://www.economist.com/agenda/displaystory.cfm?story_id=E1_GJJSGNS, May 30th 20068 Labaton Stephen, “How U.S. regulators laid the groundwork for disaster”, http://www.iht.com/articles/2008/10/03/business/03sec.php?page=1, October 3rd 2008

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Alongside loosening of the capital rules, the agency decided to rely on the computer models of the investment firms in determining the riskiness of the investments. This way, the job of monitoring the risks was also left in the hands of the banks themselves. If the regulators had to follow independent assessment, they would have been better off in judging the exposure of investment banks and contain the risks to manageable levels. But on the flip side, the Wall Street firms would not have been as liberated.

As an outcome of the rule of 2004, the SEC could monitor the bank’s risky investments in mortgage-related securities. However, supervision was a low priority task and the agency never took advantage of its ability to monitor the risky investments. Post-financial crisis, the 2004 programme was ended. The problem with the 2004 programme was that it was not appropriately utilised. The inaction on the part of the regulators can be explained either by considering that they had a laid back attitude or they had their vested interests in supporting the Wall Street or they were so ignorant that the bankers outplayed them.

Wrestle between Bankers and RegulatorsPrior to the financial crisis, the investment bankers were always considered to be a very smart lot and they

were looked at in awe. In doing varied financial activities they worked hard and at the same time took high risks. Resultantly, the returns were also very high as the profession itself was very rewarding. However, the investment bankers were also looked at scornfully for the amount of wealth they were able to amass.

The investment bankers were able to garner wealth as the financial industry was prospering in the US and the investment banks were becoming larger. With fast development of investment banks, their activities started becoming very complex. For instance, as the mortgage loans became easier for the homebuyers, there was a surge in demand for home loans. Resultantly, the loans became less affordable. So, compromising on the quality of loans, the investment banks continued lending. Since, this was sub prime lending; the banks used complex financial instruments to whisk away the risks. However, at one point, greed took over rationality. The bankers took the help of academicians in disintegrating various components of risk and traded each risk separately. For instance, in the 1970s, securitisation took birth, which in turn gave birth to Collateralised Debt Obligations (CDO). Ironically, the complex financial instrument grew very fast (Exhibit III).

Exhibit IIIUS Asset-Backed Securities Outstanding (in $ trillion)

2.5

2.0

1.5

1.0

0.5

0 1995 ’97 ’99 2001 ’03 ’05 ’07’08*

*End June


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While the investment bankers were doing hectic innovation in financial instruments, the regulators were also doing their bit. As per the first ‘Basel Accord’9 , the banks were required to set aside some minimum capital for situations when there would be defaults from big borrowers. This was an expensive proposition for the banks. They therefore resorted to means through which they could bypass the rule using methods such as securitisation. Further, to mitigate the risks from defaults, they used instruments such as Credit Default Swaps (CDS). Just like other financial instruments, CDS also grew very fast (Exhibit IV).

Exhibit IVCredit Default Swaps, Amount Outstanding, (in $ trillion)

70

60

50

40

30

20

10

0 2001 ’02 ’03 ’04 ’05 ’06 ’07 ’08*

*End June


The invention of complex financial instruments was boon to the American economy. But, for all the sophistication, a small initial position lead to a much larger exposure, CDSs serve as the best example. For a small premium, the insuring institution took a huge risk. This made it difficult for the regulators to keep track of a firm’s exposure. The financial derivatives were so complex that even the authorities were unable to comprehend and they caused much damage. With their financial and economic acumen, the investment bankers succeeded in outplaying the financial regulators. They were able to circumvent the rules framed by the regulators – sometimes subtly and most of the times arrogantly.

Little realising the consequences, the authorities started encouraging the complex instruments. They allowed the investors and businesses to spread risks. They believed that spreading of risks would make the markets and economies strong. Alan Greenspan (chairman of the Federal Reserve from 1987 to 2006) supported the growth of CDS. He said, “Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment.”10

However, there were some crises which the regulators had to tackle; bankruptcy of Drexel Burnham Lambert in 1990 after it defaulted on $100 million11 loan for example. The regulators failed to realise that the crises were actually indicators of a flaw in the system.

9 Basel Accords are sets of agreements which give recommendations regarding banking regulations. 10 “Link by Link”, http://www.economist.com/displaystory.cfm?story_id=12415730, October 16th 2008

11 “The Collapse of Drexel Burnham Lambert; Key Events for Drexel Burnham Lambert”, http://query.nytimes.com/gst/ fullpage.html?res=9C0CE1DC1638F937A25751C0A966958260, February 14th 1990

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The inability of the regulators to see the drawbacks in the system made the bankers outsmart the regulators. However, some economists suggest that the bankers outsmarting regulators is a non-issue as the regulators depended on the bankers. The financial corporations supported the political campaigns of the politicians. Therefore, the politicians who formed the government and who in turn appointed the regulators accommodated the say of the financial corporations. Thus, the regulators had to propagate the policies, which were designed with political motives rather than financial and economic wisdom. For instance John Snow, the Treasury Secretary before Paulson, promoted tax cuts despite huge budget deficits.

Though it is being suggested that the American regulations were inadequate to prevent the crisis from happening, it is worth noting that the American regulatory system did have some regulations in place. However, even the existing regulations were not effectively used. The financial system failed in playing its role of allocating capital and managing risks. Rather there was great misallocation of resources. At the same time, instead of managing risks, they assumed high risks. While there was too much freedom in the global financial markets, there was no control over exploitation of freedom.

Post-financial crisis, the SEC also drew a lot of flak. The regulators had many a time instead of enforcing the laws to regulate the bankers, made laws which favoured the investment bankers. “Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file.”12 SEC was also accused by David Kotz, the inspector general who oversaw SEC, for being lenient with Bear Stearns. The regulators have been some times accused of being supporters of deregulations so much so that in one of the articles, Alan Greenspan has been called as ‘avatar of deregulation’13 .

Further, though the American financial system was encouraging the innovations by the investment bankers, these innovations were not able save the common man from real risks. Also, the financial system ignored the innovations, which would have enhanced the efficiency of the American economy.

The regulators are also being accused of laxity in their operations. They ignored some of the indicators of trouble such as firms’ risky investments and their increased reliance on debt. The regulators are being accused of not taking timely and necessary action. There were other instances of laxity as well. In 2007, seven people were assigned by the SEC to examine the parent companies of the investment firms, which controlled the financial markets. However, the said office faced problems such as not having a director or not doing the inspections on time.

Further, in compliance with the laissez faire philosophy of the US, the regulators relied on many voluntary regulatory programmes. For instance, according to the 2004 programme the bankers had the option of voluntary risk monitoring. The regulators allowed the bankers to monitor the risks themselves thinking that they would have some self-discipline and they would monitor their risks well. However, that voluntary monitoring did not work out well as greed overpowered discipline. Roderick Hills, (one of the former chairmen of SEC) says, “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work”14 .

There are lots of allegations against the regulators for their inaction. However, Christopher Cox, chairman of SEC, tried defending the inaction on the part of the commission by saying that there was a lack of legislative authority with the commission.

Moreover, some economists are questioning the credibility of not just the regulations but also the regulators. The regulators are being questioned for not rescuing Lehman Brothers from bankruptcy though American International Group (AIG) was rescued by the government. Richard Fuld (Fuld), the head of erstwhile Lehman Brothers, claims that the US regulators were aware about every activity of the firm and its condition long before the bankruptcy. Fuld revealed that the Federal Reserve had regularly overseen the business of Lehman Brothers throughout 2008. It is alleged that the Treasury Secretary, Paulson, who was at the helm of affairs at the time of the financial crisis, did not take efforts to rescue Lehman Brothers, as he is an ex-Goldman Sachs chief. Fuld feels that had Lehman Brothers been rescued, like the way the government rescued AIG, Fannie Mae and Freddie Mac, further dislocations in the markets might have been curtailed.

With the bankers and the regulators being accused of submerging the world in financial crisis, both the markets and the regulatory structures need to be corrected and improved to ensure that a similar crisis doesn’t reappear. Economists are debating on new set of regulations where the financial corporations also need to change so as to limit the heavy profits, which accrue to the board of directors of financial organisations.12 “How U.S. regulators laid the ground work for disaster”, op.cit. 13 “Why America needs little less laissez-faire”, op.cit.14 “How U.S. regulators laid the ground work for disaster”, op.cit.

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Joseph E. Stiglitz suggests that the regulations should be framed keeping in mind not just the interests of the Wall Street but also of the entire country. Further, he suggests that those people should be entrusted with the job of regulators who do not have any vested interest in Wall Street. They should be the people who realise the meaning of an economic downfall for the country and its people. He advocates that there is a need of right regulation as well as a regulatory system that enforces the regulations.

However, Nobel laureate Myron S. Scholes feels that a heavily regulated financial system is not the solution to avoid recurrence of financial crisis. According to him, there have been instances in history when even highly regulated banking sectors have collapsed. He suggests that a crisis is caused when banks have too much leverage. Therefore, one way of avoiding crises is that banks should have either less leverage or additional equity capital.

Post-financial crisis, it is also being suggested that instead of so many regulatory bodies; there should be one super regulator. However, William Isaac, chairman of FDIC from 1981 to 198515 feels contrarily. He feels that though the current structure seems messy, it has many inherent safeguards. For instance, multiple agencies help in looking at the same issue from different angles.

In post-crisis debates, it is alleged that the very economic philosophy of the US of laissez faire is at the heart of the crisis. It resulted not only in a globally magnanimous financial crisis but also a steep income inequality within US. Thus a mature capitalist economy like that of US needs an optimum level of laissez faire, neither lesser nor more. It is being believed that government intervention and market regulation are a must. However, with government intervention, it won’t be capitalism any longer.

15 Chung Joanna and Farrell Greg, “Bigger role urged for regulator with safe hands”, http://www.ft.com/cms/s/0/1921687a-9fd2-11dd-a3fa-000077b07658.html, October 22nd 2008

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