Comparing 1928/1929 with 2004/2005

Between 1928 and Aug 1929 (2004 and 2005) the Fed targeted speculators in the stock market (mortgage/securitization) in an effort to halt excessive speculation, they certainly succeeded! Between 1929 and 1931(2006 and 2007) 5 of 6 financial institutions that failed were non regulated financial institutions.

For the next 18 months (depending on when you date the crisis to) the Government said the problem was confidence. When they finally began to address the problem, close to a change in Presidency, they first banned short sales (yes, both times) and then passed a rushed bank solvency bill that failed (yes, both times). Banks and the business classes continued to hoard partly out of uncertainty about the tax policies of the incoming Administration.

When FDR came to office he immediately closed the banks and only allowed the healthy ones to reopen. He then used the RFC in a manner different than his predecessor to finally get it right – unfortunately FDR tax policies kept us weak through the beginning of WWII. This Admin has, as announced yesterday, allowed the sick to get sicker, failed to do anything close to a real bank cleansing and is now proposing increased taxes on the business class.

Systemic risk regulators are only needed where they allow institutions to become systemically risky! For over 70 years we had banks that didn’t become systemically risky. I would propose that the concentration limits on deposits worked (in a world in which banks were deposit funded) in preventing systemic risks among banks. The systemic risk grew because as banks transitioned from deposit funding to capital markets funding we did not create any comparable rule to the deposit concentration rule. This allowed certain banks to become concentrated in being funded by, funding and intermediating in the capital markets.

The Fed is a liquidity regulator (a very good one) but it has no real skills in regulating credit risk (it had wanted to get rid of the leverage ratio and had it been successful all banks would be imperiled). It can’t work as a reputational risk regulator and it is unclear if anyone has the skills to oversee systemic operational risk.

Instead of a systemic risk regulator we should modernize the concentration rules to include deposit concentration limits and market concentration limits. It was leverage, not profitability, that allowed the big buys to get so big.