The US move to principles-based regulation

June 17, 2009

Remember the regulatory arbitrage whereby clever use of securitization could reduce the amount of capital that banks needed to hold without reducing the amount of risk on their balance sheet? Well, the white paper wants to put an end to such shenanigans:

Risk-based regulatory capital requirements… should minimize opportunities for firms to use securitization to reduce their regulatory capital regulatory capital requirements without a commensurate reduction in risk.

On the one hand, this is blindingly obvious stuff, but it’s also well worth codifying somehow, given the failures we’ve seen over the past year or two.

And here’s the language forcing banks to keep skin in the game when it comes to securitizations:

The federal banking agencies should promulgate regulations that require loan originators or sponsors to retain five percent of the credit risk of securitized exposures… The federal banking agencies should have the authority to specify the permissible forms of required risk retention (for example, first loss position or pro rata vertical slice) and the minimum duration of the required risk retention. The agencies should also have authority to provide exceptions or adjustments to these requirements as needed in certain cases, including authority to raise or lower the five percent threshold and to provide exemptions from the “no hedging” requirement that are consistent with safety and soundness.

All of this caused no little debate in the increasingly-lively Reuters Commentary newsroom, where I seem to be in a minority of one when it comes to the rules-based vs principles-based debate.

There’s no doubt that the white paper tilts quite strongly in the direction of principles-based regulation — which I think is a good thing. If you have rules, you invariably create a mini-industry of hundreds if not thousands of lawyers trying to come up with ways of getting around those rules while remaining within the law. This is not helpful. A principles-based approach, by contrast, if enforced by regulators who haven’t been completely captured by the people they’re regulating, tends to be much more constructive. (And if the regulators have been captured, it makes no difference either way.)

Didn’t a principles-based approach fail quite spectacularly in the UK? Yes — but the UK financial system was so big and so leveraged that in the face of a financial and economic crisis of this magnitude, failure was inevitable whatever the regulatory structure. I’m still of the opinion that at the margin, a principles-based approach will be more helpful and less harmful than a lawyered-up rules-based approach, and one of the good things about this white paper, in my view, is that it does build a certain amount of flexibility into the system, rather than just trying to construct new rules for financial companies to navigate their way around.

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