Events of the past two years have exposed a logical flaw in our historic approach to regulating financial institutions, especially banks.
To its credit, the Obama administration recognized this flaw in its proposals for regulatory changes. Whether the administration’s proposal for addressing the problem is the best alternative remains to be seen.
The flaw in question turns out to be a “fallacy of composition.” Something professors warn introductory philosophy and economics students about, a fallacy of composition is the erroneous assumption that what is true for an individual is necessarily true for a larger group as a whole.
For example, if you are at a Timberwolves or Wild game and cannot see the action, you may get a better view by standing up. Therefore, if everyone at the game would stand up, everyone would see the action better. Wrong! What is true for one attendee is not true for the whole crowd.
U.S. bank regulation has implicitly assumed that if one audits all individual banks to ensure that they are following sound banking practices and are not in danger of going broke, the nation’s banking system as a whole also will be sound and in no danger of insolvency. Also wrong!
That explains the abrupt turnaround from the spring of 2007, when the first cracks began to appear in securitized mortgages and in financial derivatives like credit default swaps. Federal Reserve and Treasury officials downplayed any threat to the overall economy.
After all, the banking system seemed well-capitalized, having learned its lessons after the problems of the last two decades of the 20th century, with Third-World debt write-offs, farm lenders gone bust, the savings-and-loan crisis and regionalized losses on commercial property lending.
Banks had cleaned up their risk-management procedures and fortified their balance sheets. No, government officials, financial industry spokespeople and business journalists assured us, we did not have to worry about the commercial banks this time.
That was the prevailing wisdom in August 2007, when fears about investment banks such as Bear Stearns that were realizing large losses in mortgage-backed securities led to a near-seizing up of commercial paper markets and prompted unprecedented injections of liquidity by the Fed and the European Central Bank. It was wrong.
It was wrong because some of the assets many major banks held were considerably more troubled than nearly everyone thought. But it also was wrong because as more banks faced financial problems, their prudent individual responses made them worse off as a group.
If one bank is overextended, prudence leads it to trim its balance sheet by making fewer loans or investments. Thus, in itself, one bank selling off questionable securities to secure cash is a positive act.
But if hundreds of banks do the same thing at the same time — or even if a couple dozen of the very largest banks do it simultaneously — it is bad for commercial banking as a whole. Widespread selling drives down the market price of such securities. Those lower prices hit not only the balance sheets of selling banks, but of every bank (and every investment bank, hedge fund, insurance company and pension plan) that holds this class of security, whether it be a collateralized mortgage obligation or credit default swap. That is the fallacy of composition at play here, one our banking regulation system has never explicitly addressed. The ongoing debacle shows that was a serious mistake.
The Obama administration, among other things, proposes giving additional powers to the Fed to monitor and control such collective risk to the banking sector. Whether that specific change is a good one is a separate issue, but at least we have recognized a glaring problem.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.