Lessons from the Great Recession

A new treasury secretary. A Fiscal Cliff. Sequestration. And most recently, the Federal Reserve announced that its most recent stress test results indicate that while the banking system appears to be in better shape capital-wise, the biggest banks, including Goldman Sachs, Morgan Stanley and JPM Chase might not be able to withstand another crisis.
Since his time on Wall Street and now in academia, Michael Imerman has focused on credit risk modeling, financial institutions and risk management. His dissertation examined the 2007-2009 financial crisis and he has presented his most recent and evolving study, When Enough Is Not Enough: Bank Capital and the Too Big to Fail Premium, to the Federal Reserve.
Imerman, an assistant professor in the Department of Finance at Lehigh University, discusses the Great Recession and how regulation and risk management is changing within financial markets.
Remind us, what were the major causes of the Great Recession?
“The Great Recession started as a fairly localized event resulting from declining housing values. In certain parts of the country it was worse. Lenders were lax, requiring little-to-no documentation from borrowers to establish credit worthiness and little-to-no down payments. Borrowers who perhaps shouldn’t have received mortgages did. When home prices declined, these borrowers couldn’t remain solvent.”
Also, according to Imerman:

• Banks lent too much, too easily, on low-quality loans and then incurred losses when the market soured.
• U.S. mortgage-backed securities, risky and complicated, were marketed around the world.
• Financial institutions that didn’t directly issue the unsafe loans still faced exposure by holding mortgage-backed securities or derivatives. The subprime crisis became more severe, permeating the entire financial system.
• Writing down these loans, firms began to realize their true losses. Creditors and derivative counter-parties were then requiring more collateral and more margin (in a secured loan or derivative transaction, the lender or counterparty may require collateral to back the transaction—sometimes as cash in a “margin” account). This is precisely what happened to Bear Stearns. Creditors stopped lending money.
• When Bear Stearns went under, that was the turning point, a precursor to the financial crisis. The nation went from an isolated sub-prime crisis to a credit crisis to a full-blown financial crisis. Every financial institution exposed to these loans had credit-worthiness questioned. The system became unstable.
• With loan losses mounting and the fall of Lehman Brothers, panic broke out on the interbank loan market. Investment and commercial banks suffered huge losses and potentially faced failure.
• The federal government stepped in, minimizing the amount of damage, infusing almost $250 billion into the banking system.  Waiting for the Recession to run its course took another 9 months. In the summer of 2009 things started to look brighter.
• Turmoil in European markets introduced fears of a “double dip” and erased any hope for a quick turnaround.

What new regulations do you think we will see?
“Much of my research has focused on capital requirements, a key regulatory and risk management tool for financial institutions. The previous global standard was something called Basel II, a set of international guidelines for banks created by the international Basel Committee on Banking Supervision. Introduced in 2004, it defined how banks account for their risks and cushion against losses.
“Banks are highly leveraged. The overwhelming majority of their funds are borrowed, 80-90 percent or more. They are required to have at least a certain amount of their financing from equity capital, defined as internally generated capital or externally raised shareholder capital. It serves as a buffer against losses.  Shareholders are supposed to be the primary risk-bearers; losses hit the shareholders first, protecting creditors who lend money to the bank (depositors, bondholders, or other banks).  As a result of Basel II requirements, regulators made sure that the riskiest assets were financed by a minimum of 8 percent equity capital.  However, there was some discretion about how the assets were classified. Less risky assets could have less capital – and the 8 percent capital level was averaged out over all of the assets.”
According to Imerman, the mistake was that regulatory capital, that 8 percent cushion every bank was required to have, didn’t capture the real picture. “For one thing, existing regulatory measures allow for arbitrary adjustments and gaming of the system, a practice referred to as ‘regulatory arbitrage.’  Risky assets can be moved off balance sheet or reclassified, essentially eliminating them from the equation and making the bank look safer. Furthermore, I would argue that Basel II did not appropriately distinguish the risks that should be accounted for in determining capital requirements.  For instance, they looked at asset risk without regard for how the assets were financed.  In the crisis, much of the problem was that risky assets were being financed by short-term, volatile sources of funding.  There was also no notion of liquidity risk which proved to be a critical factor in the crisis.
“Another problem that became evident during the crisis was that regulatory responsibilities were split across several different federal agencies like the Treasury, the FDIC, the Federal Reserve and the SEC). Efforts were so fragmented that institutions like Lehman Brothers could be very risky without catching the attention of any one regulator.

The Too Big To Fail Premium
Imerman’s current research, “When Enough Is Not Enough: Bank Capital and the Too Big to Fail Premium,” focuses on the amount of bank capital that the largest U.S. banks needed in the depths of the crisis. Imerman employed a model typically used in studying corporate bankruptcies to capture two relevant issues highlighted during this period: 1.) The important distinction between short-term and long-term debt in determining bank risk and 2.) The role of the cash infusions that were provided by the U.S. government to save the largest banks.
“In my research, I argue that the government’s bailout did not increase capital enough to significantly lower the risk of failure and that they represented a compound option on the government’s implicit commitment to continue to inject capital into the largest financial institutions.”
Imerman calculated the amount of capital that would have been needed to reduce the likelihood that any one bank failed. “It turns out that the model-implied capital deficiencies are much greater than the bailout they received, which suggests a puzzle. The capital positions of the largest banks were at levels that indicated a high likelihood of failure, yet none of these institutions failed. How could they survive when the market indicated they needed much more capital than was actually maintained?”
The answer is what Imerman calls the “Too Big to Fail Premium,” a function of the compound option that equity holders were given every time the government injected more capital into these large banks. Imerman’s model provides a unified way to link the amount of capital and bank risk to default probabilities, as a function of the liability structure and market information. It also provides a way to quantify the value of Too Big to Fail.
Imerman also believes the distinction between short- and long-term debts should be a focus. According to his model, it’s not just the riskiness of the assets that matter but where a bank is raising its non-equity financing. If you borrow in a risky, short-term market, you are more vulnerable to a shock, as opposed to borrowing in long-term, more stable markets. The climate of the market is an additional component of trading that must be weighed.
Using this new model, Imerman found market value capital ratios plummeting in 2007-8. This was an early warning sign. In 2008-9 capital cushions were 10 percent or less. Capital had completely eroded. Clearly, the regulatory requirement of 8 percent wasn’t enough—a lesson the nation, and the world, has learned.

How has business reacted to some of these changes?
“There’s a lot of resistance from the financial services industry to conform to more regulations. They believe they are already overregulated. It’s a fine line to walk. We don’t want to overly regulate financial institutions to the point where they are not doing what they should—making markets and providing liquidity and capital.
“The question is, ‘What compromise can Wall Street and Washington make to put us in a better position for the next crisis?’ The goal is to make some progress, not just to appease the public politically.
“Unfortunately, we will never eliminate the specter of a financial crisis. It’s a natural part of the financial manifestation of business cycles. We simply must be better equipped to minimize the real effects when they come.”
Have we learned from mistakes?
“Even in the last few weeks it appears some folks are listening,” says Imerman. Regulators in the United Kingdom are considering forcing British banks to raise billions in capital as bank supervisors are assessing the risk weights banks assign to their assets. Not surprisingly, analysts are convinced banks have understated risk. Sequestration, the Fiscal Cliff, and a new treasury secretary have once again brought conversation around to financial regulation.
“In response to the crisis, additional regulations under the Basil III Accord are now in the works, with a new way of calculating risk,” says Imerman. “With Basil III, banks will have to factor in liquidity, a major component of my research. I am not alone in arguing that the failures were not just about assets losing value, but a lack of liquid wealth.
“I do believe Too Big to Fail exists,” said Imerman. “It exists, it is there and it has to be addressed… How to address it is a different issue.  One way to address it is to break up large financial institutions, but I’m not sure we want to explicitly place restrictions on size, but perhaps penalizing firms who are too large by requiring them to hold more capital above and beyond regulatory minimums.
“The primary question is always this: Do we want our government having their hands in private enterprise? But the alternative is a network of large, interconnected institutions, where one failure can create systemic crises. The moves of any one institution—whether good or bad—have such a massive impact it distorts the market. That’s what we need to watch.”
Imerman is an author of the forthcoming study, Structural Credit Risk Models: Endogenous Versus Exogenous Default, in the Encyclopedia of Finance and Leverage, Liquidity, and Loss Spirals:  Lessons from the Lehman Failure.