Financial crisis and the lessons not learnt – How regulators still don’t get it

By Venkat Mullur, Senior Director, Financial Industry Solutions

Finance used to be considered a boring subject when I was in college. But from time to time, the laws of finance excitedly strike back, and we are reminded that no enterprise, howsoever creative and innovative, can survive solely by spending today what it hopes to earn tomorrow.

A decade ago, we had the dot-com crisis, when firms, unable to generate adequate cash to fund their operations, were subject to call options by investors looking to cash out. The stock market reaction exacerbated the firms' ability to raise capital, further fueling the liquidity crunch.

About seven years later, in 2007, something similar played out with banks and this time it was homes, instead of high-tech startups, that were the overvalued asset. As home prices appreciated in the early part of this decade, so did the secondary market for mortgage-backed securities that paid interest income to investors.

Faced with a low interest environment in the United States, investors were eagerly seeking high returns. Credit quality and interest rates, taken together, determine yield. Banks, eager to serve the abovementioned investors, started to relax lending standards. So banks packaged the income from their assets, and offered secondary market investors a steady, above-average return, based on uncertain future cash flows. Now, in normal markets, a high yield is a sure sign of credit quality deterioration and ought to serve as a warning for investors. But in 2006, when this frenzy was its peak, the underlying asset, i.e. the home, was presumed to be the ultimate backstop against any credit default.  So banks continued to lend, assuming the collateral would come in handy when defaults occurred. But wrong-way risk was the last thing on anyone's mind. When it became apparent that banks could no longer hide, using securitization and other tricks, from their bad loans, there followed an old-fashioned run on the banks.

The regulatory lesson, if someone was taking notes, would have been: An asset bubble, exacerbated by unreliable credit ratings and questionable lending practices, made the system vulnerable to a price shock which ultimately caused a liquidity crunch at deposit-taking institutions that were exposed to the said declining asset. The banks, like the startups of yore, were simply unable to fend off lenders and investors, when faced with little or no cash income from present assets.

But did the global regulatory response reflect the lessons that ought to have been learnt?  A closer look at three noteworthy regulatory responses reveals certain methodological inadequacies and a failure to address the underlying cause of bank failures.

In 2009, banking regulators in the United States conducted a stress test that involved positing adverse macroeconomic scenarios and studying the affect on the asset side of the bank's balance sheet. Most large institutions passed the test and were said to be adequately capitalized. In 2010, the European Central Bank conducted similar tests on large national banks under its jurisdiction. Again, most banks appeared to have passed the test, albeit with higher levels of capital. Following the ECB tests, the Basel Committee on Banking Supervision came out recommending higher capital levels, as part of the Basel III framework.

Focusing solely on the asset side of the balance sheet, the stress tests recommended banks hold an adequate capital buffer to protect against asset value declines. But focusing on capital buffer alone is akin to requiring a home owner to possess enough guns to fend off robbers while not recommending an alarm system or fence, or other deterrents.

Looking at bank failures in the United States, illiquidity, not capital inadequacy, appears to have been the proximate cause. If failed banks had the luxury of sufficient time to unwind and sufficient time for assets to recover in value, the capital levels would have been sufficient to cover eventual asset write-downs. So the timing of cash outflows appears to have been the proximate cause of some of the bank failures. 

By largely ignoring the deposit side of the equation, the US and ECB stress tests failed to explicitly address the dynamics of cash flows which could cause short-term operations to seize up. It is well-known that assets and liabilities have different maturities and the maturity mismatch is something that needs to be closely monitored to avoid a cash-flow crisis. In a banking stress test, one would have expected at least one or two adverse scenarios that included a severe drawdown on deposits straining a bank with a rapidly declining asset base.  

To be fair, the Basel III recommendation does call for a liquidity buffer. The SEC too has issued regulations that require money-market funds to reduce their overall asset-side maturities.  But money market funds were never the problem - they were always short-term assets. Further, it is not clear, based on the Money Market Fund Reform rule, to what degree the SEC wants banks' money market funds to cover the deposit liability.

Loans, the primary assets of most retail and commercial banks, are by definition long-term assets, and such assets will continue to be part of a bank's core asset base. What I would recommend is requiring banks (lending institutions) to posit, or simulate, adverse scenarios that involve a rapid diminution in asset values accompanied by a rapid call on liabilities.  By requiring banks to model their depositor behavior, match the resulting cash flows to their loan cash flows, and to hold capital sufficient to cover the most adverse of these scenarios, the regulators would be one step closer to preventing a liquidity crunch.

In conclusion, the regulatory reform and tests thus far have focused largely on protecting long-term assets through capital cushions.  Capital level recommendations do not appear to be explicitly tied to maturity mismatches and liquidity gaps. Furthermore, the effect of ratings on secondary market participants, and the conflict of interest between rating agencies and issuers of securities has not been adequately addressed. The reality is that bankruptcy and receivership can come long before an orderly unwinding of assets, no matter how much of capital cushion a bank holds.