BANKTHINK

The Crisis Was Not Wasted, Unfortunately

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With sharp insight and the cynicism natural to a Chicago politician, Rahm Emanuel famously pronounced in 2008, "You never want a serious crisis to go to waste." A crisis, he continued, "provides the opportunity to do things that you could not do before." How true.

For those who wanted to greatly expand the power of government over banks and nonbank financial institutions and markets, especially to expand the discretionary power of unelected agencies; to do so outside the control of the Congress and the judiciary; and to move the financial sector toward bureaucratically directed, rather than market, outcomes, the financial crisis of 2007-9 was indeed a great opportunity. Unfortunately for the economy and private sector job growth, the political actors most definitely did not let the crisis go to waste.

So we got the Dodd-Frank Act of 2010. Dodd-Frank is part of a predictable pattern, as were the previous overreactions to various corporate scandals. The Sarbanes-Oxley Act of 2002, remember, was supposed to assure the identification and management of risk. It didn't work. Neither will Dodd-Frank. Two other major banking crises during our careers were the real estate bust of 1974-76 and the multiple disasters of 1980-1992. In each case, Congress responded by piling on more burdensome laws and regulations. Each time, it failed to prevent the next crisis.

Nonetheless, we are all stuck with the most recent expansion of regulatory power and bureaucratic discretion, largely unencumbered by legal limits and definitions. Take, for example, the all-purpose regulatory expansion rationale, the fuzzy idea of "systemic risk" and its cousin "reputational risk." The often-quoted line of Justice Potter Stewart is that he could not define obscenity, but "I know it when I see it." With systemic risk, we can't define it and we don't know it when we see it. Nor can we define "reputational risk" other than to say that if we see a lawful activity we don't like, such as payday lending, we will find it presents reputational risk.

To address systemic risk, whatever it is, Dodd-Frank created the Financial Stability Oversight Council - a big committee of regulators, mostly bank regulators, chaired by the Secretary of the Treasury. It turns out that "systemic risk" means whatever a majority of FSOC says it means. Who besides big banks might be a "Systemically Important Financial Institution"? Whoever a majority of the FSOC says is one.

As Humpty Dumpty asserts in Through the Looking Glass, "A word means just what I choose it to mean." When Alice wonders how that can be, Humpty explains, "The question is who is to be master that's all." Asset managers and insurance companies threatened with being branded as SIFIs now feel they are in a Through the Looking Glass world and are discovering the real question is: Who is to be master that's all.

Consider that Fannie Mae is bigger than JPMorgan Chase, but unbelievably, FSOC does not consider Fannie a SIFI. Freddie Mac is bigger than Citigroup, but neither is Freddie a SIFI. Unleveraged asset managers are probably SIFIs, we are told, but the infinitely leveraged Fannie and Freddie, which continue to distort the housing market and create potential liability for taxpayers, are not. The Federal Reserve, which has effectively become the biggest savings and loan in the world, with an unhedged $1 trillion long-term, fixed-rate mortgage portfolio, is more likely to generate systemic risk than a long-term funded insurance company is. But can FSOC admit that its own most important member is itself a massive SIFI?

Speaking of the Federal Reserve, its power has been greatly increased as a major bureaucratic winner in Dodd-Frank. It becomes a key regulator not only of bank holding companies, but of any company of any industry which gets the SIFI label (in addition to exchanges deemed "Systemically Important Financial Market Utilities"), whether the Fed knows anything about the business or not.

Thus the Fed, which utterly failed to recognize the housing bubble, which failed to anticipate the massive resulting bust, which failed to forecast the following steep recession, is going to tell SIFIs how to run their business. The credulity of Congress, when legislating in the wake of a crisis and applying Emanuel's maxim, appears unlimited.

We need to acknowledge the fact made clear by the long history of banking crises: Regulators are not capable of preventing crises by turning banks into government-controlled bureaucracies. Not only are banks then inhibited from taking the commercial risks sufficient to support economic growth, but government control brings with it procyclical regulations like "fair value" accounting; egregious excesses like so-called "disparate impact" suits; and credit allocation to politically favored classes of loans, like residential mortgages and loans to governments. On this last point, consider the credit allocation entailed by the Fed's huge monetary expansion: mortgages and government bonds.

There is little, if anything, fundamentally new in the art of banking in the last 200 years. Dodd-Frankish mountains of regulation, and especially the suffocating regulatory burden now loaded on community banks, are not the answer. We know failures will continue to occur. Good banks diversify their risks on both the asset and liability sides, establish robust internal checks and balances, and maintain strong equity and prudent reserves to cover the mistakes they will inevitably make. Good regulators promote precisely these principles, attempt to provide countercyclical rather than procyclical context, and are ready to adjust to the regulatory mistakes that they inevitably will make.

We need an approach focused on these fundamentals. But that is not what we have got. The promoters of mountains of regulation used the most recent crisis far too well.

William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is a senior managing director at FTI Consulting and the nonexecutive chairman of Fifth Third Bancorp. Alex J. Pollock is a resident fellow at the American Enterprise Institute and former president and CEO of the Federal Home Loan Bank of Chicago. The views expressed are their own.

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Comments (15)
Well said. Hubris, as always, leads the way to the next crisis. We had investment and central banker hubris to thank for the last one, now we have regulatory hubris building blinders and straightjackets for the markets.
Posted by Gore the Ox | Friday, March 14 2014 at 11:04AM ET
An enlightening commentary, offered by observers with a lot of experience and perspective.

It is hard to avoid the worry that along with this increased government control and direction of banking will come increased government direction of lending. That directed lending may be intentional or unintentional, blatant or more subtle. We already see it with the Basel III capital rules, the QM rule, the Volcker Rule, and the proposed Basel Liquidity Coverage Ratio rule. All of these steer banks away from some assets that they call risky (whether or not history demonstrates them to be risky), and into assets that they call low risk (despite the record of just how risky some of these assets can be). Government debt and government-guaranteed assets are the big winners, favored by all of these rules. There are other examples.

And yet, government-directed lending seldom seems to end well.
Posted by WayneAbernathy | Friday, March 14 2014 at 11:07AM ET
A new book by Calomiris and Haber argues that all banking systems reflect a political bargain. Taxpayers and the consuming public are the largest and hence least focused constituencies. Hence it is not surprising that both Dodd-Frank and the new housing Finance reform proposals benefit politicians and regulators at their expense.
Posted by kvillani | Friday, March 14 2014 at 11:19AM ET
More pandering to the industry, which has only itself to blame.
Posted by uesider | Friday, March 14 2014 at 11:20AM ET
This article flipped a switch for me. I've been demonizing the mega banks for creating the '08-'09 crisis. I now see I've been blaming the spoiled child for bad behavior when at it's core, the blame lies with the parents. Had The Fed not bailed them out after all the previous crises, they might have learned enough to properly manage risk on their own. Many thanks.
Posted by brendanatQLC | Friday, March 14 2014 at 12:18PM ET
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