Hensarling’s “Market Regulation” Replacement to Dodd Frank Proves He Does Not Understand Banking

Yves here. Steve Waldman wrote a definitive post in 2009, Capital can’t be measured, on a core issue that Black discusses here. A key section:

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

By Bill Black, 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. Jointly published with New Economic Perspectives

Representative Jeb Hensarling, Chair of the House Financial Services Committee has announced that he will introduce a Republican plan to repeal key provisions of the Dodd-Frank Act and replace them with “market-based” regulation. I have explained in a prior column how theoclassical economists, for over 40 years, have created repeated criminogenic environments in finance due to their unholy ideological war against effective financial regulation. The dominant policy view among economists and senior anti-regulatory policy advisers of every administration since President Carter embraced the myth that economists had invented means by which the “markets” will effectively “regulate” finance.

The reality is, first, that what they falsely call “market” “forces” are what creates the perverse incentives that cause our recurrent, intensifying crises. Second, their “market” regulation makes those incentives even more perverse. Third, the theoclassical myths and anti-regulatory policies generate regulatory complacency based on the myth that the problem of those perverse incentives has been vanquished by “incentive compatible” regulation.

It is ironic that economists’ proudest boast is that have unique insights and predictive abilities because of their understanding of the incentive of self-interest. They brag that they have been taught to “think like economists” and understand that self-interested behavior is ubiquitous. As we have all observed, they are actually so supremely bad at understanding how perverse the incentives they worship are in the real world that their predictive record is abysmal – and getting worse.

The most famous (to nerds) policies arising from this myth are requiring banks to issue subordinated debt – and allowing them to treat this debt as “equity.” Theoclassical theory predicted that the purchasers of bank subordinated debt were the ideal source of “market discipline.” The purchasers of bank sub debt are lenders to the banks who contractually agree (in return for a higher nominal interest rate) that if the bank is liquidated through bankruptcy or a receivership the lender will not be repaid until after all secured and general creditors are paid in full. As a practical matter, this means that sub debt holders are almost certain to be wiped out if the bank is liquidated. That fact is supposed to ensure that the sub debt holders will have the proper financial incentives to be zealous in preventing any actions by management that could endanger the bank’s health. Bank sub debt is also sold in minimum denominations of $10,000, is typically purchased by lenders in blocks of over $1 million (often tens of millions of dollars), and is typically purchased by lenders that would be considered highly financially sophisticated. Together, this means that theoclassical economists predicted that sub debt holders would combine the proper financial incentives to provide the ideal “private market discipline” because subordination of their loans to the banks meant that they were exposed to very large risk of loss and because they had enough money at risk (“skin in the game”) that it was worthwhile for them to spend the money necessary to conduct effective “due diligence” and determine the bank’s true financial condition. The sub debt holders’ characteristic high financial sophistication meant that high ability to conduct effective due diligence was married to the proper incentives.

But there is a more subtle advantage that is supposed to be unique to “private market discipline” – it is not subject to the due process and equal protection clauses of federal and state constitutions. Potential sub debt holders do not need to have any basis for refusing to buy a bank’s debt. Once they have bought the debt they do not need to have any basis for refusing to renew the sub debt. They can insist on any “debt covenants” they wish before purchasing or renewing their sub debt. They can exercise those debt covenants without any procedural requirements that slow down regulatory actions.

There was only one problem with sub debt – it never worked as predicted by the theoclassical economists. There was never, anywhere in the world, an effective case of private market discipline by bank sub debt holders. As George Akerlof and Paul Romer noted in their 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit,” sub debt was typically “covenant lite” rather than stringent. The theoclassical theory predicted that sub debt should have particularly stringent covenants and that they would be enforced zealously.

The universal failure of their sub debt predictions, of course, did not cause theoclasscial economists to admit error. Instead, they developed “incentive compatible” “risk-based” Basel II capital standards. These standards were preposterous and failed even more spectacularly than sub debt.

The newest theoclassical variant on “market” regulation is Hensarling’s Republican plan. This variant relies on the myth that “capital” is a thing of great value sitting in a bank’s vaults that can easily be measured and that all we have to do is require higher capital requirements and banks will not fail or at least will fail at no or minimal cost to the public. To believe this myth one need only be ignorant of accounting, finance, and regulation.

First, capital is merely an accounting residual. Assets – Liabilities = Capital. This means that if assets are overstated or liabilities are understated (or both) capital will be overstated. Second, the way “accounting control fraud” works is to massively overstate asset values. As Akerlof and Romer explained:

We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussions of the crisis in the savings and loan industry. If net worth is inflated … incentives for looting will be created.

Yes, the point was “obvious” 23 years ago before a Nobel Laureate in Economics (Akerlof) put it in print in a famous article. By the end of 1993, we, the S&L regulators, had been putting the point to practical use for a decade as the core of our crackdown on the fraudsters. Indeed, we prioritized the S&Ls reporting the highest profits for investigation and closure. Akerlof and Romer’s article is one of the first things any Representative should read upon being named to the House Financial Services Committee. The Chair should be among the last people in the world to propose relying on capital to create effective private market discipline. But my readers know that Hensarling has never and will never read the relevant economics and criminology literature.

Third, it is epidemics of accounting control fraud that have driven our three modern financial crises – the savings and loan debacle, the Enron-era frauds, and the most recent financial crisis. Hensarling’s plan assumes that the banks’ reported capital is real rather than the product of fraud.

Similarly, “income” is merely an accounting residual. If the bank overstates revenue or understates expenses and losses, its income can be massively inflated. Charles Keating’s Lincoln Savings, for example, reported that it was the most profitable S&L in America when it was actually the suffering the worst losses of any S&L. Jamie Diamond, JPMorgan’s CEO, made this point in his March 30, 2012 letter to shareholders.

Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent [fictional] income today and losses tomorrow.

Hensarling however, is peddling not only the myth of “market” regulation but also the myth that capital regulation and accounting can be made “simple.”

The Republicans’ better approach will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements.

If he believes his words quoted above, then Hensarling has demonstrated to the world that he does not understand even the most basic aspects of banking. Let me be clear. Higher capital requirements are a good idea. The claim that such capital levels would be “too expensive” is bad economics. The idea that there should be a strong minimum capital requirement as a percentage of total liabilities rather than a more complex risk-weighted standard is also a good idea. The idea that a high capital requirement creates effective “market” regulation and obviates the need for vigorous real examination and regulation is a dangerous myth that would create the future criminogenic environments that would ensure future massive crises.