Privatization of Financial Regulation is Not Impossible
By Anthony Randazzo and Victor Nava
In July 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, the single largest expansion of rules for banking and financial markets since the Great Depression.1 Federal regulators have worked since then to begin implementing the law, though through 2012, only 30 percent of the final rulemaking required by Dodd-Frank has been completed. Still, 848 pages of legislation have already grown into a staggering 8,883 pages of rules and regulations.2 Intense debates have broken out over nearly every Dodd-Frank rule proposal, and such disagreements have severely delayed the implementation of the most controversial parts of the legislation.
There have been many suggestions that Congress revisit the Dodd-Frank Act and repeal some of the powers given to regulators in the wake of the financial crisis, not least because government regulations are already estimated to cost American taxpayers and businesses $1.8 trillion annually.3 The Government Accountability Office puts the cost of implementing the Dodd-Frank bill alone at $2.9 billion.4 Other critics of Dodd-Frank cite the failure of regulators to prevent or even anticipate the financial crisis-why, they ask, should we give more power to organizations that have manifestly failed to carry out their core functions effectively?
A more prescriptive argument is that private oversight, on an industry basis, with properly aligned incentives and detailed bankruptcy rules in the case of failure can be a cost-efficient, robust, and effective approach to bringing about the world that Dodd-Frank is seeking to achieve. This chapter presents three Dodd-Frank rules that could be taken out of the hands of regulators, and privatized with minimal risk.
1. Title V of the Dodd-Frank Act: Federal Insurance Oversight
Title V of the Dodd-Frank Act establishes the Federal Insurance Office (FIO), which monitors all aspects of the insurance industry.5 The new office is tasked with identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry or the financial system. The FIO is intended to coordinate and develop federal policy on international insurance matters, including representing the United States in the International Association of Insurance Supervisors. Further mandates for the FIO include monitoring access to affordable insurance by traditionally underserved communities and consumers and taking charge of administering the Terrorism Risk Insurance Program-a reinsurance program that acts as a safety net for insurance companies in the event of a terrorist act through 2014, when the terror insurance program is slated to expire.
The FIO is the first federal agency involved with virtually all aspects of the insurance industry (except health and crop insurance).6 The statute does not technically give any direct regulatory power to the FIO, but even without it, the FIO can greatly influence how insurance is regulated. For instance, as a nonvoting member of the Financial Stability Oversight Council, the FIO can identify insurance companies as non-bank systemically important financial institutions, which would lead to enhanced standards for capital requirements and stress tests which the FIO would coordinate with the Federal Reserve in administering.
The first problem with the FIO is that it raises costs for consumers. The FIO’s data-gathering authority raises the compliance costs for insurance companies, that will inevitably pass those increased costs along to consumers. Another source of increased compliance costs is that the FIO duplicates oversight provided by the National Association of Insurance Commissioners (NAIC), a group of state-level regulators that suggests rules and regulations to state governments, while setting industry standards to be followed by insurance companies.
The second problem with the FIO is that it puts taxpayers at risk. Consider state-run insurance programs, like Florida’s Citizens Property Insurance Corporation, which, despite being designed as an insurer of last resort, has ended up issuing over 1.3 million policies and over $400 billion in coverage.7 The result is that Florida is only one bad hurricane away from state bankruptcy. Similarly, the National Flood Insurance Program (NFIP) has wound up encouraging growth in hazardous areas, by shifting the associated costs from insurance providers to taxpayers. More than one-third of the 6.6 million buildings located in the one-hundred-year floodplains of participating communities have been built since the start of the NFIP-subsidized flood insurance program in 1968.8 In addition, repetitive-loss properties (properties that suffer repeated flooding, but generally receive subsidized policies) absorb a large percentage of the NFIP funds.9
One alternative to the current FIO/NAIC model that increases consumer costs and puts taxpayer dollars at the mercy of insurance risks is the privatization of rule-making and oversight in the insurance industry. Such an approach is not unprecedented in the financial sector. The accounting industry, for example, operates based on privately established Generally Accepted Accounting Principles (GAAP). Likewise, the industry standards used by all publicly traded companies, as well as many private companies, were created by the private, non-governmental Financial Accounting Standards Board (FASB), rather than the Securities and Exchange Commission.10 A similar model could be applied to the insurance industry-a private body could be tasked with establishing and enforcing industry standards nationwide, and publicizing any deviations from them. Companies that shrink away from such transparency would have to deal with that reputation in trying to attract customers, creating an incentive toward openness and compliance with established standards.
The FIO’s Terrorism Insurance Program can also be handled by the private sector. Reinsurance need not be a function of government; if insurance companies feel the need to take out insurance on their insurance, they can buy it on the private market like everyone else. While 9/11 did represent the largest claims payout in global insurance history, producing $32.5 billion in insured losses, the losses were well dispersed and paid across several lines of insurance, including property, business interruption, aviation, workers comp, life and liability.11 They were not solely concentrated on one entity or one form of insurance. The FIO is clearly not needed to run the Terrorism Insurance Program when the private sector has already proven its ability to handle such a terrorist catastrophe.
2. Title XI of the Dodd-Frank Act: Capital Requirements
A main goal of the Dodd-Frank Act is to curb systemic risk in the banking sector. Bank failure contagion is an issue that the federal government has been attempting to remedy since 1933 when, as a response to Great Depression bank-runs, the United States created the Federal Deposit Insurance Corporation (FDIC) to insure commercial bank deposits.12 The creation of deposit insurance came with a nasty side effect, however: moral hazard. If banks don’t bear full risk for their activities it may encourage them to gamble with the money depositors leave on hand. Regulations in different forms have sought to fix this glitch, including bans on particular business activities (such as the Glass-Steagall Act that separated investment and commercial banking) and capital requirements to ensure banks keep enough reserves relative to their risk.
Two major international agreements were reached prior to the financial crisis, the Basel Accord and Basel Accord II, each coordinated by the Basel Committee on Banking Supervision in Switzerland.13 The first agreement failed to prevent global financial ruin in the 1990s, and the second agreement created rules that encouraged banks to invest heavily in mortgage-backed securities-a major contributor to the crisis.14
In spite of these failures, Title XI of the Dodd-Frank Act mandates the FDIC, Treasury Department, and the Office of the Comptroller of the Currency to establish new minimum risk-based capital requirements for banks. These will be modeled on Basel III, which seeks to limit systemic risk in the banking system by forcing banks to have more capital buffers for riskier assets, higher liquidity requirements, and stricter leverage limits. This is despite the fact that the revised agreement is from the same body that has twice failed to get capital requirement rules right.
In September 2012, member of the FDIC Board of Directors Thomas Hoenig blasted the old Basel capital requirements, stating:
It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and clarity of information.15
He then turned his sights on the new Basel rules and had similarly harsh words of warning:
The poor record of Basel I, II and II.5 is that of a system fundamentally flawed. Basel III is a continuation of these efforts, but with more complexity.16
The root of Hoenig’s complaint is that Basel depends too much on estimating the risk of a particular asset and then weighting the capital requirement based on that risk. The goal is to keep banks from over-leveraging by forcing them to hold more capital if they buy riskier assets. The problem in the recent crisis was that these risk estimates turned out to be flawed. Sovereign debt was assumed to have no risk at all, and just look what has happened in Europe over the past few years. Triple-A rated mortgage-backed securities were considered to be among the safest form of capital. In fact, a group of 100 mortgages could be given a 50 percent cut in risk-weight just by packaging the loans into a security-and look at what happened in the financial crisis. The only significant changes for the new Basel capital requirements are adjusted risk weightings-banks must now hold a 2.5 percent extra capital buffer in case of another crisis, and the banks can no longer rely on credit rating agencies to determine the soundness of assets. The liquidity standards remain loose and certain mortgage-backed securities are even eligible to be counted as high quality assets towards a bank’s coverage ratio. The new rules are essentially the same as the old ones except with some new, arbitrary risk weights thrown in.17
On the flip side, if regulators set liquidity standards too tight it could dry up lending and freeze financial markets. This is the conundrum for regulators who need some kind of capital requirement regime to mitigate the moral hazard created by deposit insurance. Yet there is a remarkably simple solution to this problem: privatize the FDIC.
Without the FDIC, private deposit insurers would create their own standards for capital requirements, risk weights, and anything else that they want to require of banks. The insurance providers would base premiums and fees on the level of risk that the banks are willing to take on, much like auto insurers would charge more if you drove an accident-prone car, and health insurers would charge you more if you smoked. Competition between private insurers would discourage them from overburdening the banks with regulatory requirements, and also create a strong commercial disincentive for banks to use their customer deposits recklessly.
At present, the FDIC in effect offers a subsidized insurance rate to banks by charging lower premiums than would be found in the private sector. It is this underpricing of risk that has given banks an incentive to behave recklessly. A private deposit insurance system, charging true market rates, would force banks to also take stock of themselves and their use of customer deposits. Just as importantly, without the FDIC guaranteeing every depositor their money back up to $250,000, depositors would need to shop around for the bank they really trust with their money. This too would create competition, driving a race to the top for banks seeking a reputation for safety and security.
State-chartered credit unions, whose customer deposits are called “shares,” already use private insurers such as American Share Insurance (ASI), the nation’s largest provider of private share insurance, to provide peace of mind to depositors.18 Indeed, this idea is nothing particularly new at the national level-the German deposit insurance system was completely privately funded and managed from 1975 thru 2008, a span which saw no private account holder lose money due to a bank failure.19 (The Germans nationalized the deposit insurance system as a “precautionary” measure to “boost confidence” during the financial crisis, but the move was unnecessary: no German banks failed, and no deposit claims were made.) A system where private insurers compete for bank business, and banks compete for customers demonstrating increasingly safe practices would not only allow the free market to determine the best set of banking regulations, it would also transfer risk to the private sector and away from taxpayers.
Banks would still fail from time to time with privatized deposit insurance, and deposit insurance would still have to be paid out, but the competition among insurers would eventually lead to a better regulatory framework than Dodd-Frank. The privatization of deposit insurance ultimately means the privatization of risk, so that banks themselves share personally in the risk for their activities, and customers recognize the importance of choosing the right company to help keep their money safe.
3. Title XIV of Dodd-Frank: Mortgage Finance
The federal government has long provided subsidies for the mortgage market and incentives to buy a home, both of which played a key role in the financial crisis. Yet, Dodd-Frank does little to address the role of Fannie Mae and Freddie Mac in federal housing policy.
Instead of directly addressing the need for federal housing policy reform, Title XIV of Dodd-Frank focuses on standardizing data collection for underwriting mortgages, requiring mortgage originators to only lend to borrowers who are likely to repay their loans, and calls for standards in defining which mortgages can be securitized. The legislation also creates new property appraisal requirements, establishes the Office of Housing Counseling, and gives power to the Consumer Financial Protection Bureau to design mortgage lending forms and paperwork. Thus, Dodd-Frank seeks to tightly control the mortgage finance market, rather than address the flawed structure of federal housing policy, and by so doing discourages private sector involvement in mortgage finance.
From a business perspective, as government increasingly manages risk via regulation, the mortgage finance market holds less attraction for the private sector. Since the credit-rating agencies destroyed so much of their own credibility, the private sector lacks confidence in the rating of mortgage-backed securities and other mortgage investments. High conforming loan limits originally designed to control risk end up causing more competition from the government for market share in the mortgage finance market. Dodd-Frank-driven requirements that banks keep part of the loans they issue on their own books ties up capital that might otherwise be better deployed. And complex legalities governing residential mortgage-backed securities undermine the private sector’s ability to flexibly maneuver within the market.
While intended to prevent risky ventures, these regulatory walls have discouraged private sector engagement in the housing finance market, creating a tight environment that leads to even more government intervention. Not surprisingly, over the past three years, Fannie Mae, Freddie Mac, the Federal Housing Administration (FHA), and Ginnie Mae have collectively purchased or insured over 90 percent of new mortgage business.
The best way to get the private sector back into mortgage finance and reduce the harm that could be caused by Dodd-Frank rules on housing would be to give the mortgage industry incentives to take on more liabilities but at the same time police itself through privatizing the whole mortgage oversight system. In a May 2012 paper, Reason Foundation proposed companies in the mortgage industry come together to create a Mortgage Underwriting Standards Board (MUSB).20 This self-regulating body would take on all the roles that would otherwise be handled by regulators.
Consider, for example, two housing-related Dodd-Frank regulations: the “qualified mortgage”, which requires lenders to ensure borrowers can repay loans and makes lenders liable if borrowers with weak credit get a loan but then can’t repay it; and the “qualified residential mortgage”, which defines the characteristics of a super-safe mortgage, and then only allows lenders to securitize those mortgages, or otherwise compels them to keep a percentage of non-qualifying, and therefore presumably risky, mortgages on their books. Instead of regulators designing and enforcing these rules, the MUSB would create categories of mortgages, with various established standards. As new mortgages are issued, they would be classified to one of these categories established by the MUSB. These classifications would better reflect industry risk pricing, while also helping to establish liquidity through more-transparent lending practices. While these particular underwriting standards would not be legally required, and there would be no prohibition on securitizing mortgages that fall outside MUSB categorization, there would nevertheless be a strong market incentive to adhere to established industry standards of this sort: compliant institutions would find their bond issues far more marketable.21
The same logic can be applied to the credit rating agencies. The existing oligopolistic system fails to create incentives to keep up with the complexities of rating residential mortgage-backed securities (RMBS) and other types of assets. It prevents new companies from entering the ratings market place and competing with established firms, like Moody’s and Standard Poor’s, in coming up with better ways to rate securities. For this reason, the government’s Nationally Recognized Statistical Rating Organization (NRSRO) model appears to be fatally flawed.22
Immediate steps that can be taken to foster a more competitive environment among ratings agencies include allowing non-NRSRO agencies access to prospectuses and loan-level data files prior to the date on which the bonds are first sold.23 Currently only NRSROs are privileged with this sort of information. Another simple reform would be for Congress to authorize underwriters to include property-level address data in RMBS disclosures. This reform would be another step in the direction of allowing for more and higher quality information available on the market, which would allow investors and independent analytics firms to perform more-accurate and lower-cost risk assessments. And Congress can clear the path to allow the creation of a Mortgage Underwriting Standards Board by repealing the mortgage-related sections of Dodd-Frank.
Just as government crowds out private industry when it gets involved in aspects of the economy, government tends to crowd out incentives for private governance when it regulates. When incentives are properly aligned and proper bankruptcy rules are in place in case of failure, the private sector is more likely to construct a more effective regulatory framework than the federal government might try to engineer.
Capital requirements for banks sound like an effective solution to the moral hazard created by deposit insurance, but as became clear during the crisis, Basel capital requirement regulations were misguided attempts to preserve the deposit insurance system, and they remain a problematic way to preventing another crisis.
Similarly, state-level intervention in insurance markets has already proven problematic, leaving consumers and taxpayers worse off. Private industry groups setting standards and monitoring insurance companies is a better way to go about regulating insurance providers than the approach laid out in Dodd-Frank.
Finally, the mortgage finance industry and consumers would be better served by origination standards established by an industry assigned group rather than federal regulators. There are also private solutions to mortgage ratings, which don’t require nationally recognized statistical ratings organizations.
The capital requirement, insurance oversight, and mortgage finance provisions in Dodd-Frank are just three aspects of the legislation that the private sector could handle more effectively than federal regulators. In its quest to manage all risk, federal regulation of housing finance has contributed to the stagnation of the American housing market today that drives so much of our economy. Private governance would be a much better alternative to the bureaucratic behemoth that is Dodd-Frank.
1 Damian Paletta and Aaron Lucchetti, “Law Remakes U.S. Financial Landscape,” The Wall Street Journal. http://online.wsj.com/article/SB10001424052748704682604575369030061839958.html.
2 Davis Polk and Wardell LLP, “Dodd-Frank Progress Report.” http://www.davispolk.com/files/uploads/FIG/071812_Dodd.Frank.Progress.Report.pdf.
3 Paul Bedard, “$1.8 Trillion Shock: Obama Regs Cost 20-Times Estimate,” The Washington Examiner. http://washingtonexaminer.com/1.8-trillion-shock-obama-regs-cost-20-times-estimate/article/2508466#.ULPq_IZPLWM.
4 Victoria McGrane, “GAO: Implementing Dodd-Frank Could Cost $2.9 Billion,” The Wall Street Journal. http://blogs.wsj.com/economics/2011/03/28/gao-implementing-dodd-frank-could-cost-2-9-billion/.
5 U.S. Department of the Treasury. http://www.treasury.gov/about/organizational-structure/offices/Pages/Federal-Insurance.aspx.
6 Matthew S. Brockmeier, “Beginning of the End of State-Based Insurance Regulations,” The Hill. http://thehill.com/blogs/congress-blog/healthcare/251311-beginning-of-the-end-of-state-based-inusrance-regulation.
7 Jeffrey J. Pompe and James R. Rinehart, “Property Insurance for Coastal Residents: Governments’ Ill Wind,” The Independent Review. Volume 13, Number 2, Fall 2008. http://www.independent.org/pdf/tir/tir_13_02_2_pompe.pdf.
10 Lynn Westergard, “Private Companies Need Modified Standards, Not Separate Rules,” Schmidt Westergard & Company, PLLC. http://www.sw-cpa.com/bottomline/articles/2011-10/gaap.htm.
12 Jeffrey Friedman, “A Perfect Storm of Ignorance,” Cato Policy Report, January/February 2010. http://www.cato.org/pubs/policy_report/v32n1/cpr32n1-1.html.
14 Anthony Randazzo and Mürat Yulek, “Refining the Story of the Financial Crises in Europe and the USA,” Insight Turkey Vol. 14, No. 2, 2012 pp. 59-81. http://reason.org/wp-content/uploads/2012/04/insight_turkey_vol_14_no_2_2012_yulek_randazzo.pdf
15 David Benoit, “FDIC’s Hoenig Wants Simpler Rules Than Basel III,” The Wall Street Journal. http://blogs.wsj.com/deals/2012/09/14/fdics-hoenig-wants-simpler-rules-than-basel-iii/
17 Anthony Randazzo, “Basel III Misses the Point; Bankers Will Still Cheat the Rules,” Minyaniville. http://www.minyanville.com/businessmarkets/articles/basel-ii-basel-iii-credit-risk/9/16/2010/id/30114.
19 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ayQUgBTLYJEc&refer=germany and http://www-wds.worldbank.org/servlet/WDSContentServer/IW3P/IB/2001/03/30/000094946_01032007445638/Rendered/PDF/multi0page.pdf.
20 Marc Joffe and Anthony Randazzo, “Restoring Trust in Mortgage-Backed Securities: How the Private Sector Can Return to Mortgage Finance,” Reason Foundation Policy Study 402, May 2012. http://reason.org/wp-content/uploads/2012/05/study_restoring_trust_in_mbs_final.pdf.