The price of exuberance – (revised) my thoughts on

The price of exuberance (or regulators heal thyself)

(I wrote this originally as an editorial for the Journal on 7 October, writing in the kitchen a dear American family friend’s home in Syracuse in the US over the weekend, and then expanded on it the following weekend, sitting in a hotel lounge on the 44th floor of the Meridian overlooking the bund in Shanghai. I seem to be coming to the US several times these few months. I was in SFO last month as one of the speakers at a very good Asian banking conference organised by the SFO Feds, and then this time for SIBOS, which was in Boston last week and next month again as a speaker/moderator at a BAI event. I have been meeting with a whole load of people and thinking about a whole load of issues around America in general, where banking is heading in the US and completely absorbing all the nuances of the economy and the people here – I must say that it is a joy to be in the US anytime, there is so much going on. Also, visiting with a range of friends in different parts of the country, from San Diego to New York and even south in Albuquerque, New Mexico gives me an opportunity to think more substantively and hopefully, accurately about issues. I also use the traveling involved to read more substantially – on my previous trip, I read Freakonomics by someone called Steven Leavitt (and passed on my copy to Benny Zhang our numbers man), and this trip I am reading My Time at the Feds, by former governor Laurence Meyer. Any feedback on the comments below are welcome.) Also, in this edited version, I am not limited by the 600 word rule in writing my thoughts.


During his time in office, Alan Greenspan, the former governor of the Federal Reserve Bank system in the U.S., was so absorbed by his theory that technology and the growth in productivity were responsible for the lack of inflation during one of history’s longest bull runs, that the theme permeates so many of his speeches and presentations.

His fellow board member at that time, Laurence Meyer, recalls in his own memoirs about the crucial years of 1996-2002, called “A term at the Fed” (which I would strongly recommend as a much more instructive dissertation than Greenspan’s more celebrated recent biography) that he was somewhat derided for preferring to measure and explain economic growth using old-fashioned indicators. (I also learnt policy decision making concepts like “symmetric” and “asymmetric” models that can actually help ordinary people like me to guess the possible directions that the Feds might take based on speeches leading to a policy meeting.)

The productivity argument was central to Greenspan’s cause of keeping interest rates low in the early 2000s. That in turn triggered a mortgage boom that expanded the financial services industry despite the impact of the corporate scandals on markets during the time.

However, by 2002 the mortgage industry had fully extended through the economy. Banks then started extracting the equity built up into mortgages by lending against it, to keep the industry growing. Greenspan obviously approved of this trend. “Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years,” he said at the time.

By 2005, when the extraction of equity was complete, and the banking industry started ravaging into even riskier customers, he used the same technology logic to explain a new phenomenon. “Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants… with these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.” He enthusiastically pointed out that subprime mortgages had already accounted for about 10 percent of total mortgages at that time.

One would imagine that armed with so much data, the Feds would have had a more complex argument for its policy decisions, but simplification in a sense is the beauty and perhaps the curse of US policy making. I have seen how other societies from the Malaysians to the French cripple their policies into rubbish and indecisions (respectively) because of contradictions built into their policy objectives just by trying to accommodate complexity at the decision makers level. But as I will explain, complexity in the US is just re-assigned.

But somehow, it seems that Greenspan an economist, completely ignored a fundamental rule in banking to his peril. What made Greenspan or all the brains in the American banking community think that lending without a buyer’s equity in a collateral was a wise or sustainable thing to do? All over the world, banks had learnt that whether it is mortgages, auto loans or share trading, buyer’s equity is the first safeguard against human default. As I alluded during one of my comments at the Feds meeting in San Francisco, if banks in an Asian country had done what the US banking industry had done – lent to mortgages without requiring personal equity in the collateral – there would be no end of so-called American experts of all kinds deriding the Asian country of being irresponsible.

So, the credit card crisis in Korea and Taiwan were irresponsible, state bailing out of Chinese bank NPLs is irresponsible, and the lending in local currency against borrowing in cheaper US dollar that gave to the Asian crisis was irresponsible. The But this being the US, pushing the envelope to allow banks to allow for “undocumented income” (what the hell is that?) in loan application forms and allowing third party companies to aggressively push customers to take on more loans than their incomes would allow them to is called “entrepreneurship”.

(My friend James Cullen of Wells Fargo and I were having a drink in a SFO bar one evening and started chatting with two young girls who were sales agents for a company that was a very large originator of mortgage loans for the banks, and they complained that they were not the bad guys, it was the banks that wanted to find these customers).

This breaking with the rules in banking gave the financial intermediation business in the US a fillip to grow unfettered and even out-stripping the growth of the economy in a dangerously unsustainable manner. At the Asian Development Bank annual conference in Kyoto in May this year, Martin Wolfe, the “celebrated” Financial Times commentator, who chaired a session comprising several Western “experts” concluded (tongue in cheek, I might add) that zero savings should be the holy grail of the most efficient financial savings, because that would mean complete deployment of financial resources, and that the US, where household savings was nearly that, denoted exactly that.

My observation in all this is that it is very interesting to watch considerable brain power going into justifying the state of affairs in the US financial system, justifying the busting of first principles and making its current circumstances sound more intelligent than it really is. There are so many laws preventing calling a spade a space, and this is where complexity and paralysis are built into the American psyche.

I will be hosting Paul Sarbanes of “Sarbanes-Oxley Act” fame in March next year as part of The Asian Banker Summit in Vietnam, and I hope that we will have considerable opportunity to debate whether the rules-based reactions to corporate fraud actually promotes corporate responsibility. It is the same phenomenon as we find in airports today – isn’t there a better way than to subject millions of innocent travelers to so much regulation just because the regulators have no clue what they are looking for or how to flush them out.

Again and again in the past few months, we see regulators, notoriously from the US, trying to prescribe rules to manage a complexity they created out of semantics.

On the other side of the equation, human society, no matter how complex or how accommodating it is of the hubris fed to it, has its own redeeming feature. The sooner regulators learn to understand it, the better. Whether American or European or Asian, ordinary people call a spade a spade and this phenomenon always pervades in the way societies respond to policies.

As an example, using complex language to explain a simple phenomenon, regulators in the U.S., the U.K., Australia and several other developed countries thought that off-balance sheet investment vehicles were technically unrelated to the primary institutions as well. Well, investors thought more simply and voted by taking out their shares of banks that they suspected had more hidden in their off-balance sheet subsidiaries than they did on their books. Logic dictates that no matter where you hedge your risks, you will be morally required to salvage it when it comes to the crunch.

In yet another example, albeit not in the US but still indicative of the species, regulators in the U.K. veered off on a tangent in the assumption that deposit insurance could prevent bank runs and encourage M&As. Obviously, customers thought otherwise and Northern Rock lent its chic name to posterity.

These string of errors in judgment demonstrates a very troubling fact. Why are regulators building mechanisms and institutionalising processes that keeps suggesting themselves as the answers to everything? I am not suggesting that either off-balance sheet investment vehicles or deposit insurance are inherently wrong. My point is that they are not right just because the regulators says they are.

Regulators have either stopped asking the most obvious questions or correcting themselves to the most obvious indicators. The reason appears to be in the way regulators are structured or motivated these days. They are not structured to see themselves invisible or ancillary to everyday business. This finds its source in yet another first principle – power corrupts and absolute power corrupts absolutely. You would not imagine that this rule should apply to regulators of today. After all they appear to be constantly under publicity, although I would argue not necessarily under scrutiny. But our large business institutions are increasingly over-regulated, and none more so than banks, and the more power regulators are given, the more regulators corrupt their own roles.

Even in countries that say that they are increasingly principles based, I don’t think so. They absorb the opportunity to dominate and prescribe rules to businesses like a Japanese monster character gorging on electricity to grow more evil. I see this in many regulators, in obvious ways, such as the manner in which Basel II is discussed and implemented and in insidious ways, like the way in which Singapore’s MAS designed its banking education programme to spend tax-payers money for an industry that is generates billions of dollars in profit around a scheme that revolves around “selected” universities and cruelly excludes the very people like me who generate the creativity for this industry. (Whoever is driving the current programme probably reads my blog where I once complained that there is no credible banking education in a city that says it is a financial center and who also sees exactly what we do through The Asian Banker. But I digress just to prove the point about how endemic this tendency is amongst regulators).

There is such a valuable lesson in here for regulators. The rule in regulation should be to become invisible. No, not promote “entrepreneurship”, because that is the responsibility of entrepreneurs. No, not to promote “prudence”, because any sustainable business should know how to do that to survive. These are patronizing language that all kinds of regulators use to justify their own existence. No, not even to “let” banks fail, because when they over-regulate, they take on themselves a responsibility that was never intended and that they are not designed to administer, as the Bank of England found out to its peril. The semantics itself has become a monster that had outgrown the problem it was designed to solve.

The guiding rule in airport security should be to make airport security become so invisible that millions of ordinary people should be able to use airports without even knowing they exist. But that is so hard to do. Especially in the US. Imagine what the TSA (Transport Security Administration) would look like if their officers were not allowed to carry revolvers, hooked up with walkie talkies and shout around directing people traffic through their sordid scrutiny? That is exactly what they will be wanton to give up, even if that was part of the solution.

There is a groove in human sensibility that is its own safe-guard, and the debate between rules-based regulation, as the US system appears to be, and principles-based regulation, that much of the rest of the world wants to be, should find its bearing on this principle. For example, even as regulators around the world pay homage to deposit-insurance, they will have to ask themselves if the cost to capital and the quality of their institutions and even their own regulation measures up to the assurance that the public is looking for. If the answer is no, then not even the world’s “finest” global regulator, as the UK system prides itself to be, cannot avoid the old fashion bank run.

It is instructive here that the US deposit insurance scheme is probably the world’s only working model, having dealt with many bank failures since 1933, perhaps because it was instituted at a time when the human sensibilities I am talking about prevailed over legislation and it gave the institution of deposit insurance time to build its resources to be simple, viable and cost efficient, unlike many other new ones that are currently being built around the world.

But it’s too late to suggest that now, because at its core, Western regulatory culture has corrupted its recourse to human sensibilities, and in asking the rest of the world to emulate them, is spreading the disease worldwide. Really strange actually, because as all of us know, many of the US and UK’s finest institutions are based on the first principles of the human spirit.

In the case of the Feds, they seem to think that their mandate today is to ensure unfettered growth, fanned by politicians and the markets. Laurence Meyer’s book goes to a lot of pain to point out the independence of the Federal Reserve Bank system from the political process. In theory this is the case. But in practice, it is human nature to make decisions with an eye on posterity, to be on the center-stage. There is also the promise of a potentially $10 million a year speaking circuit career and other post-public office benefits.

The Feds board members are now players in building exuberant markets, but they will be the last to admit it. This perceived mandate made the Federal Reserve Bank lose the objectivity it required to err on the side of building long term, sustainable institutions, which banks are supposed to be, during the time of Greenspan. The problems are not difficult to understand, if we start from first principles.

In fact, I should end by adding that whether the world will see a recession or not in the next year does not rest with the Feds or any other regulator. The continued growth of China, the leveling of human resource costs through universal education, human migration and the rise of India, greater efficiencies in the commodities world, the institutionalising of financial intermediation in a series of second tier countries (ie. countries with populations of 40-60 million each) and potentially reduced spending on war if we get the right replacement to Bush are all outside of the regulator’s ambit. Four of the five points I have stated here are factors outside of the United States. One of the troubling revelations in Laurence Meyer’s book is that the US Feds try to limit their policy guidelines to domestic indicators. In fact, if anyone noticed, even after he had retired, Greenspan loathe travelling overseas, and the UK has been his only real concession (given the fact that the UK is the 51st state of its former colony). Every time you hear he gave a speech outside the US, it was via tele-conferencing – so what do you think is the world view of a man who does not see much of the world?

All of these factors were as clear as daylight in his speeches, much clearer than his subterfugation of the semantics that were meant to be public policy. Now at least, I know what to look out for in Bernanke’s speeches to the Congress and to the rest of us.



  1. Agree with your comments on Greenspan and it seems that his successor is not very different in terms of bubble-blowing.

    The point you raise regarding regulation is an important one. Regulators have been distracted by the worthy but cumbersome Basel 2 project to the exclusion of other issues such as getting to grips with old-fashioned risks like liquidity management that have been complicated by new developments such as securitisation and derivatives. The financial system is vastly more complicated than even 5 years ago and this reprensents a huge challenge to tracking risk and maintaining trust in the system. On top of this there's been competition between fianancial centres which has not resulted in an improvement of regulatory standards. It's always a balancing act but ultimately it comes down to the issues of moral hazard and pride…

  2. You brought up points that I have not even started to touch upon in my entry. Incidentally, I had a chance to re-read the entry and expanded it substantially.The original entry was based on an editorial I was writing, which was limited to 600 words. I will let your points about Basel II and liquidity risk management speak for themselves – I did not touch on them in the edited version. I would add here though that at the end of the day, liquditiy management, just as in my point about lending rules, should be scrutinized against very simple first principles. Money in, money out, plus provisions for regulatory capital. The way in which hedging instruments are sold today, they are designed for profit – to make the bank treasurer look smart to his boss. Actually, the folly of that will be revealed in our latest edition of The Asian Banker, where Benny Zhang, our numbers man has taken a look at what the annual results of Asian banks will look like next year post subprime.

  3. Footnote:
    In the October 27-28 issue of the International Herald Tribune, in his op-ed column, Paul Krugman pointed out that Edward M Gramlich, a Federal Reserve official pointed out way back in May 2004 that “increased subprime lending has been associated with higher levels of delinquency, foreclosure and, in some cases, abusive lending practices.” Krugman then goes on to point out that Gramlich tried hard as far back as 2000 to get Alan Greenspan to increase oversight of subprime lending practices, but failed because Greenspan belonged to “the Washington laissez faire culture” of believing that less government is better and so did not regulate the independent lenders who originated the subprime loans. which is the point that I was making that Greenspan ignored a problem that was growing right in front of his face, but was so preoccupied with a different pet concept of productivity and looked at everything through his favourite glasses. If he was an Asian regulator, Greenspan would have been ridiculed for such simplistic thinking. Gramlich died of cancer recently.

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