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Regulators Should Practice Civil Disobedience of Dodd-Frank

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Thanks to Dodd-Frank and other mandates, "we have hundreds of rules, many of which are uncoordinated and inconsistent with each other," JPMorgan Chase chief Jamie Dimon recently lamented. "While legislation obviously is political, we now have allowed regulation to become politicized."

He's right. And we don't need to repeal Dodd-Frank to fix at least part the problem. Instead, regulators should use their discretion under Dodd-Frank to act without discretion. In doing so, career regulators can rescue their reputation back from Congress.

What caused the financial crisis? Oh, lots of things.

But a big factor was that government central planners, rather than free markets, decided what was risky and what was not. Nudged by politicians, regulators determined, for example, that certain mortgage-related securities must be perfectly safe, thus allowing financial institutions to borrow oodles of money against them. Congress also forced regulators to treat some derivatives differently from others, even though, absent consistent limits on borrowing, they could all pose unacceptable risk.

You would think, then, that Congress and President Obama would have learned from these past mistakes. They should have admitted that the government simply wasn’t very good at determining what was safe and what wasn't – and said that they would no longer try.

They should have said that they would impose consistent, clear limits on financial firms and financial instruments, making all financial firms carry a certain percentage of capital against their borrowed money no matter what their perceived risk, for one thing.

Instead, Congress and the president blithely doubled down on their past errors. Just think about one provision of Dodd-Frank.

The law gives a new acronymed board – the Financial Stability Oversight Council, or FSOC – discretion to figure out which nonbank financial firms are "systemically important financial institutions" – SIFIs – and which are not. (Big banks like Dimon's are automatically SIFIs.)

This task is so complicated that nearly two years after Dodd-Frank became law, the smartest people in the world – Treasury Secretary Tim Geithner and colleagues from other regulatory bodies, who sit on FSOC – are still figuring out exactly how to do it.

Last week, they issued a 93-page rule to explain the process. It took them 93 pages to say that they'll look at big financial firms carefully to decide if they're risky or not, then give the firms an opportunity to say they’re not risky, then vote, then, perhaps, discuss it all over again and vote again.

They don't expect to finish this process anytime soon – likely not until the end of this year. And after that, they still have to decide what, exactly, to do with such "risky" firms: ask them to hold more capital? Ask them to submit additional reports to the Fed and the Treasury? Break them up?

What Geithner and colleagues should do instead is say that it's FSOC itself – a nonbank firm if there ever was one – that poses an unacceptable risk to the financial system and the economy.

Why? Regulators should say that it is simply impossible for a small group of people, vulnerable not only to political and private-sector pressures but to groupthink and herd mentality, to figure out what poses a risk and what doesn't. Only markets can do this job.

Moreover, markets can't do the job if regulators try to do it for them. Designating firms as SIFIs immediately sends a signal to the market that it's the government, not investors, that is responsible for making sure that these firms don't fail. The market then will figure that regulators would never let a SIFI go through bankruptcy, as such a failure would be a signal of government failure.

Government acceptance of systemic risk only compounds it.

To remedy the systemic risk at FSOC, Geithner et. al. should say that FSOC will de-risk itself by saying that no nonbank is systemically risky. He should then say that it is the policy of the U.S. government to have other rules and regulations in place that mean that any firm can fail, without taking down the rest of the economy.

Regulators should also say that though it's not their fault that Congress is making them designate big banks as systemically risky, their extra regulatory mandate on such banks will be … nothing.

Geithner can say that it is also the policy of the U.S. government to treat all banks alike, big or small – meaning that if one gets into a lot of trouble, it won't get any special treatment for its bondholders and counterparties. Such a statement would send the right signal to the market.

The fact that Congress gave regulators lots of discretion shows that politicians trust the experts to do the right thing. The experts should know that the right thing to do is to give up their discretion – so that markets, not bureaucrats, can pick winners and losers.

Nicole Gelinas, a Chartered Financial Analyst, is a contributing editor to the Manhattan Institute’s City Journal. She tweets @nicolegelinas 

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Comments (4)
Largely agree; however, the one mistake here relates to how to recover and, in the limit resolve, SIFIs, G-SIFIs, and non-bank entities (like NYSE, CBOT, DTC, etc) contribute to our compound systemic risk. FSOC can't figure it out, which is why the banks and related must 1) create comprehensive risk appetite frameworks, 2) instantiate that RAF into a Risk 2.0 backbone, 3) determine when and under what circumstances a "mini-resolution" or enterprise resolution would be necessary, and 4) guide the regulators as to how to properly "see" risk within their own organizations (i.e., living wills and recovery and resolution plans). While some firms may not like to spend the cash to achieve these objectives to enhance systemic stability, perhaps that is just too bad. Their actions - not the regulators - created the on-going global financial crisis, and they continue to be rewarded via HUGE pay packages for this bad behavior. If non-subsidized corporations were to handle their business as irresponsibly as some SIFIs and non-financial organizations have done, they would possibly get thrown in jail (e.g., Enron comes to mind). Yes, the government contributed to this problem in spades with the GSEs and all other related subsidies (and Congress is to blame for that, not the regulators), the SIFIs always could've said "no" to assuming the risks. They didn't and the global system about came down. Something is wrong in Kansas. Dodd-Frank will NEVER fix it, and it is a horrible law; however, enhancing internal systems to achieve the objectives mentioned above must be required. It is no longer up to the banks. They failed. We - as a society - cannot allow that to happen again, and punishment should me meted out as needed (by "free" markets....not "capital" markets). Let freedom ring, as long as these oligopolies/utilities recognize: they exist in present form and profitability due to government subsidies, not their brilliance. If brilliance and prudence defines the character and integrity of the SIFIs, they did a fairly bad job of showing this brilliance given recent historical experience. Perhaps the bigger question is: where were the boards? Where were the owners? How did they and the rating agencies allow the bubble to build in the first place? Is it a fundamental problem with the corporate structure itself? There are some that think so (read: The Corporation). Equity markets don't equal "free market capitalism". Perhaps partnerships, trusts, and mutual forms are the better approach? The fundamental problem (incentives) is far more complex than many would like to admit.
Posted by Stentor | Wednesday, April 11 2012 at 2:14PM ET
Are you serious? Do you really think the financial meltdown was caused by regulators overregulating? Are you rational in suggesting that regulators ignore the mandates of Congress in Dodd-Frank? A little history. It was the absence of regulation and the unsafe and unsound financial practices of regulated and systematically important unregulated entities that led to the biggest financial meltdown since the Great Depression. They couldn't crank out the teaser mortgages to unqualified applicants fast enough and the Bush Administration and OCC told the regulators to back off. Consumers were steered into products they were unqualified for amidst a maze of utterly confusing terms while the big boys on Wall Street just securitized everything and walked away with millions. Great free enterprise that was. Let's just go back and do it again. Time and again (remember the savings and loan crisis of the 1980s?), it has been shown that when financial institutions operate effectively unregulated, they will wreck havoc putting their own short-term profits over the safety and soundness of the financial system and the taxpayers will wind up eating the losses while the bad guys walk away with tens of million dollars in bonuses for wrecking the economy. Dodd-Frank is designed to put an end to that. It's not perfect but if it existed 10 years ago, we would not have had our lost decade. Telling regulators to just ignore the law is irresponsible and typical of the mentality that caused the need for Dodd-Frank.
Posted by randyh44 | Thursday, April 12 2012 at 4:05PM ET
Wrong Randy. It hasn't been "free enterprise" for a long time in the US and to suggest that regulation will solve the REAL core problem(s) is simply...well...funny. Ever since we decided to subsidize and direct credit to certain asset classes - via back-stop USG guarantees) and make mortgages - and a lot of other "credit" - a "RIGHT" (the 28th Amendment?) via FHLMC, FNMA, GNMA the FHA, SBA, Student Loans, the Ag Industry, etc, etc - we have not had free markets. We have had subsidized, opaque directed credit that created massive malinvestment in those asset classes with the most perverse incentives. When the regulators didn't stop the Alt-A, subprime, and Pay Option Arms (POA) BY FOLLOWING THEIR OWN GUIDANCE (read the SR letters, the OCC Bulletins, and the Comptroller's Handbook on Loan Portfolio Management), the cake was baked. But why did the regulators even need to stop it? Were it not for Affordable Housing mandates and complicit congresspeople who wined and dined with FHLMC and FNMA, perhaps there would be no Alt-A and subprime, much less the evil POA instrument (for medium on low-income households). Moreover, why does FHLMC and FNMA even need a balance sheet? They don't, except to pay dividends to (former) shareholders and make sure the CEOs get obscene pay packages. They just need to approve the underwriting and collect the g-fee.

The reason the regulators didn't (and couldn't, and still won't be able) to stop it is that as long as the GSE banks (i.e., the GSIFI and many other firms) were making profits everyone "kept dancing". The regulators are fighting a losing battle when the banks get a "heads I win" and "tails the public lose" payoff profile. You think a bunch of regulators - who are paid 100x less than the bankers making the strategic enterprise decisions on risk appetite - are going to stop corporations from earning all the $$ on the upside when they KNOW they will be bailed out on the downside from continuing their dirty deeds? Lobby the Congress? Take little junkets to resorts to discuss "policy"? This sounds like the Land of Oz, not reality (but funny that someone would really think this).

The REALITY is not to over-regulate but to ensure better internal risk governance, risk management, transparency, liquidity and capital. There isn't a bank supervisor on Earth that would disagree with this, but: where was the liquidity component in Basel 2? Where is the interest rate risk component in Basel 2? Many supervisors asked this question, but Basel is a "reversion to the mean" process, not a developed world "best practice" process. Basel is sausage making done not just across one large national economy, but across ALL economies. Different regimes for different market maturities....but this requires far too much complexity. Heck, the risk-weight function in Basel 2 was SPECIFICALLY designed to let banks leverage more by holding LESS capital. Using a single factor model, the REGULATORS baked MODEL RISK directly into the capital rule itself. Read Banking on Basel by Governor Tarullo, and then ask why we haven't jumped out of Basel? Because the FRB likes running the place? This is why regulatory capital is a flawed concept too. Tangible common equity...pure equity is the measure, not a perverse definition of capital.
Posted by Stentor | Thursday, April 12 2012 at 7:04PM ET
Final thought: It took a near global depression (which still may be coming by the way, despite the "marketing" that tells us different) to get Basel 3, which added some of the additional factors to the capital and policy mandate (e.g., liquidity; new capital definition (i.e., debt shouldn't count as capital....what a concept!; etc); however, Basel 4 is already needed due to weaknesses in Basel 3. It took a crisis like the on-going crisis to mandate stress tests, and yet the Fed STILL won't release methodologies (because their models are bad, top-down tools, not bottom up data-intensive cash-flow tools)? This week they have to ask Governor Tarullo to hold workshops/outreach to build consensus and "calm fears"?

It should surely be understand by now: we don't have FREE MARKETS. Capitalism didn't fail, it just hasn't been practiced. We have "created" an oligopolistic system wherein the larger cross-border banks are in substance not a lot different from FHLMC and FNMA. So, is TBTF really dead? No. Not until Title II of DFA is seen working in practice. The GSIFI/GSEs are funding at wholesale rates below where they were before the crisis: the markets know they are USG guaranteed (to date). This is a relatively ugly kind of forbearance, the kind Hoenig used to get criticized for criticizing (even though he has been largely on target all along). Even some of the large industrial HC's aren't in the stress test, even through they present large liquidity risks. Some aren't, in fact, even considered a "bank" under DFA because of - it would appear - the "soft skill" (i.e., political influence) capabilities of certain executives.

The regulators (sorry, supervisors) have a CRITICAL job to do and they deserve very little criticism IMO, even though they are blamed for being asleep. They were NOT asleep. Many firms were simply punch-drunk - Krugmanesque style.

Most of the working professional supervisors I know are some of the best thinkers and risk watch-dogs around, and the FRB has the best of the best. The Men in Black. However, Report of Exam findings are regularly diluted by senior regulatory leaders in hopes of helping their "constituents" work out of their "issues" in the normal course of business.

Bottom-line: we have to get rid of the subsidies and correct poor structural incentives. We need to hold banks and other financial companies responsible for their decisions. We need far more transparency (Title I of the DFA and the OFR would be fine, if it wasn't tucked inside the Administration). We require more disclosure. We should have a fiduciary standard that Boards must adhere to (SEC seems to have abandoned this notion). Deposit insurance should be "downsized" based on risk. Maybe it should be $100k at max (tied to an index thanks to the on-going dollar depreciation we will continue to witness for years), and be RATCHETED down as a firm's financial condition gets worse (or better yet, get rid of deposit insurance altogether for banks above a certain size....let them actually have to pay a MARKET rate of interest to those poor, subsidizers of banking assets: poorly compensated creditors - the retail depositors).

The future is going to be different, but we should also make sure it isn't merely different for difference sake. It should also be better. The DFA is not better, it is a Gordian Knot that was issued even prior to the Presidentially appointed FCIC. Anyone in the industry knows this, as do most of the regulators. While Nicole's article might be slightly off center, it isn't as off-center as implied. Applause to Nicole for creating some "thinking".....
Posted by Stentor | Friday, April 13 2012 at 5:50AM ET
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