BankThink

Regulators Need to See the Big Picture

The go-go years of financial services growth are over. Today the focus is on capital adequacy, strict underwriting standards and conservative investing. The panicked days of September 2008 that spawned the Dodd-Frank Act mean the days of light-touch regulation also are gone.

The rallying cry for this regulatory sea change among many policy makers is "Never again!" The question we should be asking is not whether the new regulations faithfully implement the words on Dodd Frank's many pages, but whether, at the end of the day, they form a coherent framework for a sound and dynamic financial system.

The answer depends on the extent to which we succeed in preventing all these efforts from devolving into a new version of fragmented regulation that fails to restore and maintain confidence in the markets and providers of financial services. Now, in the midst of a number of important and far-reaching rulemakings, we need to avoid enshrining in the rule books mandates that are antithetical to this goal.

Financial services companies and the markets in which they operate already are subject to a regulatory and supervisory environment that bears little in common with the halcyon pre-crisis days. New tools developed in the midst of the crisis, such as stress testing, now inform supervisory action. The FDIC has implemented an orderly liquidation authority that could be used to unwind systemically important financial companies as an alternative to bankruptcy. Congress has subjected OTC derivatives such as credit default swaps to comprehensive regulation for the first time. The SEC and FDIC have taken initial steps to address the securitization markets, and the SEC has adopted rules to increase the resilience of money market funds. Under regulatory scrutiny banking organizations have already exited virtually all of their pure proprietary trading units.

Even the regulators have changed, both in identity and orientation. The Consumer Financial Protection Bureau marks the first financial services regulator dedicated solely to safeguarding consumer financial interests. The Federal Reserve has reconfigured itself to institutionalize a more macro-prudential supervisory focus.

The industry and regulators need to take a hard and comprehensive look at where we have come and what remains to be done while they still have time.

A slew of regulator-driven or Dodd-Frank-mandated initiatives are currently pending, from risk retention requirements for securitizations and the implementation of the Volcker Rule to a highly-anticipated second round of money market fund reforms. And, of course, housing finance reform and the fate of the GSEs remain on the horizon.

We should assess whether and how each new reform fits within a coherent regulatory framework. Just as we recognize and manage risk within companies on an enterprise-wide level rather than at the line of business only, we should be building a coherent framework in which risk is assessed across industries and markets.

We should not be content to address risk within any particular product or sector in isolation. Such a siloed approach, while understandable given the limits of regulators' jurisdictional authorities, would surely be foolhardy. It would overlook the fact that systemic risk is greater than the mere sum of its parts and runs counter to the spirit of Dodd-Frank.

Building a coherent regulatory framework will always be a challenge, but we make considerable strides in that direction if we keep in mind several principles. First, we should take full advantage of Congress's decision to empower the regulators to implement additional reforms through a deliberative and dynamic rulemaking process, rather than prescribe granular rules in statute that reflect an accommodation specific to a point in time. This approach enables us to assess reform efforts against the current regulatory environment, not the one that preceded the crisis or that existed when Dodd-Frank was enacted.

Though the rulemaking process can be slow, it allows the regulators to obtain input and get the rules right in the context of the regulatory environment that is emerging. With each rule that is finalized, the regulatory landscape becomes clearer and the need to ensure that each successive rule fit within a coherent framework all the more acute. Although, in some cases, Congress imposed ambitious deadlines for rulemakings, speed and certainty must take a back seat to sound policy designed to make our financial system more stable but still robust.

The rulemaking process is by no means a one-sided endeavor. It depends upon the goodwill and constructive engagement of industry no less than the deliberative and thoughtful approach of the regulators. Inevitably the rules will be finalized with or without the industry's participation, but without it, the rules and those subject to the rules will surely suffer and diminish the likelihood of achieving a workable framework.

Second, the regulators should avoid pursuing incremental (and possibly illusory) reductions in risk for vastly diminishing returns. The desire to minimize risk in a particular sector or product is understandable and desirable, but only up to a point. We should not overlook its associated costs, especially where those costs include the migration of risk to another sector or product that is less regulated and therefore results in more — not less — risk to the financial system.

Finally, the agencies should pursue efforts to reduce risk in a manner that honors Congressional desire to ensure robust capital markets in the U.S. and to preserve consumer choice in a number of important financial products and activities, like securitization, money market funds, market making and hedging, mortgage lending, and swaps. Congress considered many of these products and activities in the course of enacting tough regulatory reform legislation but did not prohibit them. On the contrary, Congress recognized the need to preserve them for our economy to thrive, albeit within an enhanced regulatory framework to make them safer.

A totally coherent regulatory framework will and should always be an aspiration, but we will have taken important steps towards that goal if we proceed in a collaborative, integrated manner. Now is the time to assess whether the framework we are building is in fact sound and sustainable — not after the rules books have gone to press.

Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.

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