Endnotes

¹Although this disagreement attracted some attention, Wall and Koch (2000) argued that both sides have overstated their case. Investors do not rely solely on accounting loans loss provisions when judging the value of a bank's loan portfolio. Similarly, if US bank supervisors think that banks' loan loss allowance is less than appropriate, the supervisors have ample power to require banks to hold more capital.

²Wall and Eisenbeis (1999) argued that regulating the financial sector involves both internal and external resolution. Pure internal resolution would require that one agency have control over every regulatory goal that touches financial firms, including nonfinancial goals such as those related to employer-employee relationships. The resulting agency's mandate would be so broad as to dilute the level of expertise among the senior managers of the agency, undercutting one of the main reasons for forming a specialized agency. On the other hand, pure external resolution would require setting up a regulatory agency for every goal, such as an agency for every business conduct goal. The resulting proliferation of agencies would be hugely inefficient.

³The superintendent at the Canadian Office of the Superintendent of Financial Institutions recently attributed the current strength of the Canadian banking system in part to having a mandate that is totally focused on solvency and that does not include other goals such as the competitiveness of the domestic financial system (Clark 2009).

⁴Although operational independence is important for the long-run effectiveness of prudential supervision, political authorities will sometimes allow tougher prudential policies that conflict with some other goals. The International Monetary Fund (2009) noted that the Bank of Thailand's legal subordination to the Ministry of Finance at the time the report was drafted could lead to interference or delays in regulatory actions. However, that report also noted that the Bank of Thailand had tightened restrictions on consumer and mortgage lending. Similarly, Panagariya (2009) noted that the Bank of India also lacked operational independence but could resist government efforts to accelerate financial deregulation.

⁵Although exactly what structure would best create an incentive for the supervisor to accomplish these goals is not obvious.

⁶The claim is not that a regulatory agency overseeing many sectors of the financial sector would never exercise forbearance; such an agency would also have some incentives to forbear. However, there is a difference between a broad agency that risks being rebuked by policymakers for inadequate supervision and a narrow agency that risks being abolished by policymakers.

⁷Some subsidiaries may also be subject to prudential supervision by another supervisor. For example, an insurance subsidiary of a large banking group may be subject to prudential regulation, both by an insurance supervisor and the consolidated supervisor. But, the consolidated supervisor must be able to examine and, when necessary, regulate the insurance subsidiary.

⁸Central banks issuing such reports included the Bank Negara of Malaysia, Bank of Canada, Bank of England, Bank of Indonesia, Bank of Japan, Bank of Korea, European Central Bank, Hong Kong Monetary Authority, Monetary Authority of Singapore, People's Bank of China, Reserve Bank of Australia, and Reserve Bank of New Zealand.

⁹See US Government Accountability Office (2007) for a discussion of supervisory efforts to reduce processing backlogs in the CDS market.

¹⁰Issues related to cross-border relationships are discussed in the following section.

¹¹Garcia (2009) discussed some critical weaknesses in microprudential supervision.

¹²One could view this approach as agreement with the Turner (2009) comment in a speech that “regulators were too focused on the institution-by-institution supervision of idiosyncratic risk” during the recent crisis. It is also consistent with his recommendation that “in [the] future, regulators need to do more sectoral analysis and be more willing to make judgements about the sustainability of whole business models,” at least in those cases where the business model depends upon unsound practices.

¹³Gerardi et al. (2009) showed that although subprime credit scores improved somewhat through the 2000s, other risk factors increased substantially, including the fraction of loans with low documentation, and high leverage.

¹⁴An interesting question is why banks in Asia had little exposure to these “toxic” securities, especially given their high ratings by the ratings agencies. Gruenwald and Tan (2009) suggested several possible reasons, including natural conservatism?or, more likely, conservatism that grew out of the lessons of the Asian financial crisis. They also suggested a reason that I find plausible: ample investment opportunities in the region. Many of the banks in Europe that got caught with large exposures were suffering from weak investment opportunities at home, particularly in Germany. Finally, they also suggested that luck deserves some of the credit.

¹⁵In a development that was not widely appreciated at the time, a substantial fraction of the US banks' funding came from a collection of US government–sponsored enterprises called the Federal Home Loan Banks, according to Ashcraft, Bech, and Frame (2009). The Federal Home Loan Banks are restricted to making loans to their members, and membership is restricted to US chartered depository institutions and some insurance companies.

¹⁶Although there are many issues that a macroprudential supervisor could have eventually identified in the mortgage market, it is less clear that this identification could have happened in time to prevent the recent turmoil. As often happens in boom markets, standards slipped over time, and it is often difficult to say at what point standards have become excessively weak. However, even if stronger regulation had been put in place too late to prevent the crisis, it might have changed market practices in time to reduce the scale of the problem. At a minimum, a better understanding of what had been going on in the marketplace might have helped policymakers formulate more effective responses when the problems were revealed.

¹⁷Concern should not be limited to concentrations in exposure to an individual institution. Brunnermeier et al. (2009: 24) drew a distinction between financial institutions that are “individually systemic” and financial institutions that are “systemic as part of a herd.” They specifically discussed the case of highly leveraged hedge funds that are individually not of great concern, but whose correlated fluctuations may be systemic. Rosengren (2009) similarly emphasized that macroprudential supervision needs to look across institutions.

¹⁸Private label refers to RMBSs that are not issued by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), or Government National Mortgage Association (Ginnie Mae).

¹⁹See Tanta (2008) for a discussion of how the subprime market evolved over time.

²⁰A presentation by Miyoshi (2006) made this point in a more general setting. Miyoshi pointed out that the analytic framework for macroprudential regulation is underdeveloped, as are the assumptions used in stress tests. Given these weaknesses, Miyoshi's presentation showed that it can be difficult to get regulated institutions and the public to accept tighter regulation.

²¹Although this is a good example of the political difficulty of dealing with popular innovations, this discussion is not intended to imply that Regulation Q rate ceilings should have been maintained.

²²This asymmetry of the impact is not unique; microprudential regulators have long faced a similar but less severe problem. However, the mistakes of overregulation by microprudential supervisors are likely to be more observable than those by a macroprudential supervisor. The microprudential supervisor's ability to constrain innovation is limited to the set of domestic firms that it regulates. Other firms, both foreign firms and those with a different domestic supervisor, may not be so constrained. This allows potential customers to see the value of the innovation and allows these other firms to gain market share at the expense of those subject to the regulation. However, a macroprudential supervisor that has the ability to supervise all aspects of the financial system will not face competition from other domestic supervisors. If the macroprudential supervisors reach a global agreement to stifle an innovation, the innovations' benefits also will not be observable in foreign markets.

²³See Eisenbeis and Kaufman (2007) for a summary of deposit insurance systems in the European Union (EU).

²⁴See Milne and Wood (2008) for a discussion of the collapse of Northern Rock.

²⁵See Bliss and Kaufman (2006) for a comparison of the US corporate bankruptcy regime with the special resolutions regime applicable to commercial banks.

²⁶Insured depositories are firms that are chartered to take deposits from the public and are insured by a government agency. This group includes federally insured commercial banks, industrial banks, savings banks, and savings and loan associations. The government-sponsored enterprises subject to special-resolution regimes include Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. See Wall, Eisenbeis, and Frame (2005) for an analysis of the merits of special resolutions for Fannie Mae and Freddie Mac.

²⁷Even the countries of the EU have not yet adopted a single, efficient mechanism for the reorganization and liquidation of a cross-border banking group. See Garcia, Lastra, and Nieto (2009) for more information.

²⁸I am not aware of any prior proposal to mandate the use of reverse convertible securities.

²⁹Implicit in this is also a belief, backed up by historical data in his article, that the prudential supervisors will not force sufficient writedowns in the value of the distressed bank's assets.

³⁰In a few cases, preferred shareholders have been persuaded to convert to common shares. In some other cases, preferred stock dividends have been suspended and they do not cumulate while suspended. But the charter must be withdrawn before preferred stock can be written down. Moreover, if a distressed firm's condition should improve sufficiently to allow it to pay dividends, preferred dividends will continue to have priority over common dividends. This raises the possibility that common shareholders will control the governance of the firm even though these shareholders have little prospect of receiving dividends in the foreseeable future.

³¹The bank supervisors would also be authorized to appoint interim managers after the conversion and before the new board meets if doing so would, in the supervisor's judgment, help to preserve the value of the bank.

³²Except in the case where the original owners also own all of the reverse convertible securities.

³³In order to avoid having any funds leaving the subsidiary, this transaction could be structured as the parent and subsidiary first swapping shares, and the securities holders then converting their claims into the parent's common stock.

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