A recent and thoughtful BankThink column by Hester Peirce draws on a memorable speech by Friedrich August von Hayek to argue that banking regulators should demonstrate humility and acknowledge the limitations of their understanding of the financial industry. It is not entirely clear from the article whether Peirce opposes bank regulation altogether or just detests those regulators who embrace "the pretense of knowledge."
Should bank regulators be humble? Certainly. We don't need to read Hayek to know this. But their humility alone is not enough to fix the banking industry in the aftermath of the financial crisis and the unnecessarily burdensome regulations of the Dodd-Frank Act.
Adam Smith, the father of capitalism, recognized that banking regulations were necessary, even when rules imposed a "manifest violation of the natural liberty" of the banker. In his classic Wealth of Nations, Smith compares the need for banking regulation to fire prevention. "The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed," he writes.
Smith knew that bankers, like all people, can be vulnerable to "the contempt of risk and the presumptuous hope of success." So to protect society from presumptuous bankers, Smith was willing to curb bankers' freedom in return for what he believed was a greater good.
This message seemingly escaped former Federal Reserve chair Alan Greenspan, a devotee of libertarian Ayn Rand. Greenspan's trust in free markets perhaps went unchallenged until the financial crisis of 2008. During a congressional hearing on Oct. 23 of that year, Congressman Henry Waxman asked the former Fed chairman, "Do you feel that your ideology pushed you to make decisions that you wish you had not made?"
Greenspan acknowledged that it had. "Yes, I've found a flaw," he said. "I've been very distressed by that fact." He went on to concede that "that those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief."
As Greenspan's words show, bankers must be humble too. The financial crisis proved that too many of us had "contempt for risk and presumptuous hope for success."
The failure of nearly 3,500 banks since the 1980s is disturbing proof of a profoundly flawed U.S. banking system. Bankers, board directors, regulators and politicians are all part of this broken system.
The solution goes far beyond the need for humble bank regulators. Even the most modest cannot fix a system made more fragile by post-financial crisis legislation and impossibly burdensome whack-a-mole regulation.
The real lesson we should learn from Hayek is one that goes unmentioned in Peirce's article. "It is the general demand for quick and determined action that is the demanding element" in a crisis, Hayek writes in The Road to Serfdom. Congress's fevered push to fix the problems revealed by the financial crisis led to the ill-conceived Dodd-Frank legislation. Now Congress has made a bad system worse by putting regulators in a position where they must act with "the pretense of knowledge."
"Once the free working of the marked is impeded to a certain degree," Hayek warned, "the planner will be forced to extend his controls until they become all-comprehensive." That's the situation we have today. To move beyond it, three things must happen.
First, now that the financial crisis is past, Congress needs to move beyond the "quick and determined action" of Dodd-Frank. Until a majority of lawmakers recognize the unintentional consequences of 30,000 pages of bank rules, bank examiners will stay their course. Dodd-Frank laws should be stripped down to the rules that matter most for protecting the financial system while fueling sustainable economic growth.
Second, bankers and bank directors must prove capable of protecting customers and shareholders through the business cycle. This will take time. It will also require leadership from a new generation of senior management who acknowledge the inherent weaknesses of the U.S. banking system and act to remedy the systemic deficiencies that they can control.
Lastly, the nation's best bank examiners must speak candidly with Congress about the risks of over-engineering the banking system. Not the least of those risks is the one identified by Peircethat unwieldy regulations will interfere with industry participants' ability to access information and act upon it, thereby leading to less efficient markets.
Absent those three actions, expect U.S. banks to remain fragile and on the road of serfdom themselves.
Richard J. Parsons is the author of "Broke: America's Banking System Common Sense Ideas to Fix Banking in America," published in 2013 by the Risk Management Association. He worked for 31 years at Bank of America.