Dodd-Frank was one of the worst laws ever enacted. My guess is they will blow it on prediction markets too. Prediction markets are great, except not in athletics or movie/stage/tv awards. CFTC should regulate, but states ought to do sports etc
"The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run"
Was it? Lehman Bros. wasn't a bank supervised by the Federal Reserve. Neither was the American International Group (AIG). In what way was this a failure of the U.S. financial regulatory regime?
By which I mean becomes readily apparent with only a little bit of research.
Regulatory failures included not realizing the scale of the exposures, not grasping the interconnectivity between highly regulated and less regulated players, not understanding that ample liquidity masks actual default rates (eg credit card balances rolled from bank A to even hungrier bank B count as being paid off at bank A, lowering default experience and encouraging more risk, same with mortgage loans quickly paid off due to “flipping” a property - lowers experienced default risk meaning VAR and credit models encourage more risk). See also Minsky.
Critially, a regulator-imposed capital charge regime (Basel 2) that zero-weighted “AAA” assets, was a huge contributor, causing the manufacture of these assets when too easy Fed policy collapsed interest rates and credit spreads. European banks needed short term dollar financing to fund all of the “AAA” assets they bought and then suddenly nobody would lend to these banks (liquidity crisis).
You are right, though, about the SEC regulated broker dealers getting into more trouble than the banks.
I’d have to dig up the analysis I did way back when, but my recollection is that Lehman tripled the size of its balance sheet assets from 2004-end 2007, while increasing its leverage ratio to 30-1 or so. Merrill and Bear Stearns more than doubled the size of their balance sheets in those few years, without increasing capital (massive leverage). These firms were simply large carry trades that relied on short term funding continually being rolled over until the better assets were bundled and sold off (and replaced with ever more assets funded by short term credit, repo and commercial paper)
As in 2020-2022 the Fed in 2004-2005 depressed yields and incented players to take ever crazier risks if they wanted to earn positive spread. Their was suddenly a rush for yield (credit spread by non banks and capital efficient “AAA” yield by banks) as well as a rush for consumer assets that seemingly offered high realized carry (credit cards and mortgages) relative to corporate loans. Banks that had those higher yielding portfolios traded at much higher multiples than more conservative banks.
Goldman was a little more responsible in balance sheet leverage than the other brokers, but they relied very heavily on AiG for “AAA” credit insurance wrappers for the assets they sold off.
Ultimately a lot of the funding for the brokers like Lehman came from commercial banks as did some of the credit hedging. JPM, Citi and B of A were amongst Lehman’s largest creditors in bankruptcy.
Yellen really blew it with SVB. One of the initiatives post GFC was to force banks to have more long term funding (corporate debt) and to e sure adequate, liquid, short term assets vs deposits.
Senior corporate term debt should be pari passu with large uninsured deposits.
Yellen chose to save depositors and stuff bond holders to pay for it. And now all short term deposits are effectively guaranteed
So much for banks sourcing more long-term funding to prevent runs. Between SVB and credit Suisse, that will never happen again. Instead we have the taxpayer on the hook for all short term funding. Insanity.
And if the Fed had done even a passable job of regulation and continued irresponsible QE and ZIRP well beyond when needed then US commercial/regional banks wouldn’t have been scrambling to buy 15 year paper at sub 2 percent to make a tiny RoA vs deposits and SVB never would have been able to make such a ridiculous bet by rolling short term deposits of PE and VC sponsors into long dated mortgage backs.
Their management should have been jailed (but they were big donors) and the SF Fed team should have been sacked.
Seems like we have been playing regulatory cat & mouse forever. Regulations get written, clever people find ways around them or the regulators get captured by the industry they are charged with regulating. Financial institutions take risks, that’s part of business. When the risks pay off the C-suite is richly rewarded, if they blow up the C-suite rides off with their millions intact. And that is the problem - in too many cases leadership has no skin in the game. So how about replacing thousands of pages of complex regulations with something simple. You take an imprudent risk that results in your institution suffering a loss that requires public intervention and you are rendered destitute. Bank account, portfolio, retirement, real estate, toys - gone. Applies to the C-suite. Maybe with skin in the game these people will start managing these institutions like it was their money - because in a way it will be.
Dodd-Frank was one of the worst laws ever enacted. My guess is they will blow it on prediction markets too. Prediction markets are great, except not in athletics or movie/stage/tv awards. CFTC should regulate, but states ought to do sports etc
"The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run"
Was it? Lehman Bros. wasn't a bank supervised by the Federal Reserve. Neither was the American International Group (AIG). In what way was this a failure of the U.S. financial regulatory regime?
The answers are out there and self-evident for the curious
"Self-evident"? How so?
By which I mean becomes readily apparent with only a little bit of research.
Regulatory failures included not realizing the scale of the exposures, not grasping the interconnectivity between highly regulated and less regulated players, not understanding that ample liquidity masks actual default rates (eg credit card balances rolled from bank A to even hungrier bank B count as being paid off at bank A, lowering default experience and encouraging more risk, same with mortgage loans quickly paid off due to “flipping” a property - lowers experienced default risk meaning VAR and credit models encourage more risk). See also Minsky.
Critially, a regulator-imposed capital charge regime (Basel 2) that zero-weighted “AAA” assets, was a huge contributor, causing the manufacture of these assets when too easy Fed policy collapsed interest rates and credit spreads. European banks needed short term dollar financing to fund all of the “AAA” assets they bought and then suddenly nobody would lend to these banks (liquidity crisis).
You are right, though, about the SEC regulated broker dealers getting into more trouble than the banks.
I’d have to dig up the analysis I did way back when, but my recollection is that Lehman tripled the size of its balance sheet assets from 2004-end 2007, while increasing its leverage ratio to 30-1 or so. Merrill and Bear Stearns more than doubled the size of their balance sheets in those few years, without increasing capital (massive leverage). These firms were simply large carry trades that relied on short term funding continually being rolled over until the better assets were bundled and sold off (and replaced with ever more assets funded by short term credit, repo and commercial paper)
As in 2020-2022 the Fed in 2004-2005 depressed yields and incented players to take ever crazier risks if they wanted to earn positive spread. Their was suddenly a rush for yield (credit spread by non banks and capital efficient “AAA” yield by banks) as well as a rush for consumer assets that seemingly offered high realized carry (credit cards and mortgages) relative to corporate loans. Banks that had those higher yielding portfolios traded at much higher multiples than more conservative banks.
Goldman was a little more responsible in balance sheet leverage than the other brokers, but they relied very heavily on AiG for “AAA” credit insurance wrappers for the assets they sold off.
Ultimately a lot of the funding for the brokers like Lehman came from commercial banks as did some of the credit hedging. JPM, Citi and B of A were amongst Lehman’s largest creditors in bankruptcy.
Yellen really blew it with SVB. One of the initiatives post GFC was to force banks to have more long term funding (corporate debt) and to e sure adequate, liquid, short term assets vs deposits.
Senior corporate term debt should be pari passu with large uninsured deposits.
Yellen chose to save depositors and stuff bond holders to pay for it. And now all short term deposits are effectively guaranteed
So much for banks sourcing more long-term funding to prevent runs. Between SVB and credit Suisse, that will never happen again. Instead we have the taxpayer on the hook for all short term funding. Insanity.
And if the Fed had done even a passable job of regulation and continued irresponsible QE and ZIRP well beyond when needed then US commercial/regional banks wouldn’t have been scrambling to buy 15 year paper at sub 2 percent to make a tiny RoA vs deposits and SVB never would have been able to make such a ridiculous bet by rolling short term deposits of PE and VC sponsors into long dated mortgage backs.
Their management should have been jailed (but they were big donors) and the SF Fed team should have been sacked.
Really great article Professor Cochrane! Nailed the problems with our current(and past) financial regulation regime.
Seems like we have been playing regulatory cat & mouse forever. Regulations get written, clever people find ways around them or the regulators get captured by the industry they are charged with regulating. Financial institutions take risks, that’s part of business. When the risks pay off the C-suite is richly rewarded, if they blow up the C-suite rides off with their millions intact. And that is the problem - in too many cases leadership has no skin in the game. So how about replacing thousands of pages of complex regulations with something simple. You take an imprudent risk that results in your institution suffering a loss that requires public intervention and you are rendered destitute. Bank account, portfolio, retirement, real estate, toys - gone. Applies to the C-suite. Maybe with skin in the game these people will start managing these institutions like it was their money - because in a way it will be.
Mervyn King had a better idea in a post GFC book- less leverage and more capital in the system.
Unfortunately neither voters nor politicians want this- they love booms and easy credit and then search for scapegoats when it all blows up