Archive

Posts Tagged ‘banks’

The Problem with Regulating Banks is the Regulators

April 8, 2010 Leave a comment

Lost among all the discussion about how to regulate banks and financial markets in order to avoid a repeat of recent events is this: in order to effectively regulate something the regulators have to be good at their jobs.

Tyler Cowen writes:

Bank regulation is a tough slog, it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible legislature, “toughness” can be counterproductive, the historic periodic of regulatory “easiness” relied on cartelization and near-automatic profits, and it is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.

Arnold Kling writes:

I do not propose breaking up large banks as a solution for risk cycles in banking. I have a pessimistic view, in which I think that risk cycles are inevitable. I see breaking up large banks as making it easier to disentangle banks from government. That is a good thing by itself, even if it does nothing to change the amplitude of the risk cycle. However, it is quite possible that the amplitude of risk cycles would be reduced if government were less involved. The presumption among those on the left who favor regulation is always that regulators will somehow be smarter than banks over the course of the risk cycle, when the evidence strikes me as showing the reverse to be the case.

Finally, here is Gregory Mankiw:

Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake.

It seems to me that one way to avoid the problem of ineffective regulators, or at least to mitigate it, is to pay regulators market-clearing rates, in order to attract people who would have otherwise gone into banking or trading. In other words, if financial market regulators earned salaries on par with mid-level bankers and traders, financial regulatory bodies may very well prove adept at being able to regulate market participants because the regulators would be competing on equal cognitive footing with those participants. A more succinct way of saying this: staff regulatory agencies with the same exceptionally bright people who work on Wall St. and you may actually have people capable of understanding markets. Perhaps, though, I am attributing too much importance to intelligence and too little to something else. Nonetheless, I think Cowen, Kling, and Mankiw’s comments are all correct and not enough attention is paid to them.

Update: There’s an interesting discussion here of Brazil’s regulatory structure. Simply put bank executives have a lot more on the line if things go bad:

The recent proposals by Senator Dodd do not go far enough in reining in a financial system that still incentivizes excessive risk taking. The suggestions I’ve made above are no panacea, either, but if any of them seems even the least bit Draconian to those occupying the corner suites on Wall Street, they should be very thankful our Congress has not yet adopted the Brazilian approach to financial regulation. In the most recent cover story of “Grant’s Interest Rate Observer” (www.grantspub.com), Jim Grant casts an approving eye on the Brazilian practice of holding a bank’s officers and board members accountable when things go awry at the institution they are charged with guiding. He quotes two principals at Dynamo Capital, who relate that “the net worth of officers and board members is blocked in cases of litigation, losses arising from negligent management or filings for bankruptcy.”

Having one’s net worth on the line while in office is sobering enough for a bank manager or director, but the Brazilians have added a sharp claw-back provision as well. The rule is in effect not just when managers and directors are on the job but also for a full five years after they leave office — longer if legal proceedings are the unfortunate result. What a great concept; with the chances for reward come the full responsibilities for failure! It makes one wonder whether Chuck Prince would have still been dancing in 2006/2007 if every penny he owned was on the line, or if Dick Fuld would have thought twice before levering Lehman’s equity thirtyfold or more.

In the not too distant past, Wall Street firms were partnerships and bank shareholders were liable when the bank they owned hit the rocks. Since we can’t turn back the clock, and since the average Congressperson is unlikely to understand half of my above-listed suggestions (let alone enact them), I would reluctantly settle for the following reforms: Put CDS on proper exchanges; institute a hard cap on leverage of no more than 12 times tangible common equity; and put in place a Brazilian-inspired rule to hold managers and directors financially responsible for failure. As long as banks are run by human beings, we’ll never be able to prevent bankers from making dumb decisions. But with these simple and enforceable border mechanisms in place, we can at least lower the systemic costs of those poor decisions while requiring those who made them to shoulder as much of the financial burden as they can bear. Who knows? Maybe even our contentious Congress will grasp the benefits.