Some ways to keep the dance going

Posted Dec. 23, 2009, at 6:31 p.m.

Congress may be taking the wrong path to reforming our crisis-prone financial system. The bill that just passed the House of Representatives continues the traditional focus on making individual banks safer. But our financial crisis was rooted in the way the whole system functioned, not so much in the behavior of individual banks. We need to deal with the system as a whole.

Here’s an illustration of how the system has been functioning. Suppose a few banks try to boost their profits by buying risky securities that pay a high interest rate — say mortgage-backed securities whose value rests partly on subprime loans. The actions of a few banks won’t affect the market much. But if other banks imitate the first ones, the prices of these risky securities will rise rapidly and a credit boom will be touched off.

Eventually the rise in security prices must come to a halt, for one reason or another. In 2008, a major reason was that many homeowners defaulted on their mortgages, leading banks to sell their mortgage-backed securities. So the prices of these securities fell rapidly. Securities held by many banks — not just the banks that started this process — lost most of their value. The survival of many banks suddenly was in doubt.

In 2007, the former head of Citigroup, Chuck Prince, drew an analogy with musical chairs: “When the music stops … things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Well, many banks still were dancing in 2007. But in 2008, the music stopped — and millions of Americans suffered the consequences of a very empty dance hall.

For years, U.S. regulations have focused on individual banks’ own capital and how this capital relates to their holdings of risky securities. If an individual bank increases its holdings of risky securities, it is required to put aside more capital.

But this focus on individual banks may make the whole system less safe, rather than safer. Suppose that during a credit boom a rating agency — perhaps Moody’s — announces that several securities have become very risky. To avoid having to add more capital — a step that harms bank stockholders — many banks will sell the risky securities. And because they all will do this at once, the securities’ prices will fall. This is when the music stops — and when those banks that are left holding the securities will be threatened.

The new House bill leaves unchanged this counterproductive focus on individual banks.

Is there a better approach? Yes, according to two recent pathbreaking reports, one from the Bank of England and the other from England’s University of Warwick.

Policy should focus on better ways to moderate credit booms, according to both reports. When a credit boom is just beginning, bank regulators — such as our Federal Reserve — would raise the minimum capital requirements for all banks, not just a few individual banks. Clearly, all banks that continue to increase their security holdings and to extend more loans would have to endure the pain of raising new capital. Because these steps would be imposed on all banks, they would restrain the growth of credit throughout the system. The credit boom will slow down.

Further, the new capital requirements would be highest for large banks and those most interconnected with the rest of the financial system. So the new requirements would most strongly restrain those banks whose actions have the greatest impact on the whole system. This makes sense: If these banks were to fail, the whole system would be in jeopardy.

Under this approach, the dance would not end suddenly. Because dancers would have to pay a price for joining the dance, some would leave the party early. The dance would simply wind down rather than end abruptly, and hopefully a financial collapse would be avoided.

This approach seems superior to the current one. It could be implemented gradually and early in the boom. It would be targeted mainly at the banks whose failure would most harm the whole system. And it could be implemented in small increments, affecting all banks slightly — unlike the current system, which can drastically affect a few individual banks that are left holding toxic securities.

Bankers and lawmakers need to consider these ideas carefully. Let’s hope they do so before the music stops again.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

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