Lesson of the Financial Crisis: Too Many "Dumb" Regulations. We Need "Smarter," Not More Regs
University of Chicago libertarian-leaning finance professor John Cochrane is now blogging at The Grumpy Economist, here's an excerpt from his excellent post today:
I am often asked, "doesn't the financial crisis mean we need more regulation?" It's one of those maddening questions, because the answer is "that's the wrong question," which gets you nowhere.MP: For examples of "smarter" financial and banking regulations, we can look north to our Canadian neighbor. While our historically fragile banking system lead to 9,000 bank failures during the Great Depression, about 3,000 bank failures during the S&L crisis, and 427 bank failures from 2008-2011 from the "Great Recession," Canada experienced almost no bank failures during any OF those periods. What's so "smart" about Canada's regulations that allowed it to avoid the thousands of bank failures that occurred in the U.S.?
For regulation is not "more" or "less," something you just pour into a cup until you've had enough like a good beer. Regulation is most of all "smart" or "dumb." Dumb regulations produce the opposite of their intended effects, have all sorts of unintended consequences, or get used for fully intended but pernicious consequences like driving out competition. Smart regulations don't.
The main lesson of the financial crisis is not that we did not have "enough" regulations -- we had hundreds of thousands of pages of regulation. The lesson of the financial crisis is that most of those were "dumb" regulations. Their massive unintended consequences led to a fragile financial structure. Yes, we need financial regulation, but "smarter," not necessarily more."
1. Canada never restricted branch banking the way the U.S. did until 1994. By forcing banks to operate in a single state, they were forced to generally be small and non-diversified in their loan portfolios. This was an especially important factor in the 9,000 U.S. bank failures during the 1930s when Canada had none.
2. Canada's underwriting standards for home mortgage lending are much more conservative than the U.S. and capital requirements for banks are much higher.
3. Canada doesn't have an equivalent to our GEE-sponsored secondary mortgage market (no Fannie or Freddie), so the Canadian banks that originate home mortgages typically keep most of those loans on their own balance sheets, which is another factor that keeps underwriting standards much more conservative than in the U.S. In the U.S. there's more of an incentive to originate mortgages and then sell them in the secondary market, which then allows the banks to lend more.
4. Mortgages in Canada are full recourse loans, meaning that the homeowner/borrower is responsible for their mortgage debt even if they lose their home through foreclosure. In most U.S. states, homeowners can live in their home for several years or more without making payments, walk away following foreclosure, and then are not held responsible for the deficiency. Not so in Canada. The banks there will follow you forever, and even garnish your wages.
5. Most mortgages in Canada generally require a 20% down payment, and there are no 30-year fixed rate mortgages. Canadian banks will issue 25-year or 30-year mortages, but interest rates are adjusted every five years, like a 5-year ARM. If a borrower in Canada can't come up with the 20% down payment, they have to purchase mortgage insurance from a private insurance company and pay the full premium up front. And the private mortgage insurance company has to approve the property appraisal before the deal can go through.
Related: See my article "Due North: Canada's Marvelous Mortgage and Banking System."