How Bad Regulation Created The Crisis
Former FDIC chief laments ‘wrongheaded’ moves by SEC

By William M. Isaac

When the history of the current financial crisis is written, wrongheaded regulatory and accounting policies will go down as major villains. There are plenty of candidates top prize on the Wall of Shame, but none can compare to the mistakes made by the Securities and Exchange Commission.

Market Value Accounting
The SEC decided in the early 1990s to move financial institutions toward partial “market value accounting.” Treasury Secretary Nicholas Brady, Federal Reserve Chairman Alan Greenspan and Federal Deposit Insurance Corp. Chairman William Taylor objected strongly.

Greenspan and Taylor noted that prior to 1938 regulators required banks to use market value accounting for investments. President Roosevelt asked the Secretary of the Treasury to convene bank regulators to consider whether regulatory policies were preventing economic recovery. They identified market value accounting as a major impediment to bank lending and switched to historical-cost accounting.

Brady was prescient in his 1992 letter: “[Market value accounting] could result in extremely volatile earnings and capital. This volatility would not be indicative of a bank’s operating results and would therefore be misleading to…users of financial statements…Moreover, MVA could even result in more intense and frequent credit crunches, since a temporary dip in asset prices would result in immediate reductions in bank capital and an inevitable retrenchment in bank lending capacity.”

The SEC charged ahead with market value accounting, destroying over $500 billion of capital during the past year, which has been a major factor in creating the credit crunch. The SEC was arrogant in ignoring the lessons of history and adopting partial market value accounting over the objections of bank regulators and the Treasury. Its refusal to suspend this failed policy in the current crisis is unfathomable.

Bank Reserves
The SEC’s quest for accounting nirvana led it to bring an enforcement action in 1999 alleging that SunTrust Bank was managing its earnings by creating excessive loan loss reserves. Banks could no longer use judgment in establishing reserves. They had to develop predictive models based on past experience, causing reserving policy to become pro-cyclical alongside market value accounting.

Instead of creating larger reserves in good times, banks showed higher earnings and used those earnings to leverage their balance sheets and pay higher dividends and larger bonuses. In today’s down-cycle, banks are required to create ever higher reserves, which destroy profits, capital and lending capacity.

Reduction of Capital
The SEC’s next blunder was to succumb to pressure from investment banking firms in 2004 and reduce regulatory capital requirements. Incredibly, the SEC allowed the regulated firms (e.g., Bear Stearns and Lehman Brothers) to develop their own models for determining how much capital would be appropriate. The result was a massive increase in leverage.

Models are pro-cyclical, using past experience to predict future capital needs. In good times, little capital is required and in bad times the models’ demand for capital is insatiable. In fairness, I note that bank regulators have also unwisely employed pro-cyclical capital models.

The Uptick Rule
Having lit a fire, the SEC added gasoline by eliminating the “uptick rule” in 2007. The uptick rule required that a short sale could only be made at a price above the previous transaction in that security.

The rule was put into place in 1938 to stop abusive short-selling transactions that were decimating the markets. Eliminating the uptick rule in combination with introducing market value accounting, inhibiting loan loss reserves and reducing capital requirements set the stage for the crisis.

There are other contributors to today’s financial crisis, including greed, highly pro-cyclical bank regulatory policies, fiscal and monetary policies, and government programs promoting home ownership at any cost. But if the SEC had taken none of its four actions, the subprime mortgage problems would have been managed without creating a financial panic.

Our new President and Congress urgently need to get the SEC on the same page as the rest of the government in stabilizing the financial system and the economy. The SEC can no longer be allowed to pretend its failed policies have had nothing to do with creating the mess we are in.

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