Law and Order: FDIC

How Congress Botched Bank Regulation and How to Fix It

As we established in “Basel: Faulty,” the 2008 financial crisis was more the result of bad regulation than a case of free markets run amok.  Furthermore, the crisis was concentrated in European banks and US shadow banks. US commercial banks weathered the storm impressively well.

In this paper,  we will first review the performance of US commercial banks during the crisis. We will then argue that the failure of policymakers to grasp the true nature of the crisis led to a misguided regulatory response intent on deflecting culpability from themselves and on punishing the banks.  This response burdened the banking industry and weighed heavily on the post-crisis economic recovery.  We will conclude by arguing that policymakers should reappraise bank regulation and step back from Dodd Frank’s back door nationalization of the commercial banking industry.

In the final section, I present recommendations for changes in the bank regulatory structure.  In a nutshell:

1. “Title XI” of Dodd Frank must be repealed — immediately. Title XI politicizes any future bank rescue efforts with potentially catastrophic consequences.

2. Current excessive bank capital requirements should be reduced and capital allocation decisions taken away from regulators and returned to managements and directors.

3. The FDIC should be converted into a public / private corporation owned and funded by banks and jointly managed by bankers and regulators. This should obviate any future perception of taxpayer “bailouts.”

Note on Terminology. By “commercial banks” I mean deposit-taking institutions regulated by the Federal Reserve, the FDIC and / or the OCC.    “Shadow banks” include all other US-domiciled financial institutions (In 2008, these included Washington Mutual, Fannie Mae, AIG, Countrywide, General Motors, and Merrill Lynch. ) “European banks” are European-domiciled financial institutions, most with significant US-based operations. Shadow Banks and European banks caused the vast bulk of the problems in 2007 – 2009.

“We Wuz Framed:” Railroading Commercial Banks

Many buy into the myth that all or nearly all US banks needed bailouts during the crisis.  This is fantasy.  In fact, unlike Europeans and US shadow banks, US commercial banks weathered the crisis impressively well.  The industry suffered a loss in just one year – 2008.  Depending how you define it, the aggregate loss for the industry was between $10-$40 billion.   This represented between 1 and 6 percent of their $650 billion in 2007 equity.  In perspective, the industry simply gave back in 2008 some of what it had earned 2007. The total industry loss was less than what the government spent to bail out GM and Chrysler.

Yes, some commercial banks failed, but that is entirely to be expected, even welcomed, in a capitalist system.  Yes, TARP was forced on the industry, but that was completely unnecessary. Yes, Citigroup, the perennial weak link, received an equity infusion, but Citi was certainly not insolvent.  BankAmerica received an equity infusion too, but only after being allowed to buy a failing Countrywide and  strong-armed into buying Merrill Lynch.  Overall, the industry emerged from the crisis nearly as strong as when it started.

The principal reason for US banks’ strong showing was that their balance sheets were much stronger going into the crisis.  Prudently, US regulators (notably the FDIC’s Sheila Bair) and managements had insisted on a leverage ratio far in excess of Basel minimums. While the leverage ratios for many universal European banks were 2% or below, the average for US banks was nearly 6%. Not only was this nearly triple that of many Europeans, it turned out to be far more than adequate to weather the crisis.

Even more crucially, US bank funding profiles were far superior to those of the Europeans.  This made them far less vulnerable to runs. In 2007,  Wells Fargo had $500 billion in assets and only $50 billion in what one might classify as “hot” funding.  Compare this to UBS, with $2 trillion in assets and $1.2 trillion in “hot” funding (ex-derivatives!)  Truth is, most US banks were not even in the same business as the European banks and shadow banks.

In light of US bank’s impressive performance, more onerous regulation was the last thing they, or the economy, needed.  Yet that’s exactly what they got in Dodd Frank.

Dodd Frank was a flagrant over-reaction to a system that was badly bent but far from broke.  Its intent was more to glorify its framers and be seen to punish the “banks” than it was a good faith effort to fashion an effective regulatory framework. In spite of its length, much of Dodd Frank is surprisingly vague.  Most details were left to the agencies who were under pressure from policymakers to appear tough.

Just to be clear: no one believes that banks should be entirely unregulated.  My belief,  and I think the belief of most Americans, is that regulation is sometimes necessary, but that less regulation is almost always preferable to more.  That’s not because we have blind faith in the free market to get the economy right.  It’s just that we have a whole lot more faith in the free market than we have in the Washington bureaucracy.

Dodd-Frank: A Capital Crime

The regulatory reaction to the crisis imposed a heavy burden on the banking industry and weighed on the ensuing economic recovery. It was the worst possible policy at worst possible time, stanching the flow of bank credit at a time when banks were already back on their heels. Moreover, its focus on commercial banks was misplaced; they had been as much victims of the crisis as perpetrators, and in many cases had worked with regulators to rescue troubled shadow banks.

Several key provisions of Dodd Frank and subsequent federal policy were especially misguided:

1. Onerous and arbitrary capital standards

2. Radical restructuring (in effect, nationalization) of the mortgage industry

3. Adversarial “scorched earth” examinations

4. Politically motivated lawsuits that removed capital when banks were under pressure to raise capital

5. Stress tests that were arbitrary, opaque and erratic

If regulators had been more honest about their own role in creating the crisis, they might have been a little less smug about imposing “solutions.”

Let’s home in on one of the most destructive features of Dodd Frank – capital requirements.  In typically ad hoc fashion, Dodd Frank alludes only vaguely to higher bank capital standards.  It was left to the agencies to provide specific language.  Of course, as we have discovered, capital adequacy was never an issue for US banks in the first place.  But, gauging Congress’ temperament, the agencies were punitive, arbitrarily hiking capital requirements on all banks, especially the largest ones.

The pressure from Dodd Frank to raise capital was compounded by Basel III. (If you liked Basel I and loved Basel II, you’ll thrill to Basel III!)   Given how its predecessors turned out, one can be forgiven for entertaining skepticism regarding Basel III.  Where Basel I was marked by permissive leverage and Basel II was marked by abdication of any bank supervision, Basel III features sheer, mind-numbing complexity. For just a taste of what I mean, google “Davis Polk Basel III Final Rule.”  Then ask yourself who could think this stuff up and sincerely believe it could work in the real world.

Most academics, too, misunderstood the nature of the financial crisis. Believing the crisis to be more about solvency than liquidity, many have been afflicted by a “capital fetish”, convinced that no amount of capital is ever sufficient.  The most visible among these academics are Anat Admati and Martin Hellwig.   In their book “The Bankers New Clothes” they advocate leverage ratios as high as 30%.

In making this argument, they point out—correctly — that back before the turn of the century – the 19^th, not the 20^th– bank capital ratios were much higher.  In the 1800’s these ratios were as high as 40-50%.  However, they neglect to point out that such elevated capital levels never prevented bank panics, which occurred in the US nearly every decade prior to 1932.  In fact, in 1930, just prior to the mother of all bank panics, bank capital stood at 12%, more than double that prevailing in  2007.

Moreover, they assert that bank capital is cost free to banks and to society.  That is, they claim that the stock market will happily trade off less risk (more capital) for lower returns (lower return on equity.)  So the market is just as happy with a bank that has 20% capital and a 4% ROE as it is with one boasting 5% capital and a 15%. ROE  Not only does this belief reflect a quaint allegiance to the thoroughly discredited Capital Asset Pricing Model, it almost makes one question whether they have ever actually owned a bank stock.

In fact, it is just common sense that compelling banks to hold excessive capital must impose a cost on both banks and society.  It is simply a question of opportunity costs.  Such draconian standards misallocate society’s precious capital, and we all pay the price.

The US banking industry today has $15 trillion in assets and roughly $1.4 trillion in equity — a 9% leverage ratio, give or take.  If the industry is being compelled to hold 9% but only needs 6% — $900 mil. – then $500 billion in society’s capital is being squandered.  The cost is uncertain, but at an 8-12% Cost of Capital, that’s a $40-70B annual dead weight social loss.

This cost is not just hypothetical.  In practice, there are two ways for a bank to increase its leverage ratio.  It can increase its equity, or it can reduce its assets.  Post crisis, US banks did both.  Between 2010 – 2015 total assets of the 5 largest US banks actually shrank. Applauded by policymakers, this trend is hardly consistent with robust economic growth.

Let’s get some historical perspective to estimate the cost of incenting banks not to lend.  The previous bank crisis (far less severe than 2008) was in 1991. Prior to 1991, total commercial bank loans peaked at $2.9 trillion.  Loans reached their nadir in 1992 at $2.6 trillion. In the 8 subsequent years of recovery through 2000, loans grew to $4.6 trillion, a 7.2% compound growth rate.  The economy grew 3.7% per year in that stretch.

In comparison, loans peaked in 2007 at $7.8 trillion, bottoming out at $7.1 trillion in 2009.  In 8 years of recovery through 2017, loans grew to $9.6 trillion, a compound growth rate of just 3.9%.  This is especially surprising because the 2008 crisis was so much more severe than 1991.    The slower rate of loan growth Implies a lending “shortfall” of $340 billion annually, or $2.7 trillion cumulatively over 8 years.

Of course, the really important question is, “What was the impact on the economy of this regulatorily suppressed loan growth?” Now one would think a quick call to the local economist would provide an answer to this question.  Unfortunately, I have been unable to scrounge any study that deals with this issue.  So I’ll begin the debate with my own heuristic:

Historically, $2 in nominal GDP has been associated with $1 in commercial loan growth.  This relationship has been surprisingly consistent, ranging from a high of 2.5 in 1993 to a low of 1.8 in 1986.  Even at the low end, this implies an aggregate post-crisis hit to nominal GDP of $4.9 trillion ($2.7 x 1.8), or roughly $600 billion annually.  Maybe this is too high , but even a quarter of that is $150 billion annually.  Not quite 1% of GDP, but close enough for government work.  I am convinced that this is the main reason why GDP growth from 2009 – 2017 was a measly 2.0% annually, only a bit more than half of the 3.7%  achieved from 1991 to 1999.  If these numbers are in the ballpark, then it is possible that regulatory repression post-crisis cost the economy nearly as much as the crisis itself.

Onerous capital requirements and adversarial examinations were by no means the only regulatory impediments to bank lending in the years following the crisis.  In his book “Floored,” George Selgin details how a 2008 decision by the Fed to pay interest on bank reserves allowed banks to profitably hold excess reserves.  Given the toxic post-crisis regulatory world, this was an easy decision for banks. Thus, the Fed’s efforts to stimulate the economy through quantitative easing were seriously inhibited.

A superb 2017 study by the Urban Institute corroborates the argument that regulation artificially suppressed loan availability. In “Quantifying the Tightness of Mortgage Credit and Assessing Policy Options,” economist Laurie Goodman asks why the growth in single family mortgages from 2009 — 2015 was so much slower than one would have expected.  To find the answer, she compares actual mortgage production to what it would have been had the industry adhered to credit standards prevalent in 2001-2002 (prior to sub-prime excesses.)

Goodman finds that between 2009 and 2015, 6.3 million fewer mortgages were made than would have been made under 2001-2002 credit standards.  At $150k a pop, that’s $945 billion in foregone mortgages – more than a trillion dollars in foregone home sales.  Worse, average FICO scores rose to 700 from 660 in 2001-2, indicating that low income borrowers were disproportionately denied mortgages.  This exacerbated US economic inequality.

Goodman does not explicitly blame Dodd-Frank for these shortfalls, but several rules stemming from Dodd Frank help to account for it.  Most important was the “put back rule.”  This rule allows the GSE’s to “put back” to a mortgage originator any loan that goes bad if the GSE can find a flaw in the application.  Of course, if you’ve ever taken out a mortgage, you know that the applications can be riddled with small errors, any one of which could result in the mortgage being returned to the originator.  Understandably, mortgage lenders stopped approving any mortgage that was close to borderline in quality, and most banks abandoned the business.

Two further contributors were: 1. post crisis, mortgages requiring down payments of less than 20% were scarce and 2. Banks were compelled to deduct from capital the value of their mortgage servicing intangible.

So I’ve argued that the capital burden for banks post crisis has been excessive.  This raises the question:  What IS the optimal amount of capital for a bank?

Most commentators totally wimp out on this issue. Noncommittal pabulum like this is typical:  “Managing bank capital is more art than science.  In light of the crisis we should err on the side of conservatism and maintain capital at levels as high as possible.”

Well, excuse me, but that’s just wrong.  The crisis was nothing if not an unprecedented real world experiment that told us, with some precision, just how much capital banks require under some rather extreme conditions.  Thanks to bonehead Basel, we now know that 1-2% tangible equity ratios are not adequate. (No surprise there.)  Ratios of 4-5% may be sufficient for some low risk institutions but are probably too low for a systemic standard.  But given the pre-existing regulatory regime, ratios in the 6% range were more than adequate for US banks to endure the worst financial catastrophe in 70 years and emerge with plenty of capital remaining.

Policy Recommendations

For US policymakers, there are three key lessons to be drawn from the 2008 financial crisis:

1. The crisis was caused by BAD regulation of Eurobanks and shadow banks.

2. With all its flaws, the US commercial bank regulatory structure ex-ante proved robust.

3. The response to the crisis of US financial regulators – Bernanke, Geithner, Paulsen – was massive, scattershot, unilateral, unfair, unorthodox, ad hoc, often flawed, and only borderline legal.  But luckily for us, they threw everything against the wall and enough of it stuck to save the US and European economies from total collapse.

Unconscionably, most of us – notably our legislators – have failed to fully absorb this last lesson.  The failure to do so could prove catastrophic.  I have many thoughts about ways to improve our financial regulatory structure, but one stands out as imperative: rescind Title XI of Dodd Frank.

In its zeal to be seen as tough on “bailouts”, Congress included in Dodd-Frank “Title XI.”  Title XI was intended to revise Fed section 13-3, which was used during the crisis as a pretext for huge and varied Fed support for banks, shadow banks, and European banks.  In place of the flexibility enjoyed (?) by Bernanke et al, Title XI enacts rigid guidelines for the “orderly liquidation” of SIFI’s (Systemically Important Financial Institutions.)  Most dangerously, it prohibits the Fed from lending directly to any institution that is “insolvent.”  (We know what a fraught concept solvency is.)

Under Title XI, observes Larry Ball, “any lending program <by the Fed> must be designed for a substantial number of firms, not just one . . . . and all lending must be approved by the Secretary of the Treasury. Under these rules, future Fed leaders may be helpless to counter runs on financial institutions and prevent unnecessary financial disasters. . . . .Going forward, even if the Fed’s leaders are determined to resist political pressures, their actions to preserve financial stability may be vetoed by Treasury Secretaries motivated by politics.”

For most of us, the 2008 crisis struck without warning, with greater severity than anyone could have imagined and for reasons that few foresaw. Can anyone doubt that the next financial crisis – and there will be one – will similarly sweep in out of left field? Suppose we wake up tomorrow and a computer hacker has zeroed out all of Citigroup’s accounts.  Do you think it is wise to prohibit the Fed from backstopping Citi?  Under such conditions, who’s to say if Citi is solvent or not?  If it is insolvent, so are a huge number of counterparty institutions.  And remember, any decision to fund Citi cannot wait until the next day; it must be made immediately.

Every day trillions of dollars in “daylight overdrafts” –customer payments in the process of settlement – work their way through the banking system. That these payments routinely prove out at the end of the day is borderline miraculous.  Yet there could be – and have been – “black swan” events that interrupt this process. If this happened, a bank, or many banks, would require significant funding at the end of the day, and some could be technically insolvent.  We do not want Title XI to turn an operational glitch into a financial panic.

Scrap Dodd Frank and Basel

The point is that we were lucky in the last crisis to have folks in charge who used every resource and bent every rule to get us out of the mess we had dug ourselves into.  To severely restrict options for the next set of crisis managers is folly of the worst sort.

Title XI is only the most urgent of Dodd Frank’s provisions that require revision.  As is expressed above, with few exceptions, the entire Dodd Frank / Basel III regulatory framework has been a failure and should be scrapped.

Many regulators and academics will take issue with this conclusion.  They will contend that Dodd Frank has been a resounding success because no large banks have required bailouts since it was enacted and the banking system is “safer” than it used to be.  Even if this is true, it has come at an economic cost of hundreds of billions, if not trillions of dollars, if my numbers are anywhere close to valid.

Think of it this way:  Say there’s an airport with a runway two miles long, more than sufficient for any plane.  One day, little Jimmy loses control of his big drone and crashes it on the runway.   As planes land, they struggle to avoid the wreck.  Some swerve off the runway, some run off the end of the runway, but all land safely.

Concerned, the FAA decides that the airport can be made safer if it spends $500 million dollars to add another 2 miles to the runway. Later, seeking to eliminate even the remotest chance for a crash, the FAA says, “We’ve conducted a very sophisticated stress test and we’ve concluded that if four drones crash simultaneously, you would need six more runway miles.”  Done, at a cost of $1.5 billion. So yes, maybe the airport is marginally safer, but $2 billion has been wasted and the real problem has not been addressed:  Jimmy’s got his pilot’s license.

Let’s not kid ourselves; Dodd Frank represented a de facto, back door nationalization of our banking industry.  No, the government does not own bank shares. But it has intruded into nearly every aspect of bank management.  Few significant management decisions are not contingent- implicitly or explicitly – on regulatory say so.    For the mortgage business, this nationalization has been explicit.  (See “Comradely Capitalism” in the Economist, August 30, 2016.)

Some may applaud these trends, but I believe that they are dangerous for reasons that reduce to one word – incentives.  There is a perception that regulation automatically puts folks in charge who have the public’s best interests at heart.  Nonsense.  In fact, when shareholders cede authority to regulators, power simply shifts from one self-interested constituency to another. Whereas shareholders are focused on taking measured risks to maximize stock value, regulators are primarily concerned with eliminating all risk to keep their jobs.  Recently, their method in this endeavor has been to throw enough obstacles in the way to prevent banks from ever taking risk and making money.

In case you think I’m exaggerating, consider the following quote from an economist representing the “Basel” viewpoint at a Nov. 17, 2015 Brookings Institution conference.   “The whole point … is to drive ROE’s down into the realm where you have safer institutions.”   Now THAT is the regulatory perspective full stop.

Moreover, while private sector management can be, and often is, removed if proven ineffective, regulators need to commit a truly heinous act to be dismissed.  However talented and committed a regulator may be, there is simply no upside in allowing risks to be taken.  And a capitalist economy cannot function effectively if its banks are precluded from taking risk.

As I  emphasized above, the consequences of this regulatory burden are plainly visible in the last decade’s glacial economic growth and rising inequality. It is past time to shift control of the banking industry back to its owners and managers.

Keep it Simple

So the question arises: if not Dodd Frank, then what?

I wish I could offer a visionary plan that anticipated and solved all of the future problems that the industry might face. But alas I’m not a visionary.  In fact, I’m suspicious of grand plans.  I believe that our knowledge is profoundly limited, specially our knowledge of the future.  As Keynes observed, we inhabit a world of “radical uncertainty.”  Actions taken today are likely to be rife with unintended consequences and, sadly, the bad consequences usually seem to outweigh the good ones. Our experience with Basel and Dodd Frank, properly understood, should give us pause about our ability to anticipate and effectively shape the future.

In fact, we must accept that we will never fashion the “perfect” regulatory structure.   Instead, we should take a more practical approach.  We should concentrate on what we know has worked in the past and build on that.  And one thing we know for sure is that the commercial bank regulatory framework that predated the crisis worked nicely.

As we begin our effort to design a post-Dodd Frank regulatory structure, let’s start with the regulator’s prime directive.

Ask a bank regulator today about his top priorities and, if he answers honestly, he will say:

“My top priorities are to ensure that no bank in my jurisdiction ever needs a “bailout,” and that neither I nor my superiors are ever publicly eviscerated in front of a congressional banking committee.”

From a regulatory standpoint, those objectives are understandable, if not laudable.  But I’m not sure they are the values we need to drive a vibrant economy.

Instead, let me propose an alternative prime directive:

The bank regulator’s first priority should be to establish the incentives that encourage the best managers to enter the industry and pursue the best practices once they get there.

Treating bank managers as incompetent at best and incipient criminals at worst is not the best strategy for achieving this end.

The strength of the banking industry lies not in capital ratios, or stress tests, or scorched earth examinations, but in management.  (See my post “Tale of Two SIFI’s.”) Regulatory micromanagement does not make the industry stronger, but weaker.  By focusing management time and resources inward on busy work like living wills and stress tests, the industry becomes less able to respond creatively to new challenges.  Fostering flexibility, adaptability and experimentation will ultimately build a stronger banking system than simply keeping management trapped in a straight jacket.

A better framework would be to move away from today’s Rube Goldberg meets Alice in Wonderland regulatory world toward an environment of simplicity and clarity. I believe that it is best to eschew micromanagement and instead establish broad guidelines that allow managements – and the free market – considerable operating latitude.

In his trenchant (and entertaining) 2012 essay  “The Dog and the Frisbee,” Andy Haldane, Chief Economist at the Bank of England, makes a compelling case that when it comes to regulation, simpler is better:

“. . . . .  the more complex the environment, the greater the perils of complex control.  The optimal response to a complex environment is . . . . . to simplify and streamline . . . .  In complex environments, decision rules based on one, or a few, good reasons can trump sophisticated alternatives. Less may be more. “

And,

“Complex rules may cause people to manage to the rules, for fear of falling foul of them. They may induce people to act defensively, focusing on the small print at the expense of the bigger picture. “

These ideas dovetail with those of Nassim Taleb, who is an advocate of what he calls “antifragility”: striving to fashion systems that get stronger as volatility (external stress) increases. 

To create, or at least head in the direction of, an antifragile banking system, we need to promote rules that are sufficiently flexible to allow banks to pursue their own strategies and succeed or fail in small increments in the hope of avoiding a large systemic risk event.  To do this, we must junk the current adversarial regime that strives to preclude change at all costs and instead embrace change and “randomness.”  In the words of Denis Noble, we need to learn how to “harness stochasticity.”

We should also try to give banks “skin in the game” as is also advocated by Taleb. That is, we should try to create incentives that give individual banks an interest in building a robust systemic banking structure.  We must accept that if we are to embrace change, it will be extremely difficult for regulators to stay ahead of the game.  So the banks themselves will need to pick up much of the slack.

To accomplish this, we first need to relax the byzantine capital rules for US banks.  As demonstrated above, today’s near double digit leverage ratios are far in excess of what they need to be.  We should allow banks to gradually return to pre-2007 capital levels which were clearly sufficient.  Allow the private sector, not government, to decide what to do with the freed up capital (with the important exception noted below.)  Of course, if capital standards are lowered, it must be done with care.  Rigorous examinations need to be an essential component of any large scale capital reduction.

Reform the FDIC

Next, we need to restructure the FDIC.   Not surprisingly, few Americans understand how the FDIC operates.  It is not a taxpayer financed reserve fund for bank bailouts.  In actuality, it has always been a self-insurance fund financed by premiums from banks.    Today, it is run by career FDIC employees and a few political appointees.  It has long been responsible for monitoring banks and resolving those that fail.  With Dodd Frank, it was assigned the additional task of managing the “orderly liquidation” of institutions deemed insolvent.

I propose to make the FDIC’s self-insurance function explicit by converting the agency into a special purpose private corporation owned by the banks themselves.   It would have a board of directors consisting of bankers, regulators, and industry leaders. OCC operations would be folded into the FDIC.  The banks themselves would receive a return on funds invested and benefit from lower than expected loss development.  Of course, they would also incur pro-rata losses in times of negative development.  There would be no more confusion over who was funding “bailouts.”  It would be banks, not taxpayers. This would give them an incentive to keep the FDIC well-staffed (clearly, there would also be legislative mandates), share information, and carefully monitor the behavior of all FDIC members.

Importantly, measures must be taken to ensure that small banks are represented at least in proportion to big banks. While the industry trend is clearly in the direction of consolidation, the US endowment of small banks is a unique and invaluable feature of our financial system.  It is absolutely crucial to the health of our vibrant small business sector.

A key feature of the transition to a public/private FDIC would be an actuarial study to determine the amount of reserves necessary for the fund.  Then, before banks are allowed to reduce capital levels, there would be a one-time assessment to get the FDIC’s reserves up to the actuarial minimum (plus, presumably, some additional cushion.)

Hopefully, one benefit of this proposed structure will be that any resolutions are conducted with an eye to minimizing financial losses.  Specifically, the FDIC might become more measured in its disposition of the assets it obtains from troubled banks.  In the past, aggressive FDIC asset sales have pressured real estate prices in many markets at times when those markets were already severely depressed.  Not only did this behavior mean that FDIC losses were greater than they needed to be, it also complicated workouts of troubled loans at surviving banks.  In the future, perhaps the FDIC might be willing to hold these assets in portfolio and wait to sell into improving markets.

One complication to this proposal is that today the FDIC regulates only banks, not bank holding companies.  This would have to change.  In the short term, at least, the Fed, once relieved of its Dodd Frank lending limitations, would continue to monitor bank holding companies and serve as an unfettered lender of last resort.  I’m convinced that duplication of regulatory effort, while arguably inefficient, provides effective checks and balances.  Also, while I wouldn’t want to second guess the 2008 crisis managers, I believe that (as advised by Walter Bagehot) loans from the Fed should be made expensive so such borrowing is a last resort.  TARP was unnecessary, but it was also too cheap.

I anticipate that this proposal for some will raise the specter of “regulatory capture.”  Regulatory capture has traditionally meant that a regulator identifies too closely with the entity being regulated, compromising supervisory objectives.  More recently, this term is applied to any regulator not seen as tough enough on banks.

In fact, what some call “regulatory capture” has always been a great strength of US bank regulation.  Historically, bank – regulator relations have been, if not exactly collegial, at least non-adversarial.  Banks were always careful to stay on good terms with regulators. That’s just good business. And examiners, in turn, tried to stay on good terms with the banks.  Examiners were often hired by banks into their credit and compliance departments. Ex-examiners became some of the industry’s best credit people and more than a few CEO’s.  These folks inculcated regulatory values into the industry while private sector opportunities kept examiners from acting capriciously.

To my knowledge, bank relationships never prevented regulators from taking action when necessary, whether in 2008, Texas in the 1980’s or Bank of New England in the 1990 – 1992 recession.  Again, the old system worked far better than the standard narrative allows.

It is no coincidence that my proposal might seem reminiscent of “clearing houses,” which were the de facto regulatory authority prior to the Federal Reserve Act of 1913.  Clearing houses were consortiums of banks that banded together to clear payments. In a liquidity crunch, as in the panic of 1907, the clearinghouse banks cooperated in support of weaker members while sorting through them to determine who was really solvent.  In the meantime, they issued “clearinghouse certificates” as payment to customers if cash (or specie) was not available.  All of the banks stood behind these certificates.

In Gary Gorton’s words,

“The clearinghouse response to panics was exactly the opposite of the view that it is important to “mark-to-market” the assets of the banking system.  The clearinghouse decisively recognized that the assets could not be sold and that such “marking” was meaningless.”

One issue that my proposal does not address is that of “shadow banks.”  Shadow banks were key contributors to not just the 2008 financial crisis, but many previous crises, including the Savings and Loan crisis, the 1991 Canadian bank crisis (that’s right, Canada)  and, for that matter, the  Panic of 1907. For the time being, the shadow bank problem seems to be largely resolved.  (Someone will take big losses on covenant light “leveraged loans” but it doesn’t seem these are sufficiently large – or sufficiently leveraged — to cause a systemic crisis.)   All of the major leveraged financial institutions (except insurance companies) are now regulated as commercial banks.  But all companies extend credit, so any company can theoretically become a shadow bank.  The good news is that any shadow bank must ultimately deal with a commercial bank, and hopefully our new FDIC structure will give banks the incentive to identify and head off any excesses that emerge.

I’m under no illusions that my proposals will be the last word on regulatory reform.  Nor would I want them to be.  Hopefully, they are just the start of the discussion.  For now, let’s admit that we were all wrong about the financial crisis and the lessons we drew from it.  Then let’s do something Dodd Frank never did. Lets’ have an honest, evidence based, unbiased discussion about how to achieve truly effective financial regulation.

 “I may be wrong and you may be right, and by an effort, we may get nearer to the truth.” 

Karl Popper