The April 2, 2014, Lab presentation was led by Edmond J. Safra Lab Fellow, Kim Pernell-Gallagher. During her second fellowship year, Kim has continued to investigate cross-national policy divergence in banking regulation, specifically focusing on the Basel Accords and capital adequacy standards voluntarily adopted by banks in the United States, Spain, and Canada. Her Lab seminar, titled: “How the U.S. Got it Wrong: Regulation of Securitization in Comparative and Historical Perspective” gave a historical overview of the ascribed fiscal ideologies that led these countries to adopt distinctive regulatory standards and as a result, encounter different outcomes in the wake of the financial crisis. Interestingly, Kim framed the particularly unfavorable outcomes experienced by U.S. banks as a case of institutional corruption wherein U.S. regulators were influenced by an inappropriate ideology that encouraged overly permissive regulatory standards.
Kim began the Lab presentation by explaining the significance behind capital adequacy standards and how the Basel Accord sought to mitigate potential risk by implementing these standards on an international scale. Bank capital, as she described it, can be thought of as a financial cushion that protects a bank against unexpected losses or downturns. Further, holding onto capital is expensive for banks because keeping money on hand means that the bank can’t lend it out. So when banks face tight competition, as they did in the 1970s and 1980s, they’re tempted to cut back on expensive capital. The Basel Accord sought to mitigate this risk by requiring banks to hold 8% in regulatory capital against their risk-weighted assets. But since the Basel Accord was a voluntary agreement, these standards had to be flexible enough to apply to disparate banking systems where regulators could interpret and augment the standards to fit local circumstances. In order to understand the driving forces behind the standards each country adopted, Kim examined the decisions made by the primary prudential banking regulator in each country: The Federal Reserve in the U.S., the Office of the Superintendent of Financial Institutions in Canada (OSFI), and the Bank of Spain in Spain.
Because Kim’s project focuses on bank outcomes, and the application of the Basel Accord, she focused her attention on bank involvement with securitization. She described this practice as the way in which banks (asset originators) sell assets (loans) to investors. In doing so, banks pool together assets in an effort to entice investors by reducing risk through diversification. She spoke about the incentives for banks to sell these assets through a third party legal entity known as a “conduit” or SPE or SIV. This practice allows banks to maintain off balance sheet assets that are shielded from bankruptcy and for which they are also not required to hold regulatory capital against. Further, to make assets more enticing to investors, banks provide liquidity enhancements during this process, sheltering investors from potential conduit losses. In short, when banks provide liquidity and credit enhancements, they agree to absorb some of the conduit’s losses, should any losses occur. This is of particular significance because in many countries, the banks that had provided liquidity lines to the conduits absorbed the majority of losses during the crisis because of inadequate capital standards. Specifically, when the global Asset-backed commercial paper conduit market (ABCP) collapsed in 2007, banks lost an estimated 68 to 204 billion dollars from liquidity enhancements. Loans that were originally intended to be temporary enhancements in the securitization process became permanent when investors panicked and ABCP conduits dried up. But why did losses vary so greatly between the U.S., Canada, and Spain?
Because the U.S., Canada, and Spain regulated these liquidity lines differently, they suffered accordingly, Kim explained. Banks from countries with more “permissive” regulation of securitization suffered greater securitization-related losses during the crisis. In the U.S., banks absorbed 98% of losses, as they lacked the adequate regulatory capital to absorb the losses from liquidity enhancement loans on assets that were sold off at exceedingly low rates. In Canada, where liquidity lines were regulated and defined more strictly, a protection was built in by the OSFI limiting the practice of liquidity enhancements to major market disruptions, such as a terrorist attack. Therefore, when the ABCP market failed, Canadian banks didn’t absorb losses on general market disruption, investors did. In Spain, where regulation of liquidity lines and securitization was unusually strict, if a bank had any exposure to assets in a conduit—including a liquidity line—it would receive no regulatory capital relief. Further, the Bank of Spain required 100% regulatory capital against these assets, which effectively made ABCP securitization uneconomic in Spain. It became clear why each country experienced different outcomes, but the question still remained: why had the U.S. experienced such abysmal losses? The answer, Kim explained, can be found in the regulatory ideology, or lack thereof, that guided the Federal Reserve.
In the end, Kim resisted the notion that regulatory capture was responsible for the generally lenient stance that the Federal Reserve took on securitization. Instead, she argued the U.S. regulators subscribed to an inappropriate, corrupting ideology, that believed an impartial market would regulate itself. Though the historical context is complex, Kim pointed to the infamous savings and loans crisis of the 1980s in which regulators eventually determined that the interventionist policies of the 1930s, i.e.: the FDIC safety net, had incentivized smaller banks to take excessive risks in the high interest rate environment of the 1970s. In addition to this, American regulators began to see securitization as a market-selected practice, which under the idea of market-discipline, was considered to be beneficial. Indeed, many regulators, including the former Chairman of the Federal Reserve, Alan Greenspan, viewed securitization as a practice that actively reduced risk in the banking industry. The reasoning behind this was that securitization reduced risk by transferring credit risk outside the regulated banking industry. This ideology was unique to the U.S. In summary, Kim made a strong case that regulators at the Federal Reserve subscribed to an ideology (the market is a better regulator than actual regulators) that inspired policy priorities (scale back intervention in the banking industry) that contradicted the purpose and mission of the institution they served.
-Summary composed by Joseph Hollow