Listening to Regulators Can Keep Your Bank Out of Trouble

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Our system for supervising large financial institutions is broken. Stories emerge almost daily about poor, sometimes illegal, decisions of large financial firms, including manipulation of Libor, failure of yet another firm that didn't protect customer accounts, and multibillion-dollar losses at JPMorgan Chase.

Regulators always seem to play catch-up. After failing to prevent poor decisions, they seek to impose sanctions and pledge to take "a much more aggressive posture."The dysfunction of relations with regulators is seen in news from JPMorgan Chase that – before losses emerged – the bank may have stonewalled supervisors who were trying to get information about risks in the London office.   

This needs to change. Better governance and management could have saved our largest institutions (Citi, Fannie Mae, WaMu, AIG, Lehman, etc.) from failure.  As a senior staff member at the Financial Crisis Inquiry Commission I interviewed CEOs, traders, bankers, risk officers and supervisors. We found major firms that successfully navigated the crisis. They simply made better decisions, based on better information and better processes for decisionmaking, than those that failed.

We found knowledgeable senior supervisors locked into an unworkable bureaucratic system that muffled their input. Regulators feared that, if they pushed a firm too hard, the institution might simply change charters. Countrywide did this in 2007 and migrated from supervision by the Federal Reserve and OCC to the more amenable Office of Thrift Supervision. 

The result was an implicit, if not explicit, understanding that a supervisor taking a tough stance could be overruled by senior officials concerned about losing a bank from its jurisdiction. Interagency rivalry also impaired the quality of uniform guidance and regulations. 

When they recognized problems with predatory lending or commercial real estate, it took the agencies years to formulate an interagency response, which was weak because of compromises needed to achieve consensus.

Faced with constraints, many examiners found it best to flag compliance matters that, while perhaps relatively unimportant, weren't subject to as much pushback as larger issues such as whether a CEO was disregarding or sidelining or isolating the risk office.

When bad decision-making came home to roost, it was too late for a banker to ask regulators for protection, as when Citigroup CEO Charles Prince asked then-Treasury Secretary Henry Paulson in 2007 with respect to leveraged loans "whether given the competitive pressures there wasn't a role for regulators to tamp down some of the riskier practices," and "Isn't there something you can do to order us not to take all these risks?"

There is another way.

The crisis and its immense costs suggest that companies should change their approach and try to listen to their supervisors and consider the merits of supervisory feedback. While regulators may not have the depth of expertise or access to detailed information available to managers in a large financial institution, feedback from supervisors can help to improve decisions sometimes merely by posing the right questions and pursuing the answers.

Supervisors can be especially important in providing an independent review of the quality of decision-making within a company. In making major decisions reviewable by the supervisor, can the company point to changes it made because of input from its board, from the senior management team, or from risk officers? If not, supervisors likely have found a basic shortcoming that deserves prompt attention from the board and remediation.

This is a test that supervisors can apply long before losses actually materialize from poor decisions the company is likely to make. Because this input can improve decision-making, and is efficiency-enhancing rather than a burden on supervised financial firms, this is an area where supervisors can act without excessive concern about political pushback.        

A mutually respectful relationship may prove superior to efforts of companies that hampered their regulators while engaging in risky practices that brought them to ruin. CEO Edmund Clark, who successfully led TD Bank through the crisis, argues that there must be "productive working partnerships between the industry and its regulators, enabling both parties to agree in principle on what needs to be done, and on the least intrusive way in making it happen."

The costs of organizational and management failures have been substantial. It is time for successful industry leaders to take the initiative to promote better governance, management, and supervision, and improve the public and private institutions upon which all of us depend for our well-being.    

Thomas H. Stanton teaches at Johns Hopkins University. His latest book, Why Some Firms Thrive While Others Fail:  Governance and Management Lessons from the Crisis (Oxford University Press), builds on his experience as a senior staff member at the Financial Crisis Inquiry Commission.

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Law and regulation