You can’t regulate with nostalgia

By Felix Salmon
January 3, 2013

The theme of the day, today, is nostalgia for the simple banking systems of yore, where the Bailey Building & Loan was run by simple, honorable men who had no problems complying with Basel I or its predecessors. If you have a large chunk of time today, you can start with the 9,500-word cover story in the Atlantic by Jesse Eisinger and Frank Partnoy, and then for dessert follow it up with Yalman Onaran’s 2,600-word explanation, for Bloomberg, that bank regulation these days is really complicated.

These are genuine problems. Once you’ve read the Atlantic article, which takes a deep dive into Wells Fargo’s 10-K and comes out convinced that it’s impossible to really know anything about the risks and assets in any big bank, you’ll understand why that’s a huge systemic problem:

As trust diminishes, the likelihood of another crisis grows larger. The next big storm might blow the weakened house down. Elite investors—those who move markets and control the flow of money—will flee, out of worry that the roof will collapse. The less they trust the banks, the faster and more decisively they will beat that path—disinvesting, freezing bank credit, and weakening the structure even more. In this way, fear becomes reality, and troubles that might once have been weathered become existential.

This paragraph is the heart and soul of the piece. (You’ve gotta love any article where the nut graf comes more than 2,000 words in.) We can’t trust the banks; but unless we can trust the banks, another major financial crisis is inevitable, since banks are built on trust, and without trust they are nothing.

This dynamic was central to what went wrong during the financial crisis, and a large part of the problem was the global system of bank regulation known as Basel II, which basically allowed the world’s biggest banks to simply make their own determination of what their risks were and how much capital it made sense to carry against those risks. Obviously, that didn’t work out very well. So, what can be done about this problem?

The answer of the global regulatory regime was something called Basel III. It was pushed through in something of a rush, and so it built on Basel II as a base: my metaphor is that it’s a bit like the way Windows was built on DOS. As a result, although it’s a clear improvement over Basel II, it is necessarily at least as complex as Basel II. And when complexity itself is part of the problem, extra layers of regulation are unlikely to constitute much of a solution.

That’s Onaran’s point, but I think he pushes it a bit too far. His headline is “Basel Becomes Babel as Conflicting Rules Undermine Safety”, and he talks at the very top about how “conflicting laws, divergent accounting standards and clashing rules” have “created new risks” in the banking system. But the shoe never drops: he doesn’t actually explain what these new risks are, or how Basel III undermines the safety of the baking system.

Partly, it’s a baseline game. Both the Atlantic and Bloomberg are essentially comparing Basel III to Basel I, and saying that everything is still far too complicated. By contrast, if you compare Basel III to Basel II, it’s a clear improvement. Onaran’s article is full of quotes from people saying that we should go back to a much simpler system. And the Atlantic actually lays out what such a system might look like:

Congress and regulators could have written a simple rule: “Banks are not permitted to engage in proprietary trading.” Period. Then, regulators, prosecutors, and the courts could have set about defining what proprietary trading meant. They could have established reasonable and limited exceptions in individual cases. Meanwhile, bankers considering engaging in practices that might be labeled proprietary trading would have been forced to consider the law in the sense Oliver Wendell Holmes Jr. advocated.

Legislators could adopt similarly broad disclosure rules, as Congress originally did in the Securities Exchange Act of 1934. The idea would be to require banks to disclose all material facts, without specifying how. Bankers would know that whatever they chose to put in their annual reports might be assessed at some future date by a judge who would ask one simple question: Was the report complete, clear, and accurate?

This is basically principles-based regulation, as opposed to rules-based regulation. Rather than forcing banks to comply with thousands of pages of abstruse regulation, keep things simple and deliberately vague: that’ll keep them on their toes, goes the argument, and force them to err on the side of caution.

If there were a real chance of doing this, I’d be all in favor. Principles-based regulation doesn’t always work: just look at what happened to the City of London. Banks ran rampant, committed massive Libor fraud, and required enormous bailouts; London is also, not coincidentally, the home of JP Morgan’s Chief Investment Office. Eisinger and Partnoy rightly use banks’ price-to-book ratio as an indicator of the degree to which anybody in the market understands or trusts what they’re doing; what they don’t say is that it’s hard to find a lower price-to-book ratio than Royal Bank of Scotland, which was regulated in the UK rather than the US, and which is owned not by out-of-control risk-loving capitalists, but rather by the much safer and much more risk-averse UK government.

And what neither article really admits is that regulators are painfully aware of all the problems they lay out — and many more. That’s why the UK government spent so much effort trying to lure Mark Carney over from Canada to run the Bank of England: he was one of the few regulators who managed to ensure that his national banking system didn’t implode during the crisis, or require any kind of bailout.

But the fact is that all regulation is, by its nature, path-dependent. In 1932 it was easy to install a simple system of bank regulation, because there was no existing system of bank regulation to replace or build on. Since then, as Eisinger and Partnoy write, “accounting rules have proliferated as banks, and the assets and liabilities they contain, have become more complex. Yet the rules have not kept pace with changes in the financial system.” That’s just the nature of things: complexity breeds further complexity, and with it much higher levels of endemic systemic risk.

The genius of Canada, and other countries with safe banking systems like India, is that they never allowed their banks to become highly complex in the first place. There are financial capitals like London, New York, and Frankfurt; those countries will have lots of capital flows and complexity and systemic danger. And then there are second-tier places like Toronto and Delhi, where financing can be much simpler. The problem is that you can’t turn New York into Toronto, or London into Delhi. Nor would any of the politicians in the US or the UK particularly want to do so: they get too much precious tax revenue from being global financial centers.

And it’s equally hard to take a multi-layered rules-based system, complete with a large and powerful and entrenched regulatory infrastructure, and tear it down to build something smaller and simpler. Accounting rules proliferated even during the era of deregulatory zeal in the 1990s; accounting rules will always proliferate, and it’s pretty much impossible to find an example of a regulatory system which has ever managed to go in the other direction, losing complexity, gaining constructive ambiguity, and reducing systemic risk in the process.

So while Eisinger and Partnoy and Onaran are absolutely right when it comes to diagnosing the problem, I think they’re either naive or way too optimistic when it comes to suggesting that all we need to do in terms of a solution is press some magic button and find ourselves with the banking system of the 1950s. We can’t — which is exactly why complexity and systemic risk are here to stay.

Basel III isn’t perfect, but it’s as good as we’re going to get, and is actually significantly better than most people dared hope when it first started being negotiated. And the technocrats who put Basel III together are not some group of knaves, deluding themselves that they’ve magically fixed all the problems with the banking system. They’re smart and well-intentioned regulators, who know full well what the problems are, and who are implementing the best set of patches and solutions that can be implemented in reality. Or if not the very best, then something damn close. They too would love to tear everything up and start from scratch with a much simpler system featuring much smaller banks. But, unfortunately, they can’t.


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If you want to romanticize George Bailey (and his drunk uncle), you have to keep in mind that Mr. Potter was in the same business–and, judging by the bank run–in much better shape, capital-wise.

The problem isn’t that we get nostalgic for Bailey; it’s that the Potters of today have n/o/ c/l/o/t/h/e/s/ not enough capital, and complain when that is pointed out.

Investors didn’t worry when the black box was a small part of the plane. Now, when it’s all that’s still there, Whaling away, is when we look and say (to borrow the old joke), “Yeah, that thing will fly. Like me grandmother.”

Posted by klhoughton | Report as abusive

I’m frustrated by 9,600 words pontificating on well-known problems with no practical solutions. So indulgent.

I don’t think it’s regulatory incompetence or ineptitude as much as deliberate forbearance that encourages banks to do whatever they want for as long as they want and then pay relatively minimal penalties for breaking the rules. We’ve heard over and over again that nothing or very little was done by regulators during the crisis on both sides of the Atlantic – and auditors who took their cues from politicians rather than investors – because the “financial system” may break otherwise.

Investors – and taxpayers – must demand a financial system that serves the public not the bankers. Citizens must demand solutions to meeting specific goals like furthering growth for everyone not lofty ones like “stability” or we’ll perpetuate the current system that only profits insiders.

Posted by retheauditors | Report as abusive

I’d say that a major reason for the safe banking systems in Canada and Australia – possibly the major reason – is that they have oligopolies of a few large banks, with limited competition, so spreads and fees are high. As a result, these banks can (i) earn a strong ROE even with higher capital levels and (ii) generate enough income before charge-offs that they can weather a spike in loan losses. (I am not very familiar with banks in India, so I can’t say if they benefit from the same phenomenon.)

Obtaining bank stability via oligopoly-based high pricing shouldn’t surprise anyone, as there’s a natural tension between wanting stable banks and wanting for bank customers to obtain the lowest possible fees and interest rates on borrowings (or alternately, for bank depositors to receive the highest possible interest rates). As with any business, there’s always the possibility that a truly competitive marketplace drives someone out of business. So we need to accept that either (i) we allow for somewhat higher than “competitive market” pricing on financial products and services as part of our regulatory regime as part of the price of financial stability or (ii) we need to allow financial institutions to fail and to prepare for that to happen.

Posted by realist50 | Report as abusive

Wait–was the problem that Basel II was too complex? Or that it “allowed the banks to make up their own rules?”

They’re not the same thing–though both may be true.

Or was the problem that the financial center banks were and are filled with hydrocephalic greedmonkeys whose main business was and is to enrich themselves while beggaring all of us? In which case, an effective Basel III WOULD look much like a return to Basel I, boring banking, Toronto, New Delhi?

And–by the by–if even India’s banking system proved robust and stable–India, whose tradition of public and private corruption is unmatched among great nations–than doesn’t that maybe say something important about the structure and efficacy of Basel I-style banking when set alongside the New York/London mess?

Simply saying “we can’t go back” doesn’t make it so. We actually could, if enough of us wanted to force the issue.

Oh, but Felix’s lunches would get boring …

Posted by Eericsonjr | Report as abusive

I could critique this post for same argumentative mistakes as it’s critiquing. Both articles (Atlantic and Bloomberg) make claims about the kinds of regulatory regimes we should have, but fail to support their theses. Fine. But then Felix says “what you want is impossible,” and his evidence amounts to “it hasn’t been done” and “it would be really hard.” Even if I think Felix is probably right, I’m not convinced by the lack of an argument here. More to the point, wouldn’t it be more constructive to get ahead of the curve, rather than trying to bend it back on itself? We should be asking ourselves how we shape 2050 instead of trying to recreate 1950. To that point, I would say look at how much we use the word “systemic” when describing all the things wrong with international finance. Something should be read into that. The problem with Basel III is that it’s trying to bail out a sinking, obsolete ship that was converted into a floating casino years ago.

Posted by Nathan_Samuel | Report as abusive

You could regulate with criminal prosecutions for accounting control fraud, though.

Posted by lambertstrether | Report as abusive

I wonder what Bill Black would have to say…

Posted by upstater | Report as abusive

Eericsonjr – are you trying to say that “boring” banks didn’t fail, in many cases spectacularly, in the good old days?

Remember the S&L’s getting into trouble after high short-term interest rates up-ended their whole business model, and they therefore decided to get into other types of lending that they didn’t understand very well?

Remember almost every sizable institution in Texas failing in the 1980′s after the Texas oil and property bust, because they were regionally focused institutions in a region whose economy was crushed?

Remember Continental Illinois, which popularized the term “too big to fail” in 1984?

Remember the emerging markets loan crisis of the 1980′s, which nearly took down Citibank? (Citi, across different names and business scopes, has had an illustrious history of getting itself into trouble pursuing the trend du jour).

Bubble bursts – particularly ones than involve real estate – have pretty much always resulted in a banking crisis, regardless of the regulatory regime in effect at the time.

Posted by realist50 | Report as abusive

I would encourage reading Felix’s post here and Matt Levine’s post at Dealbreaker, and skipping the Atlantic piece by Eisinger and Partnoy.

The killer for me was seeing an excerpt from the Atlantic article (quoted by Levine) where Eisinger and Partnoy seize on the fact that Wells Fargo describes its market making activities as including “taking positions to facilitate expected customer order flow”. They go into hysterics over the term “expected” versus responding to what customers actually have done.

I am not going to make a categorical claim that Basel III is perfect, or that it can’t be improved upon. I’m sure there are ways it could be better. I will categorically state, however, that I’m not going to read 9,500 words on financial regulation written by authors who don’t seem to grasp that market making (i) requires holding an inventory of securities, (ii) entails taking on positions and risks that don’t always net to zero, and (iii) like all business, is a forward looking rather than backward looking activity.

Posted by realist50 | Report as abusive

“The answer of the global regulatory regime was something called Basel III. It was pushed through in something of a rush, and so it built on Basel II as a base: my metaphor is that it’s a bit like the way Windows was built on DOS. As a result, although it’s a clear improvement over Basel II, it is necessarily at least as complex as Basel II. And when complexity itself is part of the problem, extra layers of regulation are unlikely to constitute much of a solution.”

Felix, nothing in this long post gives any comfort to the reader that Basel III represents any ‘clear improvement’ over its predecessor.

First, a rear view summary:

Basel 1: mortgage lending only requires 50% risk weighted capital. RESULT: Euro banks pile into this by way of dodgy US mortgage backed securities. OUTCOME: see 2008.
Basel 2: sovereign debt requires only 50% risk weighted capital. RESULT: Euro banks pile into this by way of PIIGS sovereign exposure. PREDICTED OUTCOME: see 2008.

In both cases, European banks were happy to ‘comply’ with Basel guidelines on capital-so they could game it. In fact, we should feel lucky that the US banks did NOT comply with Basel II-they were better capitalised in ’08 than their UK and EU stablemates.

From der Bloomberg today: “The first Basel agreement on global banking regulation, adopted in 1988, was 30 pages long and relied on simple arithmetic. The latest update, known as Basel III, runs to 509 pages and includes 78 calculus equations.”

Felix: Basel III isn’t perfect, but it’s as good as we’re going to get, and is actually significantly better than most people dared hope when it first started being negotiated. And the technocrats who put Basel III together are not some group of knaves, deluding themselves that they’ve magically fixed all the problems with the banking system. They’re smart and well-intentioned regulators………”

Right-who know differential equations.

Posted by crocodilechuck | Report as abusive

How many bankers became destitute?
How many bankers (and bond rating agency heads) went to prison for fraud? Or for that matter, were replaced by outraged shareholders?

Capitalism can’t work if losses are not taken but absorbed by governments. Capitalism can’t work if people who make loans don’t understand that they have to be paid back. Capitalism can’t work if fraud and stealing is equated with earning…

Posted by fresnodan | Report as abusive

It is true, the first Basel agreement on global banking regulation, adopted in 1988, was 30 pages long and relied on simple arithmetic. It was simple, but it was more fiction than reality.

It was not risk based (all counterparts were equally able to repay the loans), it did not recognize market risk (!) and operational risk (!!). It was a main reason for many of the problems in the banking sector. It was a huge regulatory arbitrage challenge (and opportunity).

Banks are in the business of taking risks, and we cannot describe these risks and the necessary steps to mitigate these risks in 30 pages.

George Lekatis
Basel iii Compliance Professionals Association (BiiiCPA)

Posted by George_Lekatis | Report as abusive

Realist50: I’m not suggesting that “boring banks don’t fail.” I’m suggesting, like you, I think, that when they do it’s OK–especially if they are small and in a competitive market. The S&L stuff you cite wasn’t about boring banks in geographically concentrated markets. It was about fraud. Insider fraud. Just like the 2008 scams were. The Basel structure, the gaming of “risk weightage” and all the rest are a distraction from this central fact.

Posted by Eericsonjr | Report as abusive

Eericson: I think that we have some areas of agreement, the biggest being that there has to be a credible potential that any company, including financial institutions can “fail”. That need not mean liquidation except in extreme cases, but some sort of bankruptcy or resolution process that imposes losses on shareholders followed by creditors.

That said, I differ substantially about the S&L’s. There were instances of fraud, but fraud was a small part of what happened. In terms of the monetary cost of the S&L’s, I feel confident saying that outright fraud was less than 10% of the issue. The bigger problems were a mix of incompetence (by both S&L’s and their regulators), excessive optimism, and bad economic conditions (everything from the oil bust to the 1986 Tax Reform Act, though you could argue that unsound real estate lending was going to catch up to the S&L’s sooner or later).

More broadly than just S&L’s, that to me is one of the bigger problems with journalist coverage in general. Journalists by nature are opposed to Hanlon’s razor – “Never attribute to malice that which is adequately explained by stupidity” – because malice is a far more interesting story than stupidity. That becomes a big problem in the coverage of something like the S&L crisis, because the specific instances of fraud get more coverage than the generalized incompetence, so the story ends up being that malice was the cause when it was really stupidity.

Posted by realist50 | Report as abusive

A simpler solution is to remember that the problem is not preventing banks from failing but preventing bank failures from breaking the economy. The simple way to do that is to use modern technology to offer public banking facilities for clearing and basic savings. Then banks can do what they do and go their merry way. 00416/a-modest-proposal-for-free-market- bank-reform

Posted by rootless_e | Report as abusive

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