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The Crisis Was Not Wasted, Unfortunately

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.


(15) Comments



Comments (15)
Bob -- Thanks for your thoughtful comments. You do have your facts wrong when you say each of the three major downtowns from the Depression forward have had fewer failures. The downturn of 1972-1974 had a handful of significant failures. The crisis from 1980-1992 resulted in nearly 3,000 bank and thrift failures, including many very large ones such as Continental Illinois and nine of the ten largest banks in Texas. The 2008-2009 crisis gave us about 400 failures including a number of very large ones. I see little evidence in the Dodd-Frank legislation that we learned much of anything from the 2008-2009 crisis, including the factors that caused it. I don't think anyone suggests that the private sector didn't play an important role in creating these crises. But failed fiscal, monetary, and regulatory policies were huge factors. I agree that the industry needs to engage Democrats, Repubicans, and advocacy groups to the extent they can be engaged.

Bill Isaac
Posted by billisaac | Tuesday, March 18 2014 at 7:06AM ET
As some one with 35+ years in banking, I have been through two significant banking downturns. Most regulation is a result of a reaction to a bad event. It's also clear that we and regulators have learned from these past crises. Each of the three major banking downturns from the depression forward have had fewer bank failures each time. Fewer bank failures translates into more public confidence in the safety of our industry.

However, to blame the government/Congress for the degree of over regulation is simplistic. Banks/mortgage companies/Wall St. made the decisions that translated into excessive risk taking. People get hurt by those poor management practices not just shareholders. As a response we get more regulations. Do these new regulations keep the next crisis from occurring? No, there's always a new twist but, in general, the crises are a result of poor lending practices and weak risk management. One of the reasons we get these regulations is that we as an industry don't fix the problems unless we are forced to, If instead of spending all of our time telling everyone the problems aren't our fault, we need to take responsibility for our poor decisions and propose changes ourselves. Too often we spend all of our time telling every one that whatever the proposed changes are that they will be the death of our industry. To date, that has never happened so, we don't get taken seriously when we complain.

Do I believe we have too much regulation? yes, I do. But, the only way we will ever get to a more appropriate level of regulation is to engage with all the parties impacted by banking including Democrats, consumer advocacy groups and other groups we have not seen as allies. We spend too much time worrying about being good Republicans when we should be taking a broader view if we ever expect to actually get anything done.
Posted by BobViering | Monday, March 17 2014 at 3:40PM ET
Thanks for your kind words 191111. The feedback I receive indicates that the vast majority of the professional staff of the state and federal banking agencies agrees wholeheartedly with the views I express about Dodd-Frank doing more harm than good and about the need for more effective regulation and greater market discipline.

Bill Isaac
Posted by billisaac | Saturday, March 15 2014 at 10:21AM ET
I have known Bill Isaac for a long time and this is one of his best articles. His discussion of the damage of Dodd/Frank is righ on target. Interestingly, Mr. Isaac' views are now joined by Alan Greenspan, former Federal Reserve Chairman. Chairman Greenspan, in a recent interview on Squawk Box, stated that Dodd/Frank incorrectly diagnosed the causes of the 2008 financial crisis and therefore did not come up with the right solutions. In summary, Mr. Greenspan said that Dodd/Frank is doing more harm to the economy than good. Mr. Isaac and Mr. Greenspan are two of the most respected bank regulators in the world so, based on their disagreement with this administration, I wonder how many federal agencies will go after them like they are doing to Jamie Diamond. Just wondering?
Posted by 191111 | Friday, March 14 2014 at 7:28PM ET
Ed: Act of Congress is a book whose objective was to laud the political process and Barney Frank's leadership. I think it damns both.
Posted by kvillani | Friday, March 14 2014 at 2:39PM ET
The curious thing about all of these "deregulations" is that they in effect spawned voluminous new regulations in their implementation. They were one step forward one step back exercises when you consider all of the elements of each of the bills. Maybe it could be said that some of these "rearranged" regulation, but the Federal Register would show that the body of regulation increased in each case.
Posted by WayneAbernathy | Friday, March 14 2014 at 2:01PM ET
A serious discussion can't focus solely on increased regulation. Unmentioned are some of the deregulations that lead to excess by S&Ls:

1980 - the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), removed interest rate ceilings on first mortgages for residences,while overriding state (usury laws), and allowed S&L to enter business for which they unprepared

1982 - the Alternative Mortgage Transactions Parity Act (AMTPA) loosened state restrictions on mortgage features which turned toxic

1982 - the Garn-St Germain Depository Institutions Act increased the share of assets that thrifts could hold consumer, commercial and agricultural loans, again for which they were ill-suited

And then there was
1999 - Gramm-Leach-Bliley Act(GLBA), repealed parts of the Glass-Steagall Act of 1933, which had the effect of making legal the formation of Citigroup which had taken place the previous year.
2000 - The Commodity Futures Modernization Act of 2000 (the ''Act''), which left credit default derivatives outside of any regulation.

2004 -the Securities and Exchange Commission (SEC) releases the "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities" which revised the capital requirements for five investment banks (Bear Stearns,Goldman Sachs, Morgan Stanley, Lehman Brothers, and Merrill Lynch) by replacing the 15 to 1 debt to equity balance sheet ratio limit for qualifying liquid assets with an unlimited ratio that could be justified by a bank's own risk management model.
Posted by stochastics | Friday, March 14 2014 at 1:51PM ET
Responsibility for DFA does not start and end in government. It would be interesting to see a few paragraphs discussing the inside story of what private interests the so-called "master" decided to serve and how representatives of these interests helped to write the DFA and influenced the subsequent rulemaking.
Posted by Edward Kane | Friday, March 14 2014 at 1:44PM ET
Tonada -- Thanks for your comment. Please go to my website at and you will find volumes of articles and speeches arguing for significant reforms to make financial regulation more effective and less costly and burdensome (I refer you specifically to my speech at the Federal Reserve Bank of Chicago on May 10, 2013). Dodd-Frank is not serious reform -- it is a political document rushed through Congress in an effort to assuage taxpayers understandably angry about the TARP bailout legislation which should never have been enacted in the first place. TARP was not needed an in fact did more harm than good. All Americans will all be paying the political and economic price of TARP for years to come.

Bill Isaac
Posted by billisaac | Friday, March 14 2014 at 1:18PM ET
Both Dodd-Frank and Sarbanes-Oxley are doable processes that work for the most part. The authors point out some obvious problems, but I would like to see them provide some options and solutions.
Posted by tonada1962 | Friday, March 14 2014 at 12:49PM 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
More pandering to the industry, which has only itself to blame.
Posted by uesider | Friday, March 14 2014 at 11:20AM 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
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
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
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