The definition of insanity is doing the same thing over again and expecting different results. Under this definition, current regulatory efforts like the Dodd-Frank Act and Basel III are insane.
They are going down the same path as prior failed efforts. Yet, regulators believe this time will be different. As Kenneth Rogoff recently noted, underfunded regulators adapting more complicated rules to meet increased market complexity are engaged in an arms race they cannot win.
A return to simple measures, such as a leverage ratio, is unlikely to fare any better. They are subject to Goodhart's Law, which states any measure adopted as a target for control purposes loses its relevancy. Essentially, individuals change their behavior to meet or game the target. The existing abuse of risk weighted assets illustrates this fact. For example, the ratio of RWA to total assets at many large institutions has fallen below 60%. We can expect similar efforts to game leverage ratios if they become the new standard. Thus, the problem is not with the complexity of regulation, but with its focus. We do not need simpler regulations. Rather, we need smarter regulations that recognize the role of incentives and market discipline.
The current focus is on banks as institutions. This has largely ignored the human element. Banks, however, are not inert institutions. They are a collection of individuals who manage bank activities. These individuals are sometimes overwhelmed by fear and greed. Thus, the focus should be how to make bankers behave more prudently – not just to make banks safer.
This means recognizing the role of incentives on individuals. People do what you pay them to do, not what you tell them to do. Existing regulations have produced undesirable unintended consequences. Unintended consequences are common whenever regulators attempt to influence a complex system like markets. Regulators change the dynamics and incentives among various stakeholders in ways not fully appreciated.
Current regulators have misaligned incentives to encourage excessive risk-taking as bankers are paid for good luck, but do not suffer for bad luck. The lethal combination of limited liability and government "Too Big to Fail" guarantees privatizes gains and socializes losses. Bankers collect their bonuses during bull markets, but do not return them during down markets.
Furthermore, government guarantees reduce private sector monitoring of banker behavior. Regulators are left with the unenviable task of playing catch-up due to the opaque nature of risk. As we saw during the crisis, they never see risk beforehand – only after the fact. Thus, risk builds as bankers cannot resist the temptation to gamble for riches with someone else's money, namely, the taxpayers. This represents a classic moral hazard problem with predictable consequences.
The current regulatory approach is stagnating. It has reached a dead end. Private sector responses are crowded out. Furthermore, compliance, not risk management, has become the norm. Capital is a necessary, but not sufficient condition for bank safety. The key is aligned incentives to encourage bankers to manage their capital property by prudently managing the risks they are taking. You cannot assume bankers will act prudently despite incentives to do otherwise.
Achieving this goal involves three steps. First, reintroduce an element of personal liability for highly paid senior bank executives. An example would be to have them liable for all compensation received over the five years prior to the failure of their institution. Next, the implicit government guarantee of senior creditors' claims at large banks must be phased out. This would increase private sector monitoring of bankers.