The Worst Regulation in History? Jeffrey Friedman and Wladimir Kraus on the Recourse Rule

In this post, guest bloggers Jeffrey Friedman and Wladimir Kraus, coauthors of Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation, look at the impact of the Recourse Rule, a banking regulation which took effect ten years ago.

January 1 marks the tenth anniversary of the Recourse Rule, a regulation that may be more responsible than any other factor for the financial crisis. In the five years after this obscure rule was implemented, U.S. banks acquired nearly a quarter of the world’s supply of subprime mortgage securities. Banks ended up with proportionally three times as many mortgage securities as other investors did. The reason was the Recourse Rule, which applied only to banks.

The Rule, issued by the Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and Office of Thrift Supervision in 2001, had an effective date of January 1, 2002. It strongly encouraged banks to hold highly rated mortgage-backed securities, whether they were prime or subprime, as long as they were rated AA or AAA. At the same time, it penalized banks that made business loans or even mortgage loans instead of investing in highly rated mortgage securities.

The Rule worked all too well. Business lending, penalized by the Rule, declined, even while mortgage lending and securitization took off. The Rule may have contributed to the housing bubble by sparking demand from banks for securitized mortgages. More important, the Rule concentrated the risks from securitized mortgages in the banks. When fears about the value of these bonds drove down their market value, banks had to contract lending, and eventually had to be bailed out.

Why did U.S. financial authorities enact such a disastrous regulation? It seemed logical at the time. A bank that made mortgage loans in a given locality could be imperiled by a regional housing downturn. This had been a major problem for American banks. Mortgage securities solved the problem by pooling hundreds, sometimes thousands of mortgages from various regions. By holding mortgage securities, a bank could diminish its vulnerability to local housing vicissitudes. Moreover, the highest rated securities—those rated AAA or AA—were contractually guaranteed to suffer last from any defaults in the mortgage pool.

Everyone was impressed by the safety of this contractual structure, including the regulators. So they required banks to devote two and a half times as much capital to individual mortgages as to highly rated mortgage securities, and five times as much as to business loans. The intention was to steer banks into safe securities. Only in hindsight does it seem foolish to consider AAA mortgage securities safe; ten years ago, the Recourse Rule was perfectly reasonable.

It may seem, then, that the Recourse Rule offers us no lessons. It failed only because of unavoidable human ignorance. The regulators did not anticipate a nationwide housing bubble. Prescience about the bubble was rare, and nobody can be blamed for lack of omniscience. Testifying before the Financial Crisis Inquiry Commission, former FDIC Chair Sheila Bair expressed regret for the Recourse Rule and admitted that regulators had not understood the risks. Neither had most investors.

However, the danger of a fallible regulator is much greater than the danger of a fallible investor.

A prudent response to our fallibility is to spread our bets. The Recourse Rule contradicted this principle by encouraging all banks to invest in one category of “safe” assets. Herd behavior is always a danger in markets, but this particular herd was corralled by the regulators.

Given what they knew at the time, it is hard to see how the regulators could have crafted a better rule. But by the very act of crafting any rule, they reduced market heterogeneity, making the financial system more vulnerable to a black swan. If the penalties imposed by a regulation have their intended effect, they homogenize the behavior of those who are subject to it, increasing the system’s fragility by reducing its diversity. The paradoxical lesson of the Recourse Rule is that regulation can create systemic risk even when the regulators are aiming at systemic stability.

The same lesson can be learned from the ongoing European crisis. In 2004, the Basel II accords extended the Recourse Rule’s innovation to non-U.S. banks. These banks, too, were now penalized for making business loans instead of buying mortgage-backed securities. When investments in these securities blew up, European banks had to be bailed out.

The bailouts and other European responses to the financial crisis of 2008 produced an explosion of European sovereign debt. This debt was snapped up by the capital-starved banks that were being bailed out, because the EU Capital Requirements Directive of 2006 exempted sovereign debt from all capital requirements. In 2009, the international regulatory community compounded this error, announcing that Basel III would double capital requirements on “risky” assets. This made the zero capital charge on “riskless” sovereign debt even more attractive to the banks.

In combination, the Capital Requirements Directive and Basel III encouraged European banks to buy up the government bonds that had been issued, in large part, to undo the consequences of Basel II. The same regulators who had herded European banks into mortgage-backed bonds were now herding them into government bonds. This concentrated sovereign default risk among the banks, soon generating another financial crisis. Each new EU plan for solving this crisis has been hampered by the need to bail out not only eurozone sovereigns but their main creditors, the banks.

Again, though, the regulators can hardly be blamed. Sovereign debt has always been considered a risk-free investment. The Capital Requirements Directive merely codified conventional wisdom, just as the Recourse Rule had done. And Basel III was logical, too. It is true by definition that when banks become insolvent, as in 2008, they lack enough capital. The regulators therefore blamed themselves—not for steering banks into mortgage-backed securities, but for requiring banks to hold too little capital. In response, they toughened capital requirements, pushing banks toward capital-free government bonds.

Each step down the road from the Recourse Rule has planted the seeds of the next crisis by reducing systemic diversity. The latest step has been taken by the European Central Bank, which has now lent $640 billion to European banks at extremely low interest rates. The ECB hopes to induce the banks to use these funds to buy even more sovereign debt. Given the magnitude of the current crisis, this step, too, makes sense. But it could backfire if there is a sovereign default, since it concentrates even more of the default risk in the banks. It could also backfire if, instead of adding to their mountains of government bonds, banks flee en masse to some other asset class, creating a new bubble.

A decade into this mess, there seems to be no way out of it. It may not be a happy new year.

Jeffrey Friedman is a visiting scholar in the Department of Government at the University of Texas, Austin. He is the editor of What Caused the Financial Crisis, and editor of the journal Critical Review. Wladimir Kraus is a doctoral candidate in economics at Université Paul Cézanne Aix-Marseille and associate editor of Critical Review.

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