The American Mortgage System: Crisis and Reform

15. The Road Not Taken: Our Failure in Redoing the Financial Architecture

C h a p t e r 1 5 The Road Not Taken: Our Failure in Redoing the Financial Architecture Vincent Reinhart The legislation on financial reform signed by President Barack Obama this year runs over 2,000 pages in length. Its enactment into law changes the scope of permissible activities for financial firms, shifts other activities onto organized exchanges settled in clearinghouses, and limits the scale of bank balance sheets relative to their capital. New responsibilities are given to old agencies, old functions are given to a new agency, and a council of regulators will sit atop it all to identify risks and coordinate responses. For all the legislation’s length, the substantive changes will follow as regulatory agencies write rules to put those sometimes contradictory instructions into practice. When it is done, the nation’s financial leadership will not have materially reduced either the odds or the amplitude of the next financial crisis. This was a missed opportunity as historically significant as the crisis itself. This failure follows from a misdiagnosis of the root cause of the crisis. Financial institutions and markets amplified the stresses in housing because intermediaries had issued complicated mortgage-related securities and parked residual risk on their own opaque balance sheets. Financial engineering exploited weaknesses in regulation and accounting rules by creating The Road Not Taken: Our Failure in Redoing the Financial Architecture 359 off-balance-sheet entities. And final investors were encouraged to hold mortgage -related products through official suasion. The most important incentive to the creation of this complexity and size has been the unwillingness of authorities to let institutions that are deemed to be systemically important fail. An opaque balance sheet with uncertain linkages to other firms provides its own protection. At a time of stress, government officials would rather put taxpayer funds at risk than test the resilience of the financial system through the failure of a large, complex entity. Thus managers of the biggest firms were given a strong incentive to stay big, intricate, and opaque. The net result was that balance sheets became uninformative about the risk-taking of financial firms. This made effective supervision impossible, blunted market discipline, and hindered internal controls within the firms themselves. The rabbit warren that the financial system has become hid many risks from regulators, counterparties, and managers of large firms. It also made the ground less secure when the housing shock hit. The Dodd-Frank Wall Street Reform and Consumer Protection Act financial reform legislation of 2010 focuses on activities within the existing set-up of the financial system. Some activities formerly done in banks— notably proprietary trading and some derivatives operations—must be moved off the balance sheet. More activities at more institutions will be under the scrutiny of regulators. And financial authorities will have powers to wind down more institutions. But the incentive to do most of those activities remains intact. In a market economy, this means that those activities will continue to be done. Financial institutions will spin off bits, rename other parts, and make their balance sheets further devoid of meaning. Because the largest of those institutions will remain intricately woven into the fabric of market risk-taking, financial officials will offer them the protection of being “too big to fail,” despite the new resolution authority on the books. Thus the legislative response to this complexity and related failure of regulation has been to make the system more complicated and to rely more on regulation. Indeed, a design principle would seem to be to preserve the status quo of a landscape dominated by large, complex financial intermediaries . More of the same seems a singularly insufficient response to the crisis. This is especially so when compared to the road not taken. A better result would have been to make it less likely that the government would ever again be put in the position of using public resources to preserve 360 Vincent Reinhart the operations of private entities. This requires eliminating the underlying encouragements to complexity, in terms of both the demand for and supply of complexity. The requirement of simpler and more transparent balance sheets would restore effective supervision, increase market discipline, and tighten internal controls. It would also make officials more confident that an individual firm could fail without bringing down the entire financial system with it. Such radical simplification might sound, well, radical. But the cost of financial crises is high. This includes the...