The Right Recipe for Financial Reform - Commentary by Gary Gorton

"The Right Recipe for Financial Reform"
By Gary Gorton
Published in Investment Dealers Digest May 21, 2010 
Read the article in its original context on Investment Dealers Digest website (subscription required).

Getting financial reform right has historically been difficult. Following the Panic of 1907, William A. Nash, president of the Corn Exchange State Bank of New York, wrote: "It is universally conceded that the present time is highly favorable for financial reforms. The great danger is that the remedies will be so numerous, and the diagnoses so different that the patient will linger and suffer. The doctors will assemble and discuss, but I hope...we shall not have to wait for the autopsy to find out what is the matter."

Nash was right to be concerned and we should be too, as we are in the same situation today, as Congress contemplates financial reform. In fact, following the Panic of 1907, Congress did not get it right and we went on to experience the Panic of 1914 and the Great Depression.

The most important task of financial reform is to prevent another crisis from occurring for at least another 50 years; we could hope for 75 years. Other reforms may also be important but they are not the most important because while they may improve the system, they will not prevent another crisis. Even if there was a big bailout fund, and even if there was resolution authority, it would be better not to have another crisis. That is the first order of business.

Why is financial reform so hard? One problem is that few Americans have lived through a financial crisis, and so the current one seems very special, a perfect storm of events. Not only that, most people only saw the effects of the current crisis, not the run on repo that I describe below.

Most people do not see the crisis as a systemic vulnerability of bank liabilities, which has created problems throughout our history. Few know about our long history of banking crises, so they do not see the common problem. Studs Terkel in the preface to his oral history of the Great Depression ("Hard Times"), said that our country is rich, but poor in memory.

The search for individual villains ignores the fact that capitalism is a system. As the Nobel Prize-winning economist F.A. Hayek put it: "The manufacturer does not produce shoes because he knows that Jones needs them. He produces because he knows that dozens of traders will buy certain numbers at various prices because they (or rather the retailer they serve) know that thousands of Joneses, who the manufacturer does not know, will buy them."

Banks are not shoe manufacturers, but like manufacturers, banks respond to prices. The point is to earn a profit for shareholders. And when the banking business environment changed, making traditional activities less profitable, banks changed, too. That is how the shadow banking or parallel banking system came into being.

The traditional system had evolved because during the 1980s the traditional business model of commercial banks stopped working due to new competitors: money market mutual funds, junk bonds, and so on. The system had evolved by firms making decisions over 25 to 30 years, developing a new system.

Some may remember Lowell Bryan's 1988 book, "Breaking up the Bank: Rethinking an Industry under Siege." The problem is for bank regulators to keep up with change. This kind of evolution of the banking system has happened before. Hard to believe now but the evolution of checking accounts (demand deposits) growing to replace private bank notes was momentous. It also was not understood — policymakers basically missed it for 77 years (from the Panic of 1857 until deposit insurance in 1934) while the country experienced repeated banking panics in which depositors demanded their cash back.

The legal scholar James Willard Hurst wrote: "Public policy erred as much regarding deposit-check money as regarding [pre-Civil War private] bank notes in pursuing irrelevant solutions to the problem of liquidity.

Policy was out of joint with reality, in the first place, because for a number of years it ignored the fact that deposits were an important component of the money supply. Thus various security measures adopted regarding bank operations — minimum paid-in capital, obligations limited to a state percent of capital, special stockholder liability for the bank's debts — were either explicitly limited to bank notes or were ambiguous as to their coverage of deposit liabilities"

What was adopted as "reforms" was inadequate, "out of joint with reality." A similar evolution has happened again. Sale and repurchase agreements, a very old instrument, long thought of as money, grew to become very large, larger than the regulated banking system. Repo is a kind of depository banking for firms and institutional investors. Repo is short-term — usually overnight. The depositor earns interest, and safety is insured by the depositor receiving collateral, usually asset-backed securities. Indeed, the traditional banking system, in response to competition in the 1980s, began to sell loans, or securitization (the sale of loans via asset-backed bonds). The traditional banking system funds itself by selling loans, so the two banking systems — shadow and traditional — are really different parts of the same system. They are symbiotic.

By issuance, the non-mortgage asset-backed security market was larger than the U.S. corporate debt market, both investment grade and high yield. Currently the securitization market is moribund and traditional banks are not lending.

Repo is vulnerable to the same kind of financial panic as the U.S. repeatedly experienced during most of its history. Indeed, a panic is a systemic event: when all repo depositors demand their money back, banks, which have lent long, have nowhere to go, because they were not part of the regulated system. They ended up try to sell assets, driving down the prices of all bonds, not just subprime-related bonds. This is why the prices of non-subprime-related bonds fell — a systemic event.

The word "system" keeps popping up. We refer to the shadow banking system and the banking system and to systemic risk. A systemic illness means an illness that affects the entire body. As a system, capitalism or the banking system does not respond to admonishment, reprimands; capitalism is a soulless machine. It can generate enormous wealth, foster innovation, generally improve peoples' lives. But it must be regulated to prevent crisis, not readied for the next crisis.

Gary Gorton is the Frederick Frank Class of 1954 Professor of Management and Finance at the Yale School of Management. His book "Slapped by the Invisible Hand" has just been published by Oxford University Press.