All bank regulators are captured

By Felix Salmon
November 2, 2011
Sheila Bair aims her fire squarely at Europe's banks and their regulators today, contrasting the high degrees of leverage and low degrees of capital in Europe to the safer banks we have here in the US.

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Sheila Bair aims her fire squarely at Europe’s banks and their regulators today, contrasting the high degrees of leverage and low degrees of capital in Europe to the safer banks we have here in the US.

The U.S., which has tighter rules governing how FDIC-insured banks determine the riskiness of assets, requires well-capitalized banks to hold capital equal to at least 5% of total assets, regardless of how risky they think the assets are. So for any asset, be it cash, U.S. Treasury securities, or supposedly safe mortgages, banks must hold at least 5% capital against it. European banks do not have this kind of “leverage ratio,” and Basel II has allowed them to treat sovereign debt as having zero risk. That is one of the main reasons they have loaded up on nearly $3 trillion of it…

European regulators should supplement this [9% common equity capital] requirement with the Basel III 3% leverage ratio — or even better, the U.S. 5% requirement, adjusting for accounting differences. The EBA should also use realistic loss estimates more in line with those of the IMF and private analysts. If banks have to accept dilution of their stock or temporary nationalization, so be it…

U.S. regulators made many mistakes, but because we maintained our leverage ratio and delayed Basel II implementation, FDIC-insured banks have remained much more stable than other financial institutions. Bank capital standards should not be an insider’s game. The public deserves better. Bank regulators should do their job, and it is their job, not the job of conflicted bank managers, to set minimum capital levels.

I’m sure that Bair feels that it’s her intrinsic toughness and common sense which resulted in US banks being held to tougher standards than their European counterparts. And she’s absolutely right that when it comes to capital and leverage, US regulators came out of the crisis looking better than European regulators. But not by much. US investment banks were allowed to increase their leverage and decrease their capital as much as they liked — which is one reason why Bear Stearns and Lehman Brothers collapsed so quickly. And other countries, like Canada and India, were much tougher even than the US.

The fact of the matter, however, is that all regulators are captured by banks. Or, to be a little more precise, all legislatures are captured by banks, and all regulators do what the government tells them to do.

In countries like Canada and India, there’s a very small number of strong, well-capitalized banks with a vested interest in maximizing barriers to entry. So they’re happy with very tough standards. In Europe, national banking systems are also concentrated, so in theory they could go the same way. But European banks are more likely to have cross-border and global ambitions, and in any case as a matter of contingent fact they’re not very well capitalized. So they get the regulation they want — which allows them to grow fast without having to raise lots of expensive new equity capital.

And then there’s the US, which is pretty much unique among major economies in having thousands of pretty vibrant small banks. Those small banks have a lot of political clout in Congress, and they hated Basel II, because they’re not nearly sophisticated enough to take advantage of it. So they essentially bullied Congress into keeping the old Basel I standards, for fear that otherwise they would be at a massive competitive disadvantage with respect to the big US banks like JP Morgan Chase. Congress obliged, and used the FDIC as its chosen mechanism for blocking the adoption of Basel II in the US.

Does that make the FDIC particularly virtuous? No: it makes the FDIC just as beholden to the banks as any European regulator. Look at the banks’ contributions to the FDIC insurance fund, for instance: they fell to zero, for no good reason, just because the banks didn’t like making those payments.

So Bair is hopelessly naive if she thinks that European regulators — or even American regulators — can really ever force banks collectively to do something they don’t want to do. The only reason the FDIC has any teeth at all in terms of capital requirements is that it’s in the small banks’ interest, and those small banks have a lot of political influence. There really aren’t any small banks in Europe, and European taxpayers are now on the hook for much bigger potential financial-sector losses as a result. That’s bad for Europe, and the world. But the US, and Bair, are in no particular position to deliver lectures on this subject.


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Well, Canadian banks certainly had global (read U.S.) expansions plans in the 90′s and wanted to merge to pursue them more effectively. But banks in Canada are unpopular and politicians weren’t totally dependent on them for fund raising, with the result that telling a bank to drop dead was a great move politically. So Paul Martin did exactly that. Why isn’t there a U.S. politician running against the financial sector? I think even the tea party and Occupy Wall Street share a hatred of it.

In short, it is not the regulators who are captured in the U.S., it’s the politicians.

Posted by Donsig | Report as abusive

“The fact of the matter, however, is that all regulators are captured by banks.”

No. That’s a specific case. We should be looking at the general case.

All regulators are captured by their regulatees.

Interstate Commerce whatever it was, trucking regulation about Mexican trucks entering the US, airlines pre price deregulation….come along, James Buchanan got the3 Nobel for this point.

Any system of regulation will be colonised by those it is supposed to be regulating. Because they’re the only people with enough interest in the system of regulation to bother to try.

Posted by TimWorstall | Report as abusive

Small banks aren’t necessarily unsophisticated. But they lack the scale necessary to engage in the labor-intensive regulatory arbitrage that Basel II and Basel III encourage.

But if the large banks, through Dodd-Frank, are able to impose significant fixed costs through the regulatory process, you will see the number of banks shrink, at the cost of greater systemic risk.

Posted by Publius | Report as abusive

Q. How do US banks reduce the riskiness of assets they hold?
A. Sell the poisonous stuff to the Europeans.

Posted by FifthDecade | Report as abusive

You’ve just made a great “public choice” argument for having many small banks in the system.

Posted by Sunset_Shazz | Report as abusive

Statesmen (very few I know) know very well that most of politics including regulatory policy is about competing interests, and it matters a great deal not just to prevent any one of those interests from being a blocker, but to keep then in competition.

Ideally one of the interests is stronger than the others so there is no gridlock, but the others are strong enough that the dominant one is not too dominant.

Wise regulators know how to fight their political battles in the same way.

This is also the reason why the demise of unions has been both a top policy goal of business lobbies and a catastrophe for everybody else’s regulatory interests: unions raised money from members to purchase congresspeople in competition with the chambers of commerce.

Currently the chambers of commerce are monopsonists and congresspeople can only sell themselves to one business lobby or another, so that real regulatory policy debate happens only when there the chambers of commerce are divided into factions with opposing interests.

Posted by Blissex | Report as abusive

Rereading my previous comment what I tried so say is that it is naive to expect regulators not to be captured to some (large) extent. Expecting regulation to be done by philosopher kings is quite unrealistic.

So what matters is that influence over regulators be diffuse among competing constituencies, just as it would be nice if there were a competitive market for buying congresspeople (the masters of the regulators) as there was in the past.

Even the idea of having regulators captured by the customers of the industry they regulate is a bad idea, because this has happened in the past in various countries, and the result is that the regulators then strangle the industry they regulate because their controlling constituency usually just wants lower prices (e.g. rent control in various USA cities).

Posted by Blissex | Report as abusive

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