As we noted last week, the Fed decided to issue some post-Archegos guidance telling big banks to watch their counterparty credit-risk exposures. As a banker with all too much experience dodging risk bullets told me, this guidance followed lots of prior guidance saying the same thing after each big boo-boo – think Long-Term Capital Management more than two decades ago and follow the trail of Fed statements thereafter. Each time, the Fed looks stern and banks say they’re sorry but soon go back to following the money, not the risk. And, over and over, examiners fail to notice anything amiss until the amount of realized risk is impossible to ignore. Interestingly, the Bank of England acted with the Fed but with far more force. Unlike the Fed’s renewed “you better watch out” guidance, the BoE demanded an immediate review of prime-brokering, reports back to regulators, and senior-management pay cuts if flaws go unrepaired. Thus, unlike the Fed, the Bank of England’s response to costly and thoroughly avoidable lapses has teeth. Whether the British then bite anyone is another question – the record is not replete with supervisory success – but the difference should nonetheless be instructive to the Fed’s next supervisory vice chair.
This difference is just like that between telling a child that she’ll be sorry next time and ensuring that the kid immediately knows that bad actions have tangible, actual consequences. One doesn’t have to beat the kid silly – indeed, of course one more than shouldn’t. But, vague injunctions to do better from a parent known to be more interested in watching the game are sure to lead to repeat instances of even worse behavior and then to parental temptations to so over-correct the child as to stifle the creativity that enhances competitiveness.
So it is with both bankers and examiners. In the absence of the habit of good behavior, banks will follow the money after the last scolding has worn off. And, where there’s a new issue of interest to an examiner’s overlords, the examiner will turn to that, forgetting what came before no matter what’s in the exam manual.
The appeal of the BoE’s approach versus that of the Fed is that it’s immediate, requires action, demands accountability, and warns that it will come with cost to those with the biggest impact on the incentives that drive those beneath them to improve internal controls. As the aforesaid banker said, yet another top-down call to take a look is wholly ineffectual unless the look is thorough, the results are known, and risks are quickly remediated.
I’ve read far more supervisory guidance than I care to think about and seen all too many do-over debacles. The striking thing about those that don’t turn systemic is how often the exact same banks are the ones who turn out to have laundered money for one or another mob, failed to sanction a senior officer’s conflicts, and looked the other way when big fees came ahead of far more costly risk. Each of these banks doubtless had someone reading the latest guidance telling everyone not to do what they did and yet each of these banks, sometimes joined by those they tempted, managed to find new ways to do still worse. More guidance or even new rules aren’t the answer; the answer lies in immediate, painful, costly, and embarrassing enforcement actions that cost senior management and directors in their pockets and among those whose respect they seek.