Think Twice Finance

The Banking Crisis Rewrites the Textbooks: How Computers Reregulated the Banking System While We Slept. Part 1

In the endless debate between Computo-phobes and Techno-philes I put myself in the category none-of-the-above. What computers do is neutral as I see it – the question is, “What do programmers and their management do with the opportunities computers create?”

In the banking business, the effect of computers has been ubiquitous – sometimes obvious, sometimes subtle. But there is no doubt in my mind that the changes wrought by the use of computers had a profound effect on the de facto jurisdiction of bank regulators and that industry and regulatory cognoscenti understood this at every step of the way.

De facto banking regulations were rendered obsolete by the changing use of computers to market and service customers. Banks acquired their former rivals, the money market mutual funds, and by jointly marketing the two products along with a panoply of others, were able to expand their market coverage dramatically. The unseemly result was enormous expansion in regulatory responsibility for liabilities issued or even “sponsored” on bank holding companies’ liability side of their de facto balance sheets. This is now an obvious fact but was never disclosed to the public by, for example, making this a legal responsibility of regulators.

Bank reform permitted bank holding companies to extend the range of products bank holding companies could offer investors, but it was not until this crisis that we understood that regulators had extended protection of bank deposit liabilities to protection of all short term non-capital holding company liabilities as is now so obviously happening.

This obvious enormous increase in the defacto government deficit has been largely ignored by journalists, and to a degree by professionals who should be more attentive. The poor excuse for our failure to focus is that we mistook de facto regulation for de jure regulation. This was intellectual laziness. We knew that the ultimate destination of commercial paper liabilities was the bank writing standby letters of credit for them as early as 1970. Subsequent changes such as “conduits” were never more than window dressing and knowledgable bankers and bank regulators have always been aware of this fact.

The reason that public investors have been so badly fooled is easily understood. That constituency has been and still is largely individuals and the products they consumed have remained unchanged. However, the share of products has changed dramatically. In particular, although money market mutual funds have historically been considered products that compete with bank deposits, today many money market mutual funds are owned by bank holding companies. The offering of this complex profile of products to an equally complex profile of individuals who consume them is a process that has been assigned to computers.

Thus computers and the complex multiple product-multiple consumer profit maximization questions they can ask and answer, have turned the old loss-making disintermediation of banks in the 1970’s into what has been, in the first half of the first decade of the 21^st century, a relatively profitable intermediation function of the bank holding companies, introducing more complex investments and wider choice to the community of individual investors.

A key unintended and perhaps disastrous effect of this transformation of the liability side of banks’ balance sheets, in the hindsight of 2008, is that investors have come to know ever less about the actual instruments they are acquiring. As a result they have come to rely increasingly on the opinions of third parties such as rating agencies and investment advisers to determine the safety of their investments. Most importantly, the rating agencies have become overwhelmingly important in the evaluation of investment risks, and they have become highly dependent on a few relatively similar computer programs to evaluate risks. But these programs crucially were not based on assumptions about risks associated with investor behavior in periods of volatile prices.

Thus, the development of saver portfolios of bank-related liabilities has expanded dramatically. And both investors and banks have suspended judgment, relying on computers to clear the markets for these liabilities. That has proven an egregious error.