Regulatory relief has been enacted by Congress — and while this is certainly a great first step, there’s more to be done to cure the regulatory overdose that has been building over the last 30 years.
Financial regulation is in serious need of a comprehensive overhaul. It suffers from too many laws and rules, too many regulatory agencies with too few resources and undercompensated regulators expected to overachieve and prevent the impossible. While regulatory judgments should be informed by adherence to rules and the achievement of financial ratios, it remains clear that profits, the right capital levels or stress test results are not sufficient to determine long-term financial soundness or the quality of the regulatory system. Does anyone believe that that Bear Sterns and Lehman Brothers would be in business today if they had simply had 3% more capital?
The Trump administration’s bank regulators have already begun developing a constructive agenda of topics: They’ve suggested the need to re-examine capital and leverage requirements, stress testing, the regulation of systemically important institutions, the Community Reinvestment Act, the Volcker Rule, bank control rules and the regulatory burden on community and regional banks. Hopefully, that agenda is just the beginning of the improvements that the system needs.
Quality bank regulation is not merely a function of rules and ratios. It is an art that must balance the financial behavior of banks with the need to succeed in the market. Mountains of new laws and regulations are often more distracting than constructive, and they transform regulation into a mechanical exercise of checking off boxes.
History is instructive in this regard. In the mid 1970s, bank regulation was generally grounded in supervisory experience, not rules. Between 1864 and 1976, the Office of the Comptroller of the Currency promulgated less than 200 pages of substantive rules and interpretive rulings. Much of them were about chartering and merging national banks. The comptroller relied in large part on his broad authority to examine banks, remove directors and officers, order them to cease or divest activities and investments, impose a wide range of monetary fines or simply close the bank. Those are authorities the office still possesses. But since 1976, its rules and interpretations have exploded by 500% to cover more than a thousand pages in the Code of Federal Regulations. Rules by the Federal Deposit Insurance Corp. and the Federal Reserve have become similarly bloated.
This detour from a principles-based system to a rules-based one has been, in large part, a reaction to financial crises and to the false premise that they can be eliminated by regulation. Regulation can’t create the ups nor prevent the downs of a free economy, nor can it insulate banks, as primary financiers of the economy, from suffering along with it.
In addition, big financial problems always seem to generate big legislative responses, which themselves can have unintended consequences that impact the timing and nature of future financial crises. Consider, for example, U.S. housing policy of the 1960s, which sought to make low-cost, 30-year, fixed-rate mortgages widely available by limiting the interest that institutions could pay their depositors at 5.5%. The decision was well intentioned but economically naive. As short-term interest rates moved toward 16% in the early1980s, Congress ordered the removal of interest rate caps, putting thrifts, the principal provider of home loans, in an economic headlock. They had no choice but to offer double-digit interest rates to depositors to remain liquid, while continuing to earn a fixed 6-7% on those long-term, fixed-rate mortgages. Thousands of them disappeared in the ensuing savings and loan crisis because of the negative interest rate spread they were forced into by government policy.
This was not unlike the government’s efforts in the 1990s to encourage banks to provide mortgage financing to a larger segment of potential home buyers. The subprime lending crisis that followed more than a decade later led to a global economic crisis of confidence. Fannie Mae and Freddie Mac were eventually placed in conservatorship as their government-endorsed business models were considered to be unsustainable.
Bank regulators have long possessed the broadest of enforcement authority over banks to make life and death judgments about them and their executives to ensure that they operate in a safe and sound manner. A myriad of detailed laws and rules — ones that come with their own loopholes, require endless interpretations and remain static as the economy and events change — often dilute the basic effectiveness that regulation can have.
After bank regulators make the next set of low-hanging regulatory reforms, they should examine how many banking laws and rules are simply unnecessary and counterproductive. And for once, as the president has directed, laws and regulations should be based on real cost-benefit analysis. Ubiquitous regulation may feel good, but the future of the U.S. economy depends on a more effective and efficient regulatory system.