Financial Regulatory Success under Bush and Obama?
I came across two claims of financial regulatory success this week. The Washington Post’s financial columnist, Steven Pearlstein wrote a September 14, 2010 column entitled: “Bank regulators once bamboozled, now emboldened.” A.M. Best issued a report on July 27, 2010: “A Commercial Real Estate Crisis Is Addressed – Partially.” Considering the two articles together offers some useful analytical opportunities. AMBEST makes a modest claim:
A.M. Best believes the regulators’ CRE guidance was helpful in limiting the severity of these exposures within the banking industry, which peaked at year-end 2007. Restraining this risk almost certainly improved safety and soundness of insured depository institutions and reduced the level of failures up to now – and if the guidance continues to be effective, for the future as well….
Mr. Pearlstein’s column claims that the Basel III proposals show that “the world’s bank regulators are finally getting their spines back” and frames a question:
The trillion-dollar question is whether regulators have learned from the last credit bubble the lessons necessary to prevent the next one.
He goes on to say, however, that he sought to answer that question by talking with the top professional supervisors at the banking regulatory agencies. We can agree that these supervisors acted like invertebrates during the crisis, but it is a mystery why Mr. Pearlstein would credit their promises to display courage, integrity, and competence in the next crisis.
A generous means of reviewing the top supervisors’ ability and integrity is to examine their work when they were operating at their most effective – in their 2006 CRE guidance. FDIC Chairman Donald Powell gave a speech on October 11, 2001 emphasising that it was essential that the regulators learn the lesson of the crises of the 1980s and early 1990s – CRE concentrations were disastrous.
Third, as a general rule, bank asset portfolios are much more diverse than they have been in the past. Since I am a former banker with 30 years of experience in the industry, I can’t stress too strongly the importance of a diversified portfolio. We all saw what happened during the last recession, when much of the credit risk growth was concentrated in real estate construction and development lending and leveraged financing. None of us wants to see that again.
By September 21, 2003, in his speech to the American Bankers Association, Chairman Powell was warning that CRE was already deteriorating in many markets.
Another area of potential concern is commercial real estate. We’ve seen deteriorating fundamentals over the last couple of years in many large city commercial office markets.
CRE concentration ratios, which Powell had promised “none of us wants to see [that high] again” were already higher in 2003 than they had reached in the prior crisis. By March 4, 2004, Powell was describing these already excessive and rapidly growing concentrations in benign terms:
In addition to the potential problems raised by these macroeconomic trends, the FDIC is closely monitoring the economic fundamentals of certain commercial real estate markets, principally in the Southeast and the West. Some institutions have high loan concentrations in these markets, although overall bank loan performance in this sector remains very solid at this stage.
By March 26, 2004, Powell was contrasting the industry’s “near death experience” in the 1980s and early 1990s with the “golden age” his audience was now experiencing. He ascribed the change to:
In the past two decades, we’ve seen a free-market consensus develop around an agenda of broad deregulation in our economy. As a result, we are witnessing a significant transformation in the marketplace brought on by the revolutionary economic events that characterised the end of the twentieth century.
One does not disrupt a “golden age” brought on by “a free market consensus” with regulation. The federal regulators, therefore, took no action against the rapid growth of CRE concentrations. It did not “closely monitor” the problem of CRE concentrations. It did not take effective action against individual banks and S&Ls with severe CRE concentrations.
By the time the federal regulators roused themselves (in January 2006) to propose voluntary joint “guidelines” for the steps that banks should take when they engaged in excessive concentrations in CRE lending those concentrations were several times greater than they had been during the “near death experience” “that none of us want to see again.” The federal regulators then dallied until December before adopting weakened guidelines. Even the weakened guidelines were too much for the Office of Thrift Supervision’s leaders. (OTS almost always “won” the federal regulatory competition in laxity.) OTS withdrew from the joint guideline and issued its own still weaker guideline.
December 2006, of course, was five years after Powell had expressed his view that the regulators should never again allow CRE concentrations far lower than those permitted under the guidelines. The agencies issued the joint guidelines many years after the agencies had identified the excessive CRE concentrations. The agencies compounded the ineffectual nature of the guidelines by not taking vigorous enforcement actions against even exceptionally excessive concentrations. The FDIC’s Office of the Inspector General has found this to be a recurrent problem at the FDIC. AMBEST reports: “Concentrations did continue to grow – though likely at a slower rate than otherwise – until they finally peaked near year-end 2007.” It was the financial crisis and recession, not the joint guidelines that stopped the growth in CRE concentration. Tim Long, the Office of Comptroller of the Currency’s (OCC’s) top professional supervisor (one of the regulators that Mr. Pearlstein claimed was “emboldened”) characterised the OCC’s approach to the guidelines under his supervisory leadership.
The causes of this financial crisis were remarkably similar to those we’ve seen in past crises. Regulators, bankers, auditors, and accounting standard-setters — we all lost sight of some of the most fundamental concepts of banking. We allowed credit underwriting standards to be compromised. We tolerated excessive levels of leverage. We permitted concentrations to build to dangerous levels. Finally, we did not recognise, or did not take sufficient actions to arrest, imprudent growth.
I will discuss Mr. Long’s speech about the causes of the crisis at greater length in a subsequent column. Here, I note only two points. First, he ignores “control fraud” – a leading cause of past and current crises. Several of the points he discusses as putative causes (extreme growth, the deliberate evisceration of underwriting, concentration, and extreme leverage) are actually ingredients in the recipe that maximizes a lender’s fraudulent accounting income. (In another passage in the same speech, Mr. Long agrees that the fourth ingredient in optimising fraudulent accounting income – absurdly low loss reserves – was also present.) Second, because the cause of this crisis is the same as early crises (e.g., the S&L debacle and the Enron era accounting control frauds), the OCC had no excuse for forgetting the cause and there is no reason for confidence that it will not forget it by the time the next crisis is developing.
When acting at their very best (the joint guidelines on CRE) the federal financial regulators were five years and several trillion dollars late. They compounded the weakness by (A) only adopting a guideline, (B) not enforcing it vigorously and on a timely basis against even exceptionally excessive CRE concentrations, and (C) generally refusing to require loss recognition on acquisition, development and construction (ADC) loans until their interest reserves were exhausted.
Nevertheless, the federal financial regulators were vastly better than groups that were even more tightly in thrall to theoclassical economic dogma. The banks, the real estate industry, and state financial regulators fought vociferously to prevent the issuance of the joint guidelines. The Conference of State Bank Supervisors’ arguments against the guidelines were based on arguments that were so disingenuous that they deserve special recognition:
CRE lending, however, is a market that is being managed successfully. The states scrutinize their chartered institutions to verify that risk mitigation measures are being properly applied. Field examinations have illustrated that CRE risk is being successfully identified and managed. For example, some of my fellow state regulators have participated with federal regulators on joint examinations at institutions with high CRE concentrations. In virtually all cases, either risk management practices were deemed sufficient or corrective action was implemented in a timely manner.
As regulators, we must not be overly or broadly prescriptive in how risk is managed.
As bad as the federal financial regulators were (and they were dismal), they were far better than the industry and the state regulators when it came to CRE. That’s the good news. The bad news is that that the supervisors that Mr. Pearlstein sees as emboldened remain blind to the reasons we suffer recurrent, intensifying crises. President Obama has left the invertebrates in power.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.