Regulation and Financial Crises:

Cure or Cause?
Sam Peltzman
Booth School of Business
University of Chicago
 A Much Discussed Topic…

“A certain idea of globalization is dying with the end of a

financial capitalism that had imposed its logic on the whole
economy and contributed to perverting it…..
The idea of the all-powerful market that could not be
contradicted by any rules, by any political intervention…. [was]
…a crazy idea…. The idea that the market is always right is a
crazy idea.
…Laissez-faire is over”
• Nicholas Sarkozy quoted in “Sarkozy Stresses Global Financial Overhaul,”
Erlanger, Steven. New York Times, September 26, 2008, p C9.
“The banking crash might not have occurred had
banking not been progressively deregulated
beginning in the 1970s.”
Capitalism in Crisis
RICHARD A. POSNER
Wall Street Journal May 7, 2009
 Overview
 What does regulation (and deregulation) in financial
services really mean?
 What is regulated? How? Why?

 Brief history of regulation

 Connection between regulation and financial crises

 Does regulation make things better or worse?
 What role in recent financial crisis?
 What changes have occurred?

 What lessons for the future?

 Tislach li – mainly about US
 Two Kinds of Financial Regulation
• Services
– Where located
• Branching & entry restrictions
– What could be provided
• Banks and savings banks
– Mortgages v commercial loans
• Banks and other intermediaries
– Lending & deposits v ‘universal banks’
– How much could be charged or paid
• Maximum interest rates on loans & deposits

• Financial safety & soundness

– How much risk ?
– The main topic of this talk
 Very Different Histories

• Service regulation has decreased significantly (since 1970)

– Any US bank can open a branch anywhere in the US
– EU
– They can pay any interest rate on deposits they wish
– They can (mostly) charge any interest rate on loans
– Savings bank/commercial bank distinctions have eroded

• This kind of deregulation has increased bank safety

– More diversified assets
– Less ‘disintermediation’ risk

• Financial safety regulation has increased in the same period

 What is Financial Safety Regulation ?
• Goal: Make sure bank honors obligations to depositors

• Two aspects: liquidity & solvency

– Liquidity: bank has enough cash to meet withdrawal demands
– Solvency: bank assets > deposit liabilities
– Related: fear of insolvency bank “run”

• Focus on solvency regulation here

• Two concerns
– What kind of assets can bank invest in?
– How much capital (owner’s equity) should bank have?
So Why is the Government Worried About Bank
Safety?
• Two answers
– Historical: worry that unregulated banks provided “too little”
– Contemporary reality: because of this worry, governments
intervened to assure liquidity
• This creates incentives for ‘too much’ risk taking
• That the government then tries to suppress

• Here I’ll focus on the contemporary problem

• Start with a bank that is not regulated

 A Typical Bank

This bank has $100 in assets. $80 came from depositors & the
bank’s owners invested the other $20. (‘capital ratio’ is .2)

This means that the $100 of assets can lose up to $20 of value
before depositors are threatened with loss.
 Unregulated Competition
• What if another bank in town had a capital ratio of
only .1?
– That bank could attract depositors only if
• It offered higher interest rates on deposits, or
• It held less risky assets
– $100 in cash or treasury bills would require little or no capital for safety

• So the market offered a tradeoff

– Banks with riskier assets or lower capital ratios offered
higher interest rates
– And they also failed more often
 This World Ended in the 1930s
• Many banks insolvent
• A ‘run’ on the system
• Met by government deposit guarantees
– FDIC established in the middle of 1933 bank run
– Many other countries follow
• These guarantees are often de facto
– Israel: 100% of deposits insured
• And often extend beyond deposits to other claims v
bank
– Israel: bank equity in early 1980s
– US,EU,UK: many uninsured claims 2008 & earlier
 Guarantees Change Bank Incentives

• Insured depositors do not care about a bank’s

safety
 Do you know what your bank’s capital ratio is?
 Or what it is investing your money in?
 Do you care?

 You shouldn’t care

 And the bank should act accordingly

The “Moral Hazard” of Government Guarantees
• Because depositors no longer care about safety, the
bank owners want to:
1. Reduce capital ratios
• If I reduce the capital ratio to .1 (or .01 or .001) I will not have to
pay higher interest rates to keep my depositors happy
• So why should I tie up $20 in this bank?

2. Invest in riskier assets

• $100 in treasury bills becomes a terrible investment
• If the government absorbs (most of) the risk
• Example: the bank invests its $100 at the casino…
 The Bank Goes to Las Vegas
• Our bank invests its $100 on a risky bet that
– Doubles the $100 if red comes up
– Pays $0 if black or white come up

• You wouldn’t do this with your own money

– It gives a 1/3 chance of getting $100
– & a 2/3 chance of losing $100
– It has an ‘expected value’ of -$33

• But how does it look to the Bank’s owners?

 Ans: Not Bad. Better than Staying Safe
1. If black or white come up we lose our equity
– Loss of $20 max (probably much less)

2. But if red comes up we gain $100

3. So, we have
– 2/3 chance of losing $20 (or less)
– 1/3 chance of gaining $100
– [the expected value of this bet >0
• 1/3*100-2/3*20 = +20]

4. This beats playing safe (expected value ~0)

 What Does the Example Tell Us?
1. Banks have powerful incentives to take risks by
– Preferring risky assets to safe assets
• Even if those risky assets have negative expected value
– Leveraging their balance sheet

2. The source of the risk incentive is deposit

insurance (or similar guarantees)
– This turns a negative EV bet into a winner for the bank
– Because the downside risk is borne by the government
• If black or white (or red) depositors don’t care
• They would have cared in the bad old days
 Corollary
• Unless that incentive is suppressed expect banks to
– Take risks rather than play it safe
– Reward risk taking within the bank
• Big bonuses instead of fixed salary

• Failure to understand that risk incentive will get all

of us into trouble
 Including Regulators

“those of us who have looked to the self-

interest of lending institutions to protect
shareholder’s equity (myself especially) are
in a state of shocked disbelief.”
• Alan Greenspan, October 23, 2008
 Moral Hazard: A Brief History
• First response to deposit insurance: ‘leveraging up’
– Capital ratios fall by half
 Moral Hazard: A Brief History
 First response to deposit insurance: ‘leveraging up’
 Capital ratios fall by half

 Little effect until 1980s: S&L crisis

 Macroeconomic turmoil & undiversified institutions
 Lead to losses & negative capital for many
 Which regulators try (unsuccessfully) to ignore
 Continental Illinois (1984) – first major bank rescue
 Response: tougher regulation FDICIA (1991)
 Higher minimum capital ratios
 ‘prompt corrective action’
 Round 2: Emerging Markets Crisis (late 1990s)

• FDICIA focused on capital ratio

– But said little (new) about composition of assets
• Large banks invest in emerging market debt
– Mexico, Russia, Thailand,…
– Thai devaluation  massive losses on all emerging
market debt
• Response: more regulatory tightening
– Minimum risk weighted capital ratios
– = ‘ $1 of a risky asset requires more $ of capital than $1 of
safe asset’
 The Response to Tougher Regulation
1. Convince regulator that your assets are safe
– To avoid higher capital charge for risky assets
– ‘1 subprime loan is risky but 1 share of 1000 separate
loans is not’ (asset securitization)
– Pay rating agency to say this, lobby regulators to agree

2. Move risky assets off the balance sheet (shadow

banking system)
– To unregulated entity – hedge fund, SIVs, investment
banks,…
– But (quietly) provide guarantees that do not show as a
liability
 The Unraveling (2007-08)
• A loan package is no safer than any single loan if
– They all go bad at the same time
– As sub-prime mortgages did when house prices declined
slightly (2007)
– Suddenly those ‘safe’ AAA rated packages lost most of
their value
• SIVs call on their bank guarantees
– Suddenly regulators see the liabilities
– SIVs begin to go on bank balance sheets (late 2007)
• Other shadow banks become distressed
– Bear Stearns (spring 2008)
– The rest of the investment banks (Fall 2008)
 The Collapse of Fannie & Freddie
 FNMA & FHLMC – ‘Government Sponsored Enteprises’
 Largest suppliers of credit to mortgage market
 All liabilities implicitly guaranteed by US
 In return: carry out govt housing policy
 Which included expansion of ‘sub-prime’ mortgage market
 No significant constraints on leverage

 A toxic brew of risky assets and high leverage

 Capital ratio ~ 1/3 of typical commercial bank
 Any slight uptick in sub-prime defaults could wipe them out
 Which happened in 2008

 Now explicitly government owned

 And losses subsidized for foreseeable future
 The Short Run Response to the Crisis
• “Too Big to Fail” made explicit
• Very large banks will be rescued by government
• Stockholders will lose
• But no depositor (insured or not) or other unsecured
creditor will lose anything
• TBTF extended to non-banks
– Investment banks
– Large insurers (AIG)
– Money market funds
– And more
 The Long Run Response? Two Paths
• The “moral hazard” incentives remain
• So, consequences can be reduced only if
1. The incentives are further suppressed
– More regulation of day-to-day operation
– E.g., “Volcker rule” – no trading for bank’s account

2. Or the incentives are reduced (“deterrence”)

 ‘do what you want, but pay the consequences’
 E.g., higher capital ratios
 The Actual Longer Run Response?
• A little of both
• But mainly more regulation
• Capital ratios have increased
Capital/Assets. US Commercial Banks. 1920-2013
 The Actual Longer Run Response?
• A little of both
• But mainly more regulation
• Capital ratios have increased
– By ~ same as after S&L Crisis

• Dodd Frank Act (2010)

– 16 Titles & 2000+ pages
– More regulation and more regulators
• SIFI= systemically important financial institution
– All large banks + insurers + money managers + investment banks+…

• How? TBA
– More deterrence?
• “No more bailouts”
 But the Deterrence is Not Credible
• SIFI = TBTF
• So, how can you commit not to bailout SIFI?
• Answer: you cannot. So
– “if there is a bailout it has to be repaid by a tax on the
surviving banks”
• The inevitable consequence: more moral hazard
– SIFIs have funding cost advantage (est 23 bps)
– Being safe is now taxed
 Have We Outlawed Financial Crises?
 Unlikely

 There is a little more capital in the system

 And a lot more regulation

 But there is more moral hazard

 And no credible commitment to impose losses on uninsured
creditors of SIFIs

 Not just US
 EU problem is worse & policy mix is ~ US
 In Conclusion
• Financial Crisis has many sources

• Regulation is one of them

– It was supposed to suppress the risk taking incentive
created by government guarantees
– Instead, it has generally made that incentive worse
– Even as the regulation has been increased

Insanity is doing the same thing over and over

again and expecting different results