New Banking Reforms Are Not Real Reform

April 14, 2014

Recent banking reforms will do nothing to prevent another housing crisis, say Charles Calomiris of Columbia Business School and Stephen Haber of Stanford University.

U.S. regulatory agencies have released a number of rules aimed at preventing another housing crisis, but the new regulations are completely irrelevant and do not address the real source of potential trouble -- government-sponsored enterprises and overleveraged banks making risky investments in residential mortgages.

The subprime loan crisis was caused by the reduction of mortgage underwriting standards down to levels that guaranteed anyone a home loan. Government-sponsored enterprises and banks were then allowed to back those risky loans with very little capital.

The latest regulatory regime -- from the new qualified mortgages (QM) rules to the Volcker Rule to the new Systemically Important Financial Institutions (SIFI) designation -- have the same weaknesses as did the rules in place before the subprime crisis.

  • The Consumer Financial Protection Bureau recently issued the QM rules -- a set of standards that, if met, makes a home loan protected from legal challenge. Originally, QM status required the meeting of strict underwriting standards, including a 20 percent down payment and a 28 percent housing-cost-to-income ratio. Those provisions are no longer in place. A loan can obtain QM status without that down payment, and the debt-to-income ratio was raised to 43 percent.
  • On top of this, the QM rules allow for so many exemptions from the standards that the standards are virtually worthless.
  • The Volcker Rule was implemented to ban proprietary trading -- the trading of stocks and bonds for profit. But proprietary trading, say Calomiris and Haber, was not even the cause of the subprime crisis, so banning it will do nothing to prevent a future one. Even so, while proprietary trading did allow banks to reduce the capital that they had to put into their mortgage portfolios, the rule has a massive exemption for the trading of real estate securities.
  • Any risky trading as a result of the weak Volcker Rule is unlikely to be constrained because Dodd-Frank specifically gives the Treasury secretary the power to offer assistance to any bank that has been declared a Systemically Important Financial Institution. If government losses accrue because of such assistance, taxes will be levied on other institutions to cover those losses.

Source: Charles W. Calomiris and Stephen H. Haber, "The Next Banking Crisis," Regulation Magazine, Spring 2014.

 

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