The Archbishop of Birmingham, England, Vincent Nichols, who is widely regarded as the leading candidate to become British primate (Cardinal Archbishop of Westminster), recently said: “A market controlled only by regulation, sooner or later, will succumb to its inherent drive for profit at all costs. Of course the profit motive is crucial, and responsibility to investors is a significant balancing factor in risk taking.” This responsibility “to investors,” I would argue, should rather be thought of as a responsibility “of investors” more generally. As individual economic actors, we are all responsible, and not just for limiting our particular financial risk. We also have a larger obligation to make sure that our savings are not misused. To this end, the regulations and structure of our modern financial system should, whenever possible, seek to assist rather than hinder us in this effort.
The subprime crisis highlights a critical shortcoming in our financial system when individuals do nothing more than follow rules. In recent years, as mortgage origination became increasingly systematized, loan officers and mortgage brokers were no longer expected to make assessments as to whether borrowers could actually repay their loans. Instead, they were simply asked to help borrowers meet clearly specified requirements. Reduced to putting the borrower’s statement of income in the best possible light and obtaining a favorable appraisal value for the house to be financed, mortgage originators focused on and excelled at the task at hand. Rules that were meant to make the origination process more efficient didn’t just have the intended effect of limiting the range over which judgment was exercised. They also had the unintended effect of entirely displacing that judgment.
An excess of debt, our overarching economic problem, is to a large extent a result of the same pattern of behavior, rules followed by rule-following without judgment. Banks, which created much of the debt on which we are now collectively choking, are, not coincidentally, among the most regulated private enterprises in our economy. The executives and board members running these organizations, just like individual mortgage originators, over time allowed regulations to displace their judgment. The government-is-the solution crowd would have us believe that the regulations weren’t quite right. They weren’t streamlined enough. That this problem is essentially a technical matter, and if we just combine the Office of Thrift Supervision with the Office of the Comptroller of the Currency and allow the Federal Reserve to supervise the largest financial enterprises, this problem won’t recur. Better regulation, however, while by definition a good thing, won’t prevent future banking crises.
The problem, to be clear, is not that bankers aren’t sufficiently risk averse. They are risk averse, but principally to a particular type of risk, namely the risk of making a mistake without sufficient company. Bankers’ penchant for uniformity, while ensuring that few competently managed banks have problems during normal times, also ensures an unhealthy level of systemic risk. This willingness to take on unwise risks so long as the risk-taking is done en masse was perfectly captured by Charles Prince just a few months prior to his departure as CEO of Citigroup. “As long as the music is playing, you’ve got to get up and dance,” he said famously in defense of his decision to continue making risky loans to leverage buyout firms, despite his own personal reservations about the solidity of these credits.
Given bankers’ conformist bent and regulations’ history of exacerbating rather than remedying this tendency, it is naïve of us to think that now regulation will be the solution. Bank regulation, historically speaking, has never been anything more than a thirty-year dam. Without the dam, the waters’ periodic rise washes away bankers’ imprudent investments, never allowing bankers’ imprudence to get very far out of hand. Once built, however, the dam removes the risk of regular flooding and encourages the financing of construction farther and farther out into the floodplain. That the government officially declares all building right up to the dam’s edge safe only makes matters worse. Over time, the government’s rules and bankers’ short-term self-interest win out over prudence, and massive construction occurs right at the dam’s edge. When the dam eventually breaks, as it always does, very few banks escape without extensive losses and the banking system as a whole freezes up.
The way forward requires that we confront the structural instability inherent in our banking system instead of simply focusing on building a better dam. Individual savers must reclaim their natural role as responsible economic actors and forego the convenience of risk-free bank accounts that are the root cause of the system’s instability. By relieving individual depositors of any financial risk, government- insured bank accounts act as a barrier to moral action, effectively preventing depositors from making responsible inquiries into how a bank is deploying their money. That all financial assets have risk is a reality with which individuals can and must learn to live. The clear alternative to our current system, money market-like accounts that could go down as well as up in value depending on the specific underlying investments, would require savers to know where and how their money is being lent and to make prudential judgments about how their savings ought to be deployed, a responsibility of which we are all capable.
Mr. Fieler, a money manager, writes in a private capacity.
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