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A Dangerous Combination: Financial Innovation & the Suppression of Market Forces

e21 | 02/24/2012 |

One of the most fundamental problems with the Dodd-Frank Act is its unreasonable degree of confidence in regulators’ ability to balance the competing societal goals of innovation and stability. The law itself was over 2,300 pages, but this was just the tip of the iceberg. Since the law does not specify new regulations so much as authorizes regulators to promulgate new rules, the law has actually spurred thousands of additional pages in the form of regulatory proposals. The most recent example is the “Volcker Rule,” which spurred hundreds of pages of additional regulations and is in the final stages of public comment and implementation.

The rationale for the Volcker Rule, the 243 additional pages on risk retention requirements, and the hundreds of pages of regulations devoted to new FDIC resolution authority and “living wills” is simple: large, complex financial institutions proved during 2008 to generate more risk than the economy could reasonably tolerate. In turn, the Obama Administration believed that a new, more muscular regulatory regime was required. The problem is that the Dodd-Frank Act inserts the judgment of regulators for normal market processes or functions. The result is that regulators have the unenviable and nearly impossible task of deciding the manner and terms on which credit is supplied to the nonfinancial economy.

For example, the Volcker Rule bars proprietary trading by bank holding companies. While the notion of separating “banking” and “trading” may seem innocuous to many, more credit is supplied to the economy through “trading” activities than through traditional banking. That is to say, more credit is created through securitization than direct lending, and securitization requires liquid secondary markets, facilitated by underwriters and market-makers. Hence, efforts to suppress market-making functions are likely to result in less credit supplied to the nonfinancial economy. Moreover, as law professor Charles Whitehead explains, “by dictating business models,” the rule has the potential to slow “beneficial innovation” by delaying or preventing the introduction of new products or strategies.

Some may welcome this development. After all, the introduction of innovative new products like collateralized debt obligations (CDOs) and proprietary trading are blamed by many for the financial crisis. As explained in a recent research paper from the Inter-American Development Bank, financial innovation is partly driven by a desire to repackage risk and make it more difficult to detect. This can generate periodic imbalances where too much risk is being created. The pendulum can swing the other way, however, when innovation breeds distrust. A “credit crunch” arises when profitable investments cannot get funded because the perceived risk is greater than the risk actually present in the loan or security.

The potential for market failure from innovation that is “too aggressive” can actually serve as the best form of regulation. CDOs are a perfect case in point. CDOs are bond and loan funds that have a capital structure that’s similar to corporations as opposed to mutual funds, which use a pro-rata allocation method to distribute returns. For CDOs, creditors at the “top” of the capital structure accept low returns in exchange for getting paid first, while those at the “bottom” expect to earn higher returns in exchange for accepting losses, if there are any, first. In general, the “senior” securities at the top are provided a AAA rating because of the low probability of default, while the “junior” or “mezzanine” securities at the bottom often receive a speculative grade, or are unrated because of the greater risk.

Between 2004 and 2007, CDO issuance grew exponentially (see chart above) largely because of the ability to generate more AAA-rated assets to meet investor demand. Financial engineers found that if they started new CDOs to buy the junior pieces of other CDOs, they could generate even more AAA securities. Any losses on this pool of junior securities were again reoriented from top to bottom so that senior creditors enjoyed the same degree of subordination as in the original or first CDO deal. (For example, a 25% subordination would mean that 50% of the underlying loans would have to default with recovery rates of under 50% for the AAA piece to experience losses.) So each CDO essentially created the need for another CDO to buy the risky junior securities (see graphic below).

Taken to its logical conclusion, this re-securitization would mean all assets could be AAA if they were re-securitized enough times. This was precisely the type of financial innovation that resulted in too much risk “being produced.” This imbalance was revealed when the super senior tranches of these CDOs ended up behaving nothing like AAA assets, defaulting like junk bonds but with even lower recovery rates in many circumstances. The market responded to this experience by refusing to buy CDOs under almost any circumstances. Today, a CDO could be collateralized with nothing but the most pristine new loans and it still would have difficulty finding investors precisely because perceptions have changed so dramatically. Fannie Mae and Freddie Mac dominate the mortgage markets to the extent they do today precisely because investors are not interested in buying mortgage-backed securities (MBS) that do not have a government guarantee (or a AAA rating). Absent government intervention a few years ago, the market would have shifted to a “credit crunch” state where mortgage rates had to increase to compensate investors for the uncertainty surrounding potential credit losses.

As the IADB paper explains, financial innovation “erode[s] supervisors’ ability to detect risk,” yet enhanced supervisory powers are really all that separate today’s banking system from the one that failed in 2008. Financial innovation is an iterative process that builds on successes as well as failures. The bottom line is that the normal market disincentive towards bad financial innovation has largely been eliminated through taxpayer bailouts and the perpetuation of “too big to fail” institutions.

Thus far, the regulatory response to the financial crisis threatens a false choice: between (1) thwarted innovation and less external finance available for growing businesses and households; and (2) larger, more consequential financial crises. Policymakers should and can avoid falling into this trap by replacing the Dodd-Frank regulatory thicket, including the Volcker Rule, with simple rules, amendments to the bankruptcy code, and substantial increases in margin requirements and capital levels.

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