How bank regulation fails us

Barbara Rehm is very optimistic about the state of US bank regulation:

What we do know is that Dodd-Frank gave federal regulators numerous and wide-ranging powers to tame too big to fail institutions. … Obviously, for any of this to work the regulators must translate these “words on paper” into tough, sensible rules, and then they must enforce them fairly and consistently.

Examiners have to be on top of what’s happening inside these systemically important firms and pounce when something goes awry.

I realize that’s a big unknown. Everyone — including the regulators — realizes the agencies missed the 2008 financial crisis. They overlooked gaping risk management holes because firms were booking massive profits.

And it’s fair to question how well the agencies are implementing Dodd-Frank so far.

Personally I’m disappointed that no one in power — say, Geithner or Fed Chairman Ben Bernanke — has made it his mission to expand the corps of examiners dedicated to the largest banks. This people should be better trained and better paid.

But when push comes to shove, the regulators will act.

This is a very romantic view of how regulation works and why we should be optimistic about regulation after the financial crisis.  When Ms. Rehm writes that the regulators “overlooked gaping risk management holes because firms were booking massive profits,” she is in fact obscuring what actually happened.

The regulators often understood that the banks’ profits were derived from regulatory arbitrage with the result that insufficient capital was held against the risks held on — or as was frequently the case off — their balance sheets.  They even promulgated regulations that were designed to severely curtail the growth of the asset-backed commercial paper market in 2004 precisely because the banks were not holding sufficient capital against the guarantees they were providing to commercial paper conduits.

For reasons that remain entirely unclear, at the request of the banking industry the joint bank regulators chose via guidance interpreting the regulation not to implement the regulation as it was written.  It is hard to imagine that this interpretation would stand up to judicial review — if there were a path to judicial review for that guidance.  (For more details on this issue, see Section II.A et seq. of this paper.)

While I would like to believe that “this time is different,” the evidence indicates that just because regulators know they have to act doesn’t mean they will be capable of effectively exercising their authority to do so.

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