History repeats itself, financial-regulation edition

By Felix Salmon
July 10, 2013

Here’s a quick and dirty way of judging the quality of your country’s financial regulation: to what extent do you create and impose tougher-than-international standards?

By their nature, international standards are the lowest-common-denominator. Individual countries can and should extend them and create their own rules; when those rules turn out to work well, sometimes the international community will start adopting them more broadly.

Historically, the US has a mixed record on this front. It did a good job of beefing up the fatally flawed Basel II regulations, largely because of pressure from small community banks, which weren’t sophisticated enough to lose billions of dollars on derivatives, and which didn’t want the big banks having an unfair advantage over them. As a result, the FDIC essentially kept the simpler and stronger Basel I rules in place — which turned out, in hindsight, to be a very good idea.

On the other hand, when CFTC head Brooksley Born tried to impose some sensible derivatives regulation back in the late ’90s, Treasury and the Fed lost no time in slapping her down — and kicking her out. Her ideas, they said, raised “important public policy issues that should be dealt with by the entire regulatory community” — which, of course, turned out to be code for “we’re going to do absolutely nothing about any of this”. The SEC was equally opposed, saying that it didn’t want to do anything which would risk the status of America’s banks as “the global leaders in derivatives technology and development”.

Right now, history is repeating itself. On the positive side of things, the FDIC is insisting on beefing up Basel III, specifically its non-binding 3% leverage ratio. The US is looking to double that number, in a move which might force the eight biggest banks to raise another $89 billion in capital. It’s a very good idea, since America’s banks in particular seem to be extremely good at holding roughly zero capital against their mind-bogglingly enormous derivatives books.

On the negative side of things, however, we once again have Treasury and the SEC vs the CFTC: this time, as Shahien Nasiripour predicted, Treasury secretary Jack Lew and SEC chair Mary Jo White are forcing used “a tense meeting last week” to persuade CFTC chairman Gary Gensler to delay crucial new derivatives regulations. The stated reason? “Complaints from policy makers and others about a lack of coordination between U.S. and foreign governments”. On top of that, the White House is rewarding Gensler’s zeal by refusing to nominate him for another term.

Overall, I’d say the US is not doing a great job on the regulatory front. Dodd-Frank created a lot of noise, but ultimately was much less important than Basel III; what’s more, the banks are now driving the rule-making process so as to effectively neuter most of it. Meanwhile, in lots of other corners of the regulatory universe, you can see the forces of capture at work: one prime example is the way in which the FHFA — the regulator for Fannie Mae and Freddie Mac — has hired a prominent insurance-industry lobbyist to help it regulate the very insurers he not only used to represent, but still represents.

The fact is that regulation is one of those things that doesn’t have a natural political constituency: rich banks are good at lobbying against it, while there are no effective or well-resourced lobbyists on the other side. So while it’s worth celebrating the occasional piece of capital-related good news, the long-term outlook remains exactly the same as it did in 1998: at the margin, the administration — no matter whether it’s Republican or Democrat — is going to help the financial industry be “internationally competitive”. Which is another way of saying domestically dangerous.

4 comments so far

I would recommend thinking more about public choice theory, and in particular William Niskanen’s budget-maximizing model of government agencies*, before making a blanket statement such as “the fact is that regulation is one of those things that doesn’t have a natural political constituency.”

I concur that there are no guarantees that this regulation will take an optimal or even useful form – for example, the combination of career regulators, industry lobbying, and the job movement of former regulators to the regulated industry creates incentives for regulation that entrenches incumbents and is overly complex rather than focusing on enhancing public welfare. (Regarding complexity, regulators are boosting the employment opportunities for themselves in both government and the private sector.)

More broadly, and at a political rather than bureaucratic level, a politician making promises to be tough on the banks is a vote getter, especially since 2008. It’s actually one of those relatively rare issues – immigration is another – where support and opposition cuts across party lines. The Brown-Vitter bill on bank capital is an example.

* Distilled to a 1 sentence summary, the natural incentive for the civil servants running a government agency is to maximize the budget and regulatory authority of that agency.

Posted by realist50 | Report as abusive

One reason that “America’s banks in particular seem to be extremely good at holding roughly zero capital against their mind-bogglingly enormous derivatives books” is that many people buy in to the erroneous notion that risk is a function of net exposure as opposed to gross exposure. But large gross exposures set up the possibility of a “run”, as happened at Bear and at Lehman.
http://bettingthebusiness.com/2013/02/22  /hiding-risk-by-netting-exposures/

Posted by JohnParsons | Report as abusive

This argument is INSANE. What happened to sovereignty? Why do all countries have to do the same thing? What if the ‘international standards’ are just wrong for your country? Isn’t everybody copying each other also known in the ant kingdom as the march of death1?

Country #1: funds large military expenditure, fails on delivering healthcare and education targets, taxes it’s people @ 40% (UK, USA, Canada etc)

Country #2: funds no military, focuses on delivering key social services, taxes it’s people @ 12%.

The political class of Country #1, poo-poo Country #2 for not following ‘international standards’.

Try to think for yourself instead of copying the international mediocrity.

Posted by KarloPetov | Report as abusive

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