Why Bank Reform Is Misguided

The ongoing financial crisis didn’t just happen; it was avoidable. 

In the United States, this was the first major finding in the January 2011 Financial Crisis Inquiry Commission report which stated: “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire.”  Similarly, a 2010 paper from Ross Levine of Brown University concluded that “evidence indicates that senior policymakers repeatedly designed implemented and maintained policies that destabilized the global financial system in the decade before the crisis.”

With these findings in mind, getting policy correct during this period of financial reformation is essential. It remains unclear whether we can properly afford, at a national level, another major systemic event in our financial sector; the remaining powder is, well, a bit damp.

 But the history of calibrating the right reform is sketchy, with the 1991 Federal Deposit Insurance Corporation Improvement Act and Gramm-Leach-Bliley being prominent examples. FDICIA was billed as the financial reform act that would prevent future financial disaster once and for all. Clearly, FDICIA, despite its attempt to limit regulatory forbearance, hasn’t prevented financial crises. Given how many important decisions the recent reforms have been left to supervisors’ subjective discretion (such as approving living wills and compensation plans), it is difficult to imagine that, over time, current policy constructs will forestall the next financial meltdown.

The crisis that began with a “glut of liquidity” has laid bare the fragility of our global financial system and the interactions between sovereign states and private sector banks, or, said differently, the interaction between public subsidies, capital misallocation, and bubble economics. This global systemic fragility can be better understood by taking a close looks at how policymakers, investors, and corporate governance mechanisms permitted banks to become “too big to fail.” As a former banker, one bit of wisdom I recall being taught from one of my seniors was that “with a bank charter, any nut can earn a decent profit with a phone and a fax machine. Creating value, this is more difficult.”

One of the insights of this statement is the assumption that with deposit insurance it is easy to acquire assets and turn a profit under generally accepted accounting principles. Whether those assets are earning the proper economic return is another matter. Recent proposals and studies on incentive compensation are a good beginning as they seek to focus management and members of bank boards of directors on ensuring GAAP earnings are related to the risk-taking activities of the bank. If profits aren’t adjusted for risk, overpaying for mediocre – even foolish – performance isn’t merely a possibility. It is virtually guaranteed. 

Other aspects of reform that seem like solid steps in the right direction include the efforts to limit “betting the bank” on proprietary trades, creating a mechanism for the orderly resolution of failing (or failed) cross-border financial organizations, the movement to push over-the-counter contracts onto exchanges, and improving the transparency of large-bank activity via enhanced data standards and requirements.

With these lessons in mind, and given the policy advice under consideration, you would expect to find a groundswell of support for current reform efforts. This hasn’t happened.

The reality is that it is hard to find industry practitioners, and even experienced bank supervisors, who believe that the major proposals made to date – be it the proposed Volcker Rule limits on proprietary trading, other parts of Dodd-Frank, or the proposals in the U.K.’s Vickers Report – effectively address the core causes of the financial crisis. It is indeed mysterious that so much effort has been applied toward fixing “the problem,” yet so many contributing policies and practices that helped create, extend, and deepen “the problem” remain intact.

It’s a given that we want to avoid bailouts. But the fundamental task is to ensure that no single entity is permitted to become a single point of systemic failure, regardless of lobbying dollars, soft-dollar arrangements, or whether you are a “friend of Angelo."  It's this kind of prevention that should be the policy focus, not how to mitigate or reduce the fallout when a SIFI fails.

Arguably, a SIFI, if it is truly systemically important, should no longer be considered a private entity but a type of public utility. “If you are too big to fail,” as Senator Bernard Sanders and Bank of England Governor Mervyn King have both quipped, “You are too big to exist.” Compensation, dividend, and governance schemes should reflect this reality. But it appears that much work remains to institutionalize these approaches, showing the ongoing need for improved board oversight, shareholder rights, and compensation committee standards of practice. Regarding market concentration and size, the proposed 2010 Brown-Kaufman Amendment, which would have restricted bank size, was a good start, albeit mild and incomplete. Many in the market remain unconvinced that the Dodd-Frank Act properly dealt with large-bank concentration risks, interconnectivity problems, and systemically important nonbanks.

Policymakers’ apparent desire to create numerous new regulations and agencies that, by legal nuance, define permissible and impermissible, legal and illegal, retail and universal banking is a recipe for “more of the same.”  I have yet to find a banker, or even a regulator, who thought that the industry was under-regulated prior to the crisis.

In light of many of the recently proposed reforms, it is an important time to pause and – once again – ask the question: Are policy efforts aimed at the right target?  Further, if corrections to current reform efforts are needed – or some recalibration is required – what are the key priorities and how do we go about facilitating the required change?

 Thomas Day is SunGard's in-house expert on risk management solutions and policy across the banking sector. He also serves as the vice chairman of the Professional Risk Managers' International Association.