Dead Frogs and Other Unintended Consequences

When it comes to banking in the U.S., have you noticed how often government intervention leads to unintended consequences? Don't get me wrong, I am not one of those who believe the government that governs least governs best. There is a role for enlightened government in banking.

But the operative word is "enlightened." Looking back at just the time I have been in banking (since 1980), I see two examples of government intervention that has led to devastating unintended consequences. Each created seismic disruptions to our economy. Looking over the horizon, I see two more examples that worry me a lot.

In the early 80s, the U.S. began to heal from years of high inflation.  As any banker knows, inflation is terrible for the lending business. Assets and liabilities are hard to match if inflation drives up short-term sources of funds. Savings and loans in the 70s were in a terrible predicament as deposit costs eclipsed the rates earned on fixed rate loan portfolios.

Enter into the picture well-meaning federal legislation. Intent on helping, the 1982 Garn-St. Depository Institutions Germain Act allowed S&Ls to start making certain types of commercial loans that could float with the cost of funds. 

No surprise, desperate to survive, many S&Ls rushed into commercial real estate. However, most lacked the people and processes to underwrite commercial loans. In addition, the S&Ls' regulator, the Federal Home Loan Bank Board, was unequipped to supervise commercial lending. As S&Ls flooded markets with cheap capital, it was only a matter of time before real estate values cratered.  And they did, contributing to the failure of 3000 banks and S&L institutions. 

The second example came in 1999 with the Gramm-Leach-Bliley Act.  Well intentioned, its purpose was two-fold. One, GLB enabled banks to expand and unleash fresh capital for economic growth. Two, GLB enabled banks to diversify. In theory, better diversified banks were safer banks.

A torrent of new capital flooded into the markets in the aftermath of GLB. But history shows unintended consequences. The first is that the partners who owned the investment banking firms went public. Over time, as they liquefied their investment holdings, their firms took on greater leverage and risk in pursuit of greater returns. The second is the government's failure to develop adequate regulatory processes to supervise the complex systemic risks fostered by GLB. The rest is history.

So what worries me now?  Looming on the horizon are two big problems. Both involve potential unintended consequences of actions the government is taking today.

The first reminds me of Aesop's fable of "The Scorpion and the Frog". You know the story. The scorpion asks the frog to carry him across a stream. The frog fears the scorpion will sting him, but is persuaded when the scorpion quite logically tells the frog that both of them would die if he stings the frog. Indeed, the scorpion stings. When asked by the dying frog "why?," the scorpion says "It's my nature."

As JPMorgan Chase is the latest bank to discover, it is the nature of modern government to sting banks. Though JPMorgan Chase helped the Federal Reserve Bank by rescuing Bear Stearns, it turns out the government must sting the bank four and-a-half years later. The government charged the bank with failing to disclose inherent credit weakness in the MBS portfolio it had acquired from Bear Stearns in the run up to the credit crisis.  In an apparent effort to avoid expensive and distracting litigation, JPMorgan Chase announced recently its decision to settle with the Securities and Exchange Commission. The settlement comes on top of the recently disclosed $5 to $10 billion the bank has lost from the rescue.

What are the unintended consequences?  Do not expect frogs – or banks – to help the government rescue the banking system. Similar to Congress in the 1920s after World War I, banks will become isolationists. They will be wary of the government, hesitant to enter into deals to help rescue the banking system without ironclad assurances. Congress and bank regulators could find themselves up the creek without a frog or paddle.

The second unintended consequence could be even more devastating to the banking system and global economy in the long-run.   

Quantitative easing has enormous implications for banks' balance sheets. Just as individual investors must decide how much of their investments are allocated to longer-term higher yielding bonds, banks' asset-liability committees must do the same. In a classic case of "don't fight the Federal Reserve," banks are today tempted to lock down longer-term loans and bonds in an effort to improve net interest margins. As banks go "long" in their loan portfolio, they gain not only yield, but duration risk.

What happens to the banking industry when rates rise with little warning?  Remember the 1970s S&Ls?  We could see the unintended consequences of a federal policy driving rates down so low it creates systemic risk to the banking system when rates rise.

We need enlightened leaders from government and banking to work together to identify and mitigate the risks associated with the potential unintended consequences of government intervention into the banking system.

Richard J. Parsons spent 31 years in banking.  He now writes about the industry.  His book "Broke: America's Banking System" will be published by The Risk Management Association in spring 2013. He can be contacted at Rick@10XRisk.com.