The proliferation of a rules-based system of bank regulation in the United States is proving that it may be ineffective in a modern-day economy. It missed the last crisis, creates a climate that rewards loopholes, and limits product innovation and development.
Given the change in administrations and the more friendly economic landscape that banks are operating in today, Congress and the regulators should consider recalibrating the balance between principles- and rules-based approaches. A foundation of solid rules supplemented by a general code of conduct focused on running a safe and sound institution is a better fit for the future deployment of financial products and services.
Over the last 150 years, whether intentionally or not, bank regulation has slowly evolved from one that was largely principles-based to a more rules-based system. There is general evidence of that embedded in the very nature of banking legislation that was enacted into law. In 1863, Congress established a national banking system, the Office of the Comptroller of the Currency and a national currency, all in just 18 pages. The Dodd-Frank Act needed 800 pages in 2010 to adjust banking and securities regulation.
A strong banking industry no doubt requires rules that impose strong oversight on entry into and continued participation in a federally insured system. Vigorous enforcement of illegal or inappropriate conduct and the discretion to determine which institutions live or die completes that oversight picture. In between such cradle-to-grave regulation, the regulatory system can be more effective to the extent that it enforces the use of good judgment and real-time data to measure and control risks.
A principles-based regulatory system would be akin to situational ethics for financial institutions. The facts and circumstances of a financial problem give rise to a particularized regulatory response – all focused on the goal of safety and soundness and protection of the Deposit Insurance Fund and customers. It requires sound regulatory judgment, solid expertise and the authority and willingness to make difficult decisions about what will keep both a bank and the system safe, sound and profitable.
Rules-based systems are more structured and revolve around detailed laws and regulations that both empower and prohibit bank activities, operations and investments. The generalized theory of a rules-based system is that objective standards of sound banking behavior can be applied broadly to achieve a safe and sound system.
Technology has tended to commoditize many aspects of financial services over the last 20, making economies of scale and efficiency important to achieving a profitable bottom line. Banks today operate in a competitive environment marked by high velocities of change and a continual introduction of domestic and multinational competitors. So, more than ever before, statutes and rules can rapidly become obsolete, requiring oversight to be agile and able to adapt to changing financial dynamics.
Given the near permanence of many laws and regulations, and the tendency to solve every past problem with a new law or regulation, the pendulum has swung too far in the direction of a rules-based system. This factor may be contributing to regulatory systems actually being less effective. That is not to say that the system should be entirely principles-based. Principles only work to the extent that entry into the banking business is highly scrutinized, the standards for financial health are closely monitored and breaches of conduct are appropriately enforced and remedied.
As banks are now very well aware, the more detailed the laws and regulations that are enacted, the more compliance costs increase. But more important, rules can convey a sense of false security – a belief that they are actually creating a safer and sounder system. History indicates that such a false sense of security may lead to bankers as well as regulators letting their guards down. And the more rules that are written, the more that exceptions and loopholes become important. Just because an activity is allowed by a law or regulation does not mean it is safe and sound.
Our system of regulation needs to be able to accommodate difficult and sometimes controversial regulatory judgments, especially in times of duress. Recalibrating this balance of regulation is not a simple undertaking, but it would be a beneficial step toward ensuring that laws and regulations meet their desired objectives.
Thomas P. Vartanian is the chairman of the financial institutions practice at Dechert LLP, an international law firm, and a former regulatory official at two different federal banking agencies.