BANKTHINK
RISK DOCTOR

Avoiding a Banking System that Is Unsafe at Any Speed

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Our banking system could learn a thing or two from the operation of our national, state and local highway system.

The pileup of 100 cars on a stretch of Interstate 10 in Texas last month during an unexpected fog reminds us that despite one of the safest highway systems in the world, catastrophes like this are rare but inevitable. The fact that they are not more prevalent is a direct reflection of advances in road safety engineering and automotive safety equipment, ongoing vehicle inspections and driver education and licensing. 

The U.S. interstate highway system is a marvel of engineering scale and complexity, stretching across the entire country and totaling nearly 47,000 miles. Before the construction of the interstate system, there were about six fatalities for every 100 million vehicle miles traveled. That fatality rate is now at 0.8. This safety record was only achieved by a combined effort of government regulation and market self-regulation. Had we had such an emphasis on safety in our banking sector, it is a good bet we never would have experienced the financial crisis of 2008-2009. 

But what exactly are the parallels we can apply for prudent regulation and market discipline?

If we think of the highway system as our financial markets, automobiles as our banking institutions and management as the drivers, we can begin to rationalize regulatory activities that seem somewhat disconnected by way of Dodd-Frank, and understand where deficiencies remain on the road to designing a safer banking system. 

States own and operate our highways, but responsibility for coordinating and promoting a consistent set of safety standards belongs to the Federal Highway Administration. This comes in the form of minimal pavement and roadway standards, and signage and speed limits in collaboration with the states, but each state is ultimately responsible for setting speed limits based on the unique conditions in their area. 

Beyond these highway standards, the federal government establishes certain minimal requirements for new cars such as safety equipment.  States also may impose periodic vehicle safety inspections and subject drivers to testing and licensing before they can get behind the wheel.  And importantly, such drivers'requirements vary by type of vehicle use, such as commercial or private.

With this as backdrop, what we experienced in banking in the years leading up to 2007 was a highway system with few guardrails, unmaintained in many places and that rarely had posted speed limits. In this system, many cars operated with bald tires, faulty brakes and no air bags. Many drivers were unqualified to handle their vehicles, including many operating the largest, most complex and dangerous vehicles: namely semi-trucks, the highway equivalent of a systemically important institution. 

Various financial regulatory agencies have been at work patching our highways, installing guardrails on hazardous stretches of pavement and vastly reducing speed limits. Many of these improvements were overdue. However, as we are beginning to see, there may be a danger of overcompensating in our response to the crash. While the figurative roads are vastly improved in condition, the reforms may wind up creating nightmarish financial traffic jams. 

One such worry of the banking system today is the final definition of qualified mortgages by the Consumer Financial Protection Bureau. Those rules will serve as minimum safety standards for the mortgage industry and some fear that restricting the product set too much will severely constrain the availability of credit to the mortgage market. This is just one example where our recent experience with an appalling accident paves the way for well-intended but overly cautious regulation.

Our recent approach to regulatory reform has been to start with addressing a symptom, for example, the proliferation of risky products during the housing boom. Vastly preferable would have been a combined regulatory and market-based effort to establish minimum safety standards, conduct periodic inspections and provide for an independent non-governmental organization to provide quantitative assessments of the quality of risk management at each bank. Such an approach would address many of the root causes of the crisis, provide ongoing incentives for banks to engage in continuous improvement of risk management and shift the regulatory focus from regulating products to establishing meaningful risk management practices that are taken seriously in a consistent way across the industry.  The Federal Reserve’s efforts to establish minimum risk management requirements for large banks provides a partial response to improving risk management practices but is incomplete.

Today, investors and other industry observers have no real mechanism for relating the quality of risk management in one company to another.  If we can rate the reliability, safety and efficiency of automobiles, why can’t we do the same for those activities comprising risk management – namely the identification, measurement and management of risk? 

It would be easy to construct a scorecard along each of these dimensions that assigns weights to such factors as risk governance, risk-based compensation, models, data, reporting, controls and processes. We did so at one of the institutions I led risk for and we were able to tie it directly to strategic business objectives. 

The scoring could be done by regulators and/or a Consumer Reports-like entity (perhaps paid for by investors on a fee-for-service basis, to avoid the disastrous conflicts of interest created by the rating agencies'issuer-paid model). Having such a risk management scorecard that could be used by supervisory agencies and investors alike would significantly improve the safety record for our banking system by incenting banks to focus on building strong risk management functions.  These ratings would be a bit like car insurance safe driver discounts that incent good driving behavior. Regulators could use the ratings to more precisely drive risk-based deposit pricing. Underwriters of directors and officers insurance would use the grades to better price their coverage insurance. The ratings would importantly provide investors invaluable insight into what has remained an impenetrable process. 

There is no question our banking system was unsafe at any speed, but we run the risk of creating a system in the aftermath of the twisted wreckage that threatens to severely restrict and distort capital flows. Having an Autobahn with few cars on the road defeats the purpose of such an engineering feat in the first place.

Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland. 

 

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Comments (2)
The analogy of the banking system to the highway system is a good one, but fails to go far enough. The current system allows bankers to set speed limits, road access requirements, driver qualifications and vehicle requirements arbitrarily and selectively. Like erecting a 45 mile-per-hour speed limit sign on a short stretch of an Interstate. Bankers can pull over consumers in other cars and assess fines on the spot. In other cases, they can send consumers notice of an infraction where the fine has already been removed from their account. Meanwhile the highway patrol and the traffic courts go along with the game.
Posted by jim_wells | Wednesday, December 05 2012 at 4:24PM ET
The automobile safety analogy is inapt, for two reasons:

1. Lack of regulation was not the cause of the 2008 mortgage problem. Wrong-headed regulation, turbocharged by the moral hazard of the GSEs, was

2. Government regulation in the form of speed limits and vehicle equipment requirements has not been the reason for improved safety in cars, nor will more regulation improve the soundness of the banking system.

In the US, speed limits are arbitrarily set with no real correlation to the safe traveling speed in the areas they cover. If speed limits were appropriate, we would not see 99% of drivers nominally "speeding", but we do. Artificially slowing traffic actually increases traffic density and collision rates. On the other hand, genuinely useful traffic laws, such as keeping right unless passing and not passing on the right, are not enforced. Meanwhile, now we have scandals in which municipalities "game" speed and red-light cameras to raise revenue - isn't that a form of official corruption? Doesn't this sound like some of the regulations under Dodd-Frank and Basel III?
Posted by Bob Newton | Thursday, December 06 2012 at 3:40PM ET
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