17.5 Regulation in the Wake of the Crisis

By late 2009, interventions by governments and central banks around the world had restored calm to financial markets. However, huge damage had been done to the global economy. In much of the advanced world, countries suffered their deepest slumps since the 1930s. And all indications were that the typical pattern of slow recovery after a financial crisis would be repeated, with unemployment remaining high for years to come.

The banking crisis of 2008 demonstrated, all too clearly, that financial regulation is a continuing process—that regulations will and should change over time to keep up with a changing world. The dependence on very short-term loans (called repo), the lack of regulation, and being outside the lender-of-last-resort system made the shadow banking sector vulnerable to crises and panics. So what changes will the most recent crisis bring? One thing that became all too clear in the 2008 crisis was that the traditional scope of banking regulation was too narrow. Regulating only depository institutions was clearly inadequate in a world in which a large part of banking, properly understood, is undertaken by the shadow banking sector.

In the aftermath of the crisis, then, an overhaul of financial regulation was clearly needed. And in 2010 the U.S. Congress enacted a bill that represented an effort to respond to the events of the preceding years. Like most legislation, the Wall Street Reform and Consumer Protection Act—often referred to as the DoddFrank bill—is complex in its details. But it contains four main elements:

  1. Consumer protection

  2. Derivatives regulation

  3. Regulation of shadow banks

  4. Resolution authority over non-bank financial institutions that face bankruptcy

1. Consumer Protection One factor in the financial crisis was the fact that many U.S. borrowers accepted offers they didn’t understand, such as mortgages that were easy to pay in the first two years but required sharply higher payments later on. In an effort to limit future abuses, the new law creates a special office, the Consumer Financial Protection Bureau, dedicated to policing financial industry practices and protecting borrowers.

2. Derivatives Regulation Another factor in the crisis was the proliferation of derivatives, complex financial instruments that were supposed to help spread risk but arguably simply concealed it. Under the new law, most derivatives have to be bought and sold in open, transparent markets, hopefully limiting the extent to which financial players can take on invisible risk.

3. Regulation of Shadow Banks A key element in the financial crisis, as we’ve seen, was the rise of institutions that didn’t fit the conventional definition of a bank but played the role of banks and created the risk of a banking crisis. How can regulation be extended to such institutions? Dodd-Frank does not offer an explicit new definition of what it means to be a bank. Instead, it offers a sort of financial version of “you know it when you see it.” Specifically, it gives a special panel the ability to designate financial institutions as “systemically important,” meaning that their activities have the potential to create a banking crisis. Such institutions will be subject to bank-like regulation of their capital, their investments, and so on.

4. Resolution Authority The events of 2008 made it clear that governments would often feel the need to guarantee a wide range of financial institution debts in a crisis, not just deposits. Yet how can this be done without creating huge incentive problems, motivating financial institutions to undertake overly risky behaviour in the knowledge that they will be bailed out by the government if they get into trouble? Part of the answer is to empower the government to seize control of financial institutions that require a bailout, the way it already does with failing commercial banks. (In Canada, depository banks include chartered banks, trust, mortgage and loan companies, credit unions, and caisses populaires.) This new power, known as resolution authority, should be viewed as solving a problem that seemed acute in early 2009, when several major U.S. financial institutions were teetering on the brink. Yet it wasn’t clear whether Washington had the legal authority to orchestrate a rescue that was fair to taxpayers.

All this is now law in the United States, but nobody knows for sure how the new regulations will fare in the face of a serious test. For that, we’ll just have to wait and see.

Knowing the devastating effect that a bursting housing bubble could have on our economy, the Federal Department of Finance decided to make mortgages harder to obtain and to limit the amount of debt the holder of a mortgage could carry. To achieve these goals, Canadian mortgage rules were changed in four stages: stage 1 in July 2008, stage 2 in February 2010, stage 3 in January 2011, and stage 4 in June 2012. These changes included the following:

The result of these rule changes should be to reduce the number of qualified buyers. Consequently, housing prices should rise more slowly than they have been or perhaps even decline. Jim Flaherty, the minister of finance, said that these changes in mortgage rules were necessary and would help the housing market have a “soft landing” rather than a hard one, which would be beneficial to the Canadian economy. These changes would also help put a brake on the growing level of household debt. On many occasions, Mark Carney, then governor of the Bank of Canada, expressed his concern over the historically high level of indebtedness of Canadian households; he said these mortgage rule changes were “prudent” and “timely” and would reduce the risk of household debt. Last but not least, the Office of the Superintendent of Financial Institutions (OSFI) said these rules would help reduce the default risk on mortgage loans faced by financial institutions because they discouraged institutions from lending to marginal borrowers, who would find it harder to get a mortgage. That being said, the government must prudently tighten the rules while not overly restricting mortgage market conditions; such a balance reduces the likelihood of a significant drop in home prices coming from the rule changes.

But, in fact, some argue that the finance minister has gone too far. Wayne Meon, president of the Canadian Real Estate Association, argues that these new rules were not necessary, as adjustments in the housing market were already underway. These rules might depress the real estate market further, leading to a crash. For example, according to the Royal Bank of Canada’s report on housing trends and affordability, the average price of a detached bungalow in Vancouver declined by 4.9% from $846 800 to $805 300 from the second quarter of 2012 to the third quarter of 2012. In the same time period, the housing affordability index for a detached bungalow in Vancouver dropped from 91% to 83%, and similar declines occurred in major cities such as Toronto, Ottawa, Montreal, and Edmonton.4 Some claim these declines are the result of the new changes, because the changes lowered demand for houses and resulted in homebuyers taking out smaller mortgages. The Canadian Association of Accredited Mortgage Professionals (CAAMP) also argues the new rules are too tough. A report by CAAMP suggests that up to 17% of those who would have qualified as homebuyers under the old rules now do not, and as a result, this lower demand could cause home sales to fall by 9%. This drop in sales will drive home prices downward, and lower the demand for goods and services in related industries, thus causing our still-fragile economy to slow down.

CRISIS IN THE MARKET FOR ABCP:THE CANADIAN SITUATION

In the mid-1980s, private financial institutions found a new way to make a profit: they began to issue short-term promissory notes. These companies supported, or “backed,” these notes with long-term assets that they owned (which were held in “trusts” separated from the issuing firms’ other assets and liabilities). These long-term assets were often purchased with the very funds raised by selling the notes. Asset-backed commercial paper (ABCP), as these notes were called, quickly became very popular. For instance, the amount of outstanding ABCP grew from about $11 billion in January 1997 to $115 billion in July 2007; over the same period, ABCP grew from being 21% of all the commercial paper issued in Canada to 67% of it. Shadow banks—non-depository financial institutions—can borrow money in the short term (by selling ABCP for high amounts) and lend it in the long term (by buying long-term assets at low amounts). While advantageous for the issuers of ABCP, the situation was risky because, as Canadian economist Frank Milne has noted, the shadow banking sector was largely free of the regulatory and lender-of-last-resort safety net available to deposit-taking banks.5

And indeed, trouble lay ahead: from 1997 to 2007, these private financial institutions’ portfolios of long-term assets changed to include a greater percent of items that turned out to be financially precarious, such as collateralized debt obligations and residential and commercial mortgage-backed securities based on U.S. sub-prime mortgages. As economics professor John Chant wrote in a National Post article (“Fix ABCP Flaws”) on January 23, 2009:

The 30- to 90-day maturity of the notes issued by the trusts and the longer-term nature of assets forced the trusts to continually seek refinancing for maturing notes, leaving them highly vulnerable to the vagaries of market conditions.

The assets acquired for the trusts by their sponsors included packages of securitized mortgages, many of which contained U.S. subprime mortgages. These packages were not acquired from the parties that originally made the mortgage loans. Rather, the trusts were often several steps removed, as the original lenders had sold the mortgages to others who, in turn, may have repackaged them and sold them on again. Outside observers were unable to determine the quality of the trusts’ portfolios because of the many layers separating the trusts from the original mortgage lenders.

The ABCP trusts also held synthetic assets in the form of credit derivatives. Surprisingly, they did not buy derivatives to protect themselves against credit risk but instead wrote them to take on the risks of others. Even more surprising, they did this on a levered basis that magnified their exposure to risk. These transactions also required the trusts to put up additional collateral to back their commitments according to market conditions.

In light of the trusts’ asset-liability mismatch, their exposure to subprime mortgages and their credit derivative position, ABCP trusts were essentially hedge funds, albeit with capped returns. They offered investors high risk together with low returns. All in all, they were totally unsuitable for investors seeking a safe haven and would have had few takers had their true nature been known. A broad market developed through a combination of limited information, forbearance from securities administrators and positive credit ratings.6

The repayment of ABCP by the issuing trust depends primarily on the cash flow received from the trust’s underlying asset portfolio and, due to the maturity mismatch between the notes and the underlying assets, with the trust’s ability to issue new ABCP. So, an issuer of ABCP could sustain itself during good financial times, but not during bad ones. During the summer of 2007, negative information about U.S. housing markets, falling resale prices, and rising mortgage default rates caused investors to worry about the true value of mortgage-backed securities and of the entities that had invested in them. This made investors reluctant to purchase newly issued ABCP. In August 2007, the $32 billion market for Canadian non-bank-issued ABCP froze, a circumstance that amounted to what was essentially a run on the shadow banks.7

Not only was $32 billion worth of non-bank ABCP held by financial institutions, other firms, and individuals, but an additional $200 billion worth of leveraged derivatives were at risk of unravelling. After 17 months of negotiations, consultation, and stakeholder meetings, a settlement was agreed upon. Under the plan individual investors would get their money back. The rest of the investors were to swap their insolvent ABCP for new notes, most of which matured within eight years. So, finally, investors had access to some of their funds (liquidity).

As part of the settlement, the governments of Canada, Ontario, Quebec, and Alberta agreed that they would provide a $4.5 billion “backstop facility” (essentially a line of credit) to help fund this settlement if private sector funds were unable to do so. Some people referred to this backstop facility as a government bailout. However, the federal government has noted that since the backstop is unlikely to be required, the risk to taxpayers is low. But one thing is for sure: the financial advisors who helped design this settlement are clearly among the winners, since they earned $200 million in consulting fees. This sad ABCP episode has given us many lessons about financial market regulation and reform. Only time will tell if we were able to enact the changes necessary to avoid another such crisis in the future.

Quick Review

  • When the panic hit after Lehman’s fall, governments and central banks around the world stepped in to fight the crisis and calm the markets. Most advanced economies experienced their worst slump since the 1930s.

  • In 2010, the U.S. Congress enacted the Dodd-Frank bill to remedy the regulatory oversights exposed by the crisis of 2007–2009. It created the Consumer Financial Protection Bureau to protect borrowers and consumers, implemented stricter regulation of derivatives, extended the reach of regulation to the shadow banking sector, and empowered the government to seize control of any financial institution requiringa bailout.

  • To lessen the possibility of a bursting Canadian housing bubble and the economic distress that would cause, the federal governmentinstituted, from 2008 to 2012, a series of changes designed tomake houses more difficult to buy.

Check Your Understanding 17-5

CHECK YOUR UNDERSTANDING 17-5

Question 17.7

Why does the use of short-term borrowing and being outside of the lender-of-last-resort system make shadow banks vulnerable to events similar to bank runs?

Because shadow banks like Lehman relied on short-term borrowing to fund their operations, fears about their soundness could quickly lead lenders to immediately cut off their credit and force them into failure. And without membership in the lender-of-last-resort system, shadow banks like Lehman could not borrow from the Federal Reserve to make up for the short-term loans it had lost.

Question 17.8

How do you think the ABCP crisis of 2008 would have been mitigated if there had been no shadow banking sector but only the formal depository banking sector?

If there had been only a formal depository banking sector, several factors would have mitigated the potential and scope of a banking crisis. First, there would have been no repo financing; the only short-term liabilities would have been customers’ deposits, and these would have been largely covered by deposit insurance. Second, capital requirements would have reduced banks’ willingness to take on excessive risk, such as holding onto subprime mortgages. Also, direct oversight by the Office of the Superintendent of Financial Institutions would have prevented so much concentration of risk within the banking sector. Finally, depository banks are within the lender-of-last-resort system; as a result, depository banks had another layer of protection against the fear of depositors and other creditors that they couldn’t meet their obligations. All of these factors would have reduced the potential and scope of a banking crisis.

Question 17.9

Describe the incentive problem facing the U.S. government in responding to the U.S. 2007–2009 crisis with respect to the shadow banking sector. How did the Dodd-Frank bill attempt to address those incentive problems?

Because the shadow banking sector had become such a critical part of the U.S. economy, the crisis of 2007–2009 made it clear that in the event of another crisis the government would find it necessary to guarantee a wide range of financial institution debts, including those of shadow banks as well as depository banks. This created an incentive problem because it would induce shadow banks to take more risk, knowing that the government would bail them out in the event of a meltdown. To counteract this, the Dodd-Frank bill gave the government the power to regulate “systemically important” shadow banks (those likely to require bailing out) in order to reduce their risk taking. It also gave the government the power to seize control of failing shadow banks in a way that was fair to taxpayers and didn’t unfairly enrich the owners of the banks.