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Thursday, May 14, 2009

Wilmarth on Universal Banking

The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis, by Arthur E. Wilmarth Jr., George Washington University Law School, was recently posted on SSRN.  Here is the abstract:

Since the subprime financial crisis began in mid-2007, banks and insurers around the world have reported $1.1 trillion of losses. Seventeen large universal banks account for more than half of those losses, and nine of them either failed, were nationalized, or were placed on government-funded life support. Central banks and governments in the U.S., U.K. and Europe have provided $9 trillion of support to financial institutions to prevent the collapse of global financial markets.

Given the massive losses suffered by universal banks, and the extraordinary governmental assistance they have received, they are clearly the epicenter of the global financial crisis. They were also the main private-sector catalysts for the credit boom that precipitated the crisis. During the past two decades, governmental policies in the U.S., U.K. and Europe encouraged consolidation and conglomeration within the financial services industry. Domestic and international mergers among commercial and investment banks produced a dominant group of large, complex financial institutions (LCFIs). By 2007, seventeen LCFIs held leading positions in domestic and global markets for securities underwriting, syndicated lending, asset-backed securities (ABS), over-the-counter (OTC) derivatives, and collateralized debt obligations (CDOs).

Universal banks pursued an “originate to distribute” (OTD) strategy, which included (i) originating consumer and corporate loans, (ii) packaging loans into ABS and CDOs, (iii) creating OTC derivatives whose values were derived from loans, and (iv) distributing the resulting securities and other financial instruments to investors, including off-balance-sheet conduits. LCFIs used the OTD strategy to maximize their fee income, reduce their capital charges, and transfer to investors the risks associated with securitized loans.

Securitization enabled LCFIs to extend huge volumes of home mortgages and credit card loans to nonprime borrowers. By 2006, LCFIs turned the U.S. housing market into a system of “Ponzi finance,” in which nonprime borrowers kept taking out new loans to pay off old ones. When home prices fell in 2007, and nonprime homeowners could no longer refinance their loans, defaults skyrocketed and the subprime financial crisis began.

Universal banks also followed reckless lending and securitization policies in the commercial real estate and corporate sectors. LCFIs included many of the same aggressive loan terms (including interest-only provisions and high loan-to-value ratios) in commercial mortgages and leveraged corporate loans that they included in nonprime home mortgages. In all three markets, LCFIs believed that they could (i) originate risky loans without properly screening borrowers and(ii) avoid costly post-loan monitoring of the borrowers’ behavior, because the loans were transferred to investors. In addition, LCFIs retained residual risks from their securitization programs due to (1) “warehoused” holdings of loans, ABS and CDOs, and (2) contractual and reputational commitments. Accordingly, when securitization markets collapsed in mid-2007, universal banks were exposed to significant losses.

Current regulatory policies – which rely on “market discipline” and LCFIs’ internal “risk models” – are plainly inadequate to control the proclivities in universal banks toward destructive conflicts of interest and excessive risk-taking. As shown by repeated government bailouts during the present crisis, universal banks receive enormous subsidies from their status as “too big to fail” (TBTF) institutions. Regulation of financial institutions and financial markets must be urgently reformed in order to eliminate (or greatly reduce) TBTF subsidies and establish effective control over LCFIs.

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