The most suprising thing about the financial crisis is that the problems were so widespread in the banking system but absent, or nearly so, in the so-called “shadow banking” system.
It was investment banks and commercial banks that loaded up on mortgage backed securities, rather than hedge funds, endowments, pension funds or money market funds. Why did risk become so concentrated in some of the most regulated institutions in the world?
Because the regulators held a monopoly on what constituted prudent banking and directed the banks to buy more mortgage backed securities. Jeff Friedman explains the process in The American:
For American banks, the answer seems to be an obscure regulation called the Recourse Rule. The Rule was enacted by the Fed, the FDIC, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. It was an amendment to the international Basel Accords governing banks’ capital reserves—and all over the world, these regulations appear to have caused the crisis.
A bank’s capital reserves represent funds that aren’t lent out or invested. This means that they are unprofitable, but they also might come in handy should a bank’s loans or investments turn sour. By reducing their reserves—and thus increasing their leverage—banks can, at least in principle, increase their profitability. But under the Recourse Rule, American commercial banks were required to hold 80 per cent more capital against commercial loans, 80 per cent more capital against corporate bonds, and 60 per cent more capital against individual mortgages than they had to hold against asset-backed securities, including mortgage-backed securities rated AA or AAA. The Rule thus created a 60-80 per cent incentive to buy highly rated MBS for any bank that wanted to reduce its capital reserves.
Now, the purpose of capital reserves is to cushion against unexpected trouble. So banks that increased their leverage by reducing their capital reserves were, in principle, exposing themselves to trouble. But that didn’t turn out to be the problem. At the beginning of 2008, the aggregate capital cushions of American commercial banks were 30 per cent higher than required by bank-capital regulations. The problem was not the depth of the cushions or, conversely, the height of the banks’ leverage. It was the composition of this leverage, which is to say, its overconcentration in mortgage-backed bonds. And without the Recourse Rule, there is no reason that American banks that were trying to leverage up would have converged on mortgage-backed bonds. No other group of investors—not hedge funds, not pension funds, not mutual funds—were, as a whole, so overinvested in mortgage-backed bonds. But then, only banks were subject to the Recourse Rule.
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