This blog article summarizes Chapter 4 of The Failure of Financial Regulation by A. Hira, N. J. Gaillard and T. H. Cohn (Eds.), Palgrave Macmillan, May 2019
In this book chapter, we advocate that the “financialization” of the global/US economy (i.e., the process by which financial service participants, institutions and markets increase in size and influence) has been essentially driven by moral hazard and, more precisely, by the emergent “too big to fail” (TBTF) banks. The ever-expanding influence of these entities has distorted the relations with regulators, amplified the indebtedness of economic actors, and increased systemic risk. This in turn has exacerbated further moral hazard and trapped the US economy into a vicious cycle where TBTF banks take excessive risks with the confidence they will not be allowed to fail in the event of crisis.
The globalization and growth of finance capitalism feeds off the common recognition at financial institutions around the globe that there is a positive correlation between assets under management, market share, competitive pricing advantage and therefore, earnings growth. Through the use of complex derivatives and structured finance (SF) innovation, risk managers became balkanized “Cassandras” within their own institutions and senior management, enticed by ever increasing amounts of earnings-driven current and deferred compensation, have succumbed to the false sense of security.
The technology of securitization permitted the entrance of new funding sources for capital. The larger banks recognized that the cost-effective path to further asset accumulation offered by securitization involved the sponsorship of SF issuance as part of their activities. With extraordinarily promising returns, the race to universal banking (i.e., TBTF banks) was the ultimate, decisive step. The concept of “one-stop-shopping” for financial services grew throughout the 1980s and 1990s as smaller ‘nonbanks’ – who could exploit the development of new niche products and advances in computer technology as well as the continuing momentum of deregulation – began competing for the attention of consumers. The larger banks, brokerages and life insurers began a period of consolidation and vertical integration, and pursued acquisitions in order to meet the demand. Not surprisingly, and from the perspective of the legal realists who recognize the susceptibility of a legislator’s opinion to the interests of the donor class, the repeal of Glass Steagall in 1999 was inevitable.
The “super-senior” creditworthy status granted to TBTF banks can be observed in the post-crisis changes to their capital costs and to the treatment they received from the credit rating agencies (CRAs). After the government bailed out the mega banks in 2009, research has shown that borrowing costs for banks with assets over $100 billion were one third to three quarters of a percentage point lower than that of their smaller competitors. Prior to the bailout, that advantage was reportedly less than 0.1 percentage point. By the same token, CRAs explicitly recognized support from the government by ‘notching up’ the ratings assigned to the TBTF banks, with upward adjustments ranging from two (Goldman Sachs Group) to four notches (Citigroup) (Wilmarth 2010).
In fact, starting as far back as the 1990s, the power and influence of TBTF banks had taken diffuse and insidious forms, especially through their relations with de jure and de facto financial gatekeepers. Systemic banks have used and abused the “we won’t stop unless it is confirmed to be prohibited” principle by arguing that any brake on their activities and financial innovation weakened their position and thus increased the likelihood of a crisis, and ultimately, a bailout.
In this context, financial gatekeepers should have served as “inquirers”. Their duties should have consisted of detecting and eliminating the incentives that induce TBTF banks to increase their risk-taking simply because they knew they would be rescued in case of financial distress. Such preventive action would have involved investigating whether, for example, financial sophistication and huge leverage were symptoms of moral hazard deserving restraint. Instead, de jure and de facto regulators have overlooked these aspects and instead concentrated their efforts on the non-confrontational goal of stabilizing the capital markets. By pursuing this objective their policies became increasingly distorted and transformed uncompromising gatekeepers into “lenient partners”, what we call here “sweeteners”.
Three types of “sweeteners” are scrutinized in our chapter: U.S. regulators, the Federal Reserve, and CRAs. Only the case of CRAs is examined here.
The inflation of SF ratings best illustrates the “sweetening” role played by CRAs. The SF segment accounted for an increasingly dominant share of CRAs’ revenue: 39% of Moody’s total revenue in 2007 compared to nearly 0% in the 1980s. The concentration of the MBS underwriting business diminished the bargaining power of the publicly held CRAs as they competed for their “customers” business. The pursuit of market share, combined with the concentration of MBS underwriting induced CRAs to be lax when rating RMBS and CMBS. All things equal, ratings assigned to MBS issued by the biggest firms were comparatively the most inflated. Tellingly, the rating inflation was common knowledge as investors priced into their deals the risk that large issuers received more inflated ratings than small issuers (He et al. 2012). The extent of the inflation of SF ratings was evidenced by the magnitude of downgrades and the high default rates that hit investment-grade bonds in 2008-2009.
The “sweetening” role played by CRAs is still operating today. It is reflected in the flaws in CRAs’ procedures, rating methodologies and in the ratings themselves. The most striking examples of the CRAs tacit ‘sweetening’ actions are found in their rating confirmation and affirmation letters. These letters are typically issued in response to a request from either the structuring bank or from an asset manager for the rated entity, or even from a hedge counterparty that is facing the rated entity but whose continued performance in that role requires – due to deteriorating credit or corporate reorganization or other intervening events – rating agency ‘permission’.
The second ‘sweetener’ applied by the CRAs is an imprimatur of safety that is wholly inconsistent with the legal obligations retained by the CRA in respect of the ratings they issue. The history of the CRAs together with ubiquitous marketing by sell side analysts reinforcing the perception that AAA instruments are extremely safe have burnished that imprimatur and aided in cementing the expectation of safety. Yet, in the U.S., the CRAs have embraced the legal environment that has developed around the publication of newsworthy opinion, rather than the legal requirements attaching to the statements of professional experts (Gaillard and Waibel 2018). The thresholds that currently apply for attaching liability to the CRAs in respect of their reasonably constructed opinions of the risk presented by widely distributed corporate and municipal debt issuances may be justified on public policy grounds: allocation to a centralized risk-assessor is efficient and encourages a stable and liquid market. However, those same considerations are inappropriate in the context of bi-lateral and bespoke SF and complex derivative transactions. For the investors in the highly sophisticated structured derivative products, the narrow set of circumstances required for finding liability begs the question: how is it that the CRAs are selling their expertise and deep experience and yet avoiding responsibility for negligent performance?
Other sweetening effects of CRAs are closely related to the flaws in their methodologies. For instance, Moody’s and S&P continue to describe their AAA-ratings as representing the expectation that suchdebt will be 99.995% immune to credit losses regardless of whether the issuer of that debt is party to (a) a risky swap contract provided by a low-rated counterparty, (b) a swap contract provided by a AAA-rated counterparty, or (c) no derivative contract. More globally, mis-rated counterparties and inflated credit ratings generate an interconnectedness problem. When a bank or financial institution (as a counterparty to one or more securitization swaps) carries an inflated rating, or a derivative product company overstates the adequacy of its capital resources, and either one presents a misleading credit profile to both ABS issuers and other trading partners, the error in risk management multiplies (Gaillard and Harrington 2016).
A further complication surrounds the way CRAs deal with express and implied government bailouts. The ratings assigned to banks are enhanced because CRAs take into account a probable bailout from their government. The problem is that, in case of a systemic crisis, a government may be unable to bail out all failing banks without jeopardizing its own credit position, and consequently increasing the ultimate costs of the bailout. Surprisingly, these possible bailouts do not deflate sovereign ratings, which suggests that CRAs underestimate contingent liabilities when assigning sovereign ratings (Gaillard 2017).
We believe that a new, redesigned, Glass-Steagall Act could be reinstated to cut the size of TBTF banks and eliminate their unfair competitive advantages. Concretely, mega-banks should be dismantled not only horizontally (by size) but also vertically (by line of business). With smaller and more specialized financial institutions, there is less likelihood of a taxpayer funded bailout in case of financial distress.
A radically different solution could also be advanced. If the restoration of the Glass-Steagall Act is not realistic, it would be coherent to internalize the reasonably understood externalities relating to a possible bailout. Whether through contributed subscription funding or by way of a tax, the members of the TBTF class would self-insure in place of the taxpayers. The premium that a systemic firm would pay for its possible bailout would be contingent upon GDP growth and the profits posted by the TBTF entity.
CRAs should take common sense measures: e.g., capping ratings at single-A for deals that contain derivative hedges (Harrington 2013) and deflating (i) all credit ratings by incorporating conservative assumptions regarding the correlation of credit risk across all sectors (Gaillard and Harrington 2016) and (ii) sovereign ratings specifically by incorporating the real cost of potential bailouts (Gaillard 2017).
Next, U.S. regulators should focus more on the execution of their responsibilities and less on possible market reactions to their decisions (e.g., “guidance”, transparency, etc.). In what may be an unintended bias to assume greater responsibility for macroprudential outcomes, regulators have unwittingly opened the door to microeconomic misadventures, and have too often explained away, if not turned a blind eye, to morally hazardous misbehavior.
Lastly, the Federal Reserve should revise its implicit inflation-targeting framework and include asset price movements in its monetary policy formulation process. This measure would be adequate to cope with a capitalist system where the “financial instability hypothesis” – as suggested by Minsky (1977) – has proved right.
Gaillard, N. J. 2017. Credible Sovereign Ratings: Beyond Statistics and Regulations. European Business Law Review. 28(1).
Gaillard, N. J. and W. J. Harrington. 2016. Efficient, Commonsense Actions to Foster Accurate Credit Ratings. Capital Markets Law Journal. 11(1).
Gaillard, N. J. and M. W. Waibel. 2018. The Icarus Syndrome: How Credit Rating Agencies Lost their Quasi-Immunity. Southern Methodist University Law Review. 71(4).
Harrington, W. J. 2013. Letter to Mr. Abe Losice, Securities and Exchange Commission and Mr. Felix Flinterman, European Securities and Market Authority. September 11.
He, J., J. Qian, and P. E. Strahan. 2012. Are All Ratings Created Equal? The Impact of Issuer Size on The Pricing of Mortgage-Backed Securities. Journal of Finance. 67(6).
Minsky, H. P. 1977. The Financial Instability Hypothesis: An Interpretation of Keynes and An Alternative to ‘Standard’ Theory. Nebraska Journal of Economics and Business. 16(1).
Wilmarth Jr., A. E. 2010. Reforming Financial Regulation to Address the Too-Big-to-Fail Problem. Brooklyn Journal of International Law. 35(3).