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A Must Read on the Financial Crisis

posted by Adam Levitin

Bethany McLean has a must-read article on Reuters about the role of the SEC's 2004 change in broker-dealer leverage requirements in the financial crisis.  The article thoroughly debunks the argument that "the SEC did it" by loosening broker-dealer deregulation. 

I'm really glad to see this article because there is so much sheer nonsense circulating around regarding the financial crisis and its causes. The "CRA-made-me-do-it" and the "it was the GSEs" arguments have been debunked in plenty of places, but it's good to see someone run down the SEC net capital rule argument. Irrespective of the 2012 election, I suspect we're in for a strong dose of self-serving financial crisis revisionism from financial institutions and anti-regulatory ideologues over the next few years as we hear arguments that there's "too much regulation" of banks.  

(Mind you, I'm often sympathetic to arguments that particular regulations are bad regulations, but the "too much regulation" argument is the surest sign that the proponent has no interest in whether regulation is done well; it is an argument against regulation, period, and that's a position that ideology should trump good government, facts be damned.)  

Here's a simple test of whether there is too much regulation of the banking sector:  what's the demand for banking charters?  I am unaware of any banks deciding to throw in the towel and surrender their charters, and I'm also unaware of any lack of demand for a banking charter.  The question isn't whether financial institutions can operate profitably--it's a question of how profitably.

From a public policy perspective, the specific level of profitability is irrelevant, as long as there is enough profit potential there for private risk capital to step up and provide financial services to society. The continued presence of private risk capital is a shibboleth of "overregulation." It's pretty clear that we haven't hit "peak banking" yet. 

I've found this to be a very hard conversation to have with people in the financial services industry, as many have a hardwired mindset that there is an entitlement to a particular level of profits (and that level can only increase). I guess this is the "endowment effect" in a corporate setting. But it's so fundamentally part of the worldview, that any action that might as an incidental effect reduce (as opposed to eliminate) profits is viewed as beyond the Pale of civilized activity.  


I think I have to disagree on the bank charters point. The number of chartered banks has been steadily and rapidly decreasing for years, although this is, oddly enough, due to deregulation in the sector (when interstate branching was allowed, larger banks started to eat the smaller ones). Still, can you think of any new banks that have entered the scene for a long time? There really aren't many. I'd say the demand for bank charters is weak at best. The trend has been moving towards a few very large banks for a long time, and one could argue that is precisely because bank regulation is onerous enough to require scale in order to be profitable. In essence, smaller banks are throwing in the towel and selling their charters to the big banks.

Perhaps more importantly, the specific level of profitability does matter, I think. Imagine you're considering starting either a bank or a hedge fund. Wouldn't the level of profitability matter for your decision, not just the sign? You see many, many more hedge funds being started than banks, and I would argue that's largely because of regulation, which limits the investments banks can make but does not limit hedge funds as much. The level of profit absolutely matters, even from a public policy perspective, because it affects the type and quality of financial services that are going to be offered. If all of the most talented individuals go to work at hedge funds, then the quality of financial services offered by banks is going to suffer.

I'm not trying to argue that there should be less regulation for banks, necessarily, but I disagree that the level of profitability is irrelevant, even from a public policy perspective. And, I don't see much demand for bank charters at all, unless you're one of the top 20 banks.

Ben, you make a fair point about the smaller banks throwing in the towel, but that's a trend that's been going on for several decades. It isn't at all clear that it relates to regulatory burdens. There are economies of scale that smaller banks' can't realize. There may be some in terms of compliance costs too, but there doesn't seem to be a shortage of banking services or even retail banking services in this country. There are bank "deserts" but it's hard to believe that less regulation would change that.

I agree that the level of profitability matters in terms of whether an individual investor decides whether to seek a banking charter or to deploy his capital in another venture. Let's put aside the fact that the hedge fund can perform some of the functions provided by a chartered bank (e.g., making loans). Still, as long as we have sufficient capital deployed in the banking sector to meet the economy's needs, I don't see why we need to be concerned about whether the marginal investor is choosing to open a bank or open a hedge fund. We only have a problem if the supply of banking services isn't meeting demand.

You argue that the level of profit affects the type and quality of financial services offered. Does it? If the profits are reinvested, perhaps, but if they're dividended out? If they're invested in compensating managers, perhaps it results in better quality services, but it might not, and it might merely result in more profitable services, but which aren't better for the public. Consider, does BofA offer better quality services than the local non-profit credit union? BofA offers more services, but I'm not sure they're better (perhaps a fancier website, but certainly worse customer service).

But let's say you're right. Does that imply that we should always want higher profits in the banking sector? I can't imagine it does. Instead, it seems to me that we're likely haggling over price (and maybe semantics)--there has to be enough profitability, yes, and perhaps that has to relate to alternative investment options, but it likely isn't static and likely isn't current levels of profitability.

Perhaps the biggest problem is the desire to find "the cause" of the financial crisis. As with any major disaster, it is a combination of many factors coming together in the wrong way at the wrong time.

No, it wasn't the fault of the CRA or GSEs, but they were a factor. It wasn't strictly deregulation, but it was a factor (I'd say the nature of recent banking regulations and capital requirements contributed). Greed and deceptive lending contributed, as did faulty risk models, etc, etc, etc.

Unfortunately this doesn't provide a single villain, and doesn't satisfy any political ideology looking to blame the other side.

This feels like a politically motivated discussion point, to suggest that gov't regulations are good and not bad. While self regulations is absurd, that banks could walk from hard ratios in favor of model based exposure surely allowed wall street to take on more leverage and clearly a reason Wall Street welcomed the move in 2004.


"I'm also unaware of any lack of demand for a banking charter."

FDIC's 2011Q3 Quarterly Banking Report:

"No New Charters Were Added in the Quarter

The number of insured institutions reporting financial results declined to 7,436 at the end of the quarter, from 7,513 in the second quarter. Mergers absorbed 49 institutions during the quarter, and 26 institutions failed. One institution had not yet reported third-quarter
results. For only the second time in the 39 years for which data are available, no new charters were added during the quarter (the other occasion was second quarter 2010)."

Year New Charters
2010 11
2009 31
2008 98
2007 181
2006 194
2005 179
2004 128
2003 118
2002 95
2001 146
2000 223
1999 270
1998 221
1997 199
1996 157
1995 111
1994 68
1993 67
1992 80
1991 114
1990 191

I'd say there's a lack of demand for bank charters


Thanks for the response. It's definitely open for debate whether higher profits would actually translate into better financial services for customers. In most industries, I would be pretty comfortable arguing that it does, but the banking industry is certainly a special case. My general thought was that profits attract the best talent, but as you said that might or might not translate into better quality services. It all comes down to how banks compete with one another: do they compete by offering better quality products at better prices, as in most markets, or do they compete by pulling the wool over unsuspecting consumers' eyes in ever-more profitable ways (either by offering poor products like overdraft protection or by making extremely risky investments which harm taxpayers in general)? My hunch is that it's kind of a mixture of these two, really. Perhaps the CFPB can help curb the "bad" type of competition a bit...that will be interesting to watch play out.


I don't know for sure, but isn't it the case that the FDIC is requiring all newly chartered banks to buy some of the bad assets of existing banks. I've heard that this is the case, though I can't put my finger on where.

Here's an example of the claim that the FDIC isn't approving new charters via a founder and director of Commerce National Bank:
"most bankers were aware that the FDIC was specifically denying approval for any charter applicant. More than likely the regulators felt overwhelmed by the number of troubled banks that were under critical watch and control."


In other words if the FDIC has spent the last few years declining new bank charters, is it any wonder that few are expending the significant resources required to apply for a new charter. It's far from clear that this is a "demand" phenomenon.

It seems like the FDIC is worried about new sound banks (because they don't have legacy bad assets) taking over business from the existing banks that the FDIC wants to keep running in hopes of reducing its losses.


I think it's really up to the discretion of the regional directors at the OCC/ state regulators so I would imagine there's little uniformity.

From what I've heard, it's the opposite - the OCC is reluctant to allow new investors without banking experience to take over troubled institutions, even if they have sufficient capital. There was a Texas bank, Main Street Bank, that gave up its charter last year in order to reorganize as a specialty finance company.

At least if we're talking about depository institutions, it doesn't do much good to get OCC or state approval, if the FDIC's going to reject you. So the FDIC could be source of "uniformity."

Unfortunately this is an issue for which there is no hard data that I know of, so the "facts" all seem to be based on bankers' anecdotes. My only point is that it is far from clear that this is a problem of "demand" for bank charters.


I really don't think your quote from the American Banker purports what you interpret it to say. The next sentences are:

"Leading securities analysts say that no one is making application and cite the challenging environment, slumping revenues and profits and the fact it has been easier to purchase a failed bank than to start from scratch. This would lead to the conclusion that no one really sees the opportunity of a new bank today."

Which seems to support my position a lot more than yours.

@bzhou: "Which seems to support my position a lot more than yours."

Not at all. You are making a strong claim that "the" cause of the fall in bank charters is a collapse in demand. I am making a much softer claim that underlying causes are far from clear.

The full quote is: "Last year, for the first time in anyone's recollection, there were no new bank charters approved, with the exception of three specifically blessed to acquire failed banks. This wasn't earth shattering news as most bankers were aware that the FDIC was specifically denying approval for any charter applicant. More than likely the regulators felt overwhelmed by the number of troubled banks that were under critical watch and control. Leading securities analysts say that no one is making application and cite the challenging environment, slumping revenues and profits and the fact it has been easier to purchase a failed bank than to start from scratch. This would lead to the conclusion that no one really sees the opportunity of a new bank today."

All of the articles I've found discussing the collapse in bank charters mention as one of the key factors the regulators' reluctance to give charters. Given this environment it's hardly surprising if applications have fallen.

I never claimed to know for sure what caused the decline in bank chartering. I simply pointed out that nobody knows whether the cause is a fall in demand or an unwillingness to supply.

That was interesting and also contrary to what I understand your political leanings to be so appreciate your link to it.

The book Engineering the Financial Crisis has some interesting things to say on this topic. To wit, there is regulatory capital and then there is managerial capital - no management wants to walk close to the regulatory capital minimum because below that, they likely lose their jobs so they all tend to keep a buffer above the regulatory minimum. It also points out how bank capital rules awarded preferred status to mortgages, sovereign debt and securitizations, exactly the classes of debt that bubbled and burst in the last five years, so that the definition of "capital" was slanted, and maybe the "capital" that was there in one decade wasn't as good "capital" of another era.

Last, I think that one also needs to remember that another rule was adopted at this time, namely mark to market, which put much more pressure on asset values and thus on net capital.

Like Mr Wicklund above, I think it is a complex set of factors and the regulators were definitely part of the problem, not just in terms of omission but also by way of commission.


What do you mean "nobody knows whether the cause is a fall in demand or an unwillingness to supply"?

That's obviously not true, the FDIC knows.

"[Andrew] Gray [a spokesman for the FDIC] said the FDIC hasn't changed its application process, however. He noted that application volumes declined significantly from 2008 to 2010 and said "there hasn't been a change in the way the applications have been reviewed … certainly it's been a challenging economic environment, and the quality of the applications we've received have reflected that."


@bzhou: "That's obviously not true, the FDIC knows."

Fair enough. Someone at the FDIC probably does know, but it's far from clear that those individuals will be willing to make that information public. Regulators often claim not to have changed policy, even when they have very clearly changed policy. (I'm thinking of the Fed in 2007 and the careful use of the word "clarification.")

I don't have access to SNL.com. Your quote, however, clearly implies that the FDIC increased its rejection rate (just as the bankers have complained). And I don't have access to see what factors the FDIC is citing as "conspir[ing] to keep the number of approved de novo institutions" low. The assertion by the FDIC spokesman that "there hasn't been a change in the way the applications have been reviewed" doesn't even necessarily mean that standards for review haven't changes (i.e. he could be referring to process only).

I, for one, would like more information.

The loosening didn't do the deed itself, but it was the last ring of the dinner bell. The SEC made it clear it was not interested in enforcing anything, and the hogs headed for the trough.

Is there an assumption that fractional reserve banking is good? That a centrally managed economy is fine? That a government owned bank like Ally exists to make subprime auto loans? You are living in the good old days of 2007-2008. Party on with your student loans. The problems are worse now.

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