Commentary

The Debt Trap

The last six months have witnessed banking regulators taking several “victory laps” as the Basel capital negotiations proceeded faster than expected and the U.S. Congress passed the Dodd-Frank Act. The self-congratulations, however, have been premature and misplaced, as regulators and legislators have, in reality, done little to reverse the imbalances and perverse incentives that lead to the financial crisis.

While Basel III will, over time, bring more capital into the banking system, it continues to skew bank incentives in the direction of loading up on sovereign and mortgage debt. It is no coincidence that these are also the two areas that were the source of the worst problems during the financial crisis. Entities such as Greece and Fannie Mae are not risk-free, and any system of bank supervision that treats their debt as such is inviting disaster. The need for market discipline

Pushing financial institutions to act as subsidized sources of demand for government and mortgage debt also insures that these sectors gain capital at the expense of productive investment, ultimately leading to lower economic growth.

While some degree of calm has returned to the financial markets, it is certain to be only a precursor to further troubles.”

If there was one reform objective that should have ranked above all others, it was returning market discipline to our financial markets. Implicit and explicit guarantees permeate the financial system; resulting in widespread moral hazard and the under-pricing of risk. In the rush to protect creditors, governments have hastened the demise of market discipline. By codifying the FDIC’s guarantee of bank debt and raising the deposit insurance limit, Dodd-Frank has for all purposes eliminated the risk of loss to bank creditors. This would not be so fundamental a problem if banks held substantial equity; yet even under Basel III, the primary source of funding for banks will continue to be debt, not equity.

Then banks, or households for that matter, would be foolish to reduce their leverage any more than required, given the large tax incentives for debt versus equity. Most national tax codes subsidize debt by making interest payments deductible, while subjecting equity gains to taxation. This treatment drives a large wedge between the cost of debt and equity financing. The massive leverage that contributed to the financial crisis should not have been a surprise to anyone. The disappointment is that these tax biases remain in place. No chance for progress

Progress is also lacking in the reform of our monetary systems. Mismanaged monetary policy by central banks across the world, particularly the Federal Reserve, contributed to the asset bubbles upon which the financial crisis was built, while currencies manipulations drove imbalances that distorted global credit and product markets. Recent Federal Reserve actions, including another round of quantitative easing, indicate that instead of learning from their mistakes, monetary authorities are intent on repeating previous errors.

While some degree of calm has returned to the financial markets, it is certain to be only a precursor to further troubles. The forces which created the financial crisis — loose money, mis-priced or hidden government guarantees, and tax-based debt subsidies — all remain in place. Immediate attention to these imbalances is required if we hope to avoid a repeat of the recent financial crisis.

Mark Calabria is director of financial regulation studies at the Cato Institute.