Was the sometimes gruesome WaMU hearing this week designed principally to put OTS’s scalp on a tomahawk? We don’t think so, in part because OTS is already totally toast. Instead, we see it as part of a push not only to pass the reform legislation in as tough a form as Democrats can get, but also to rewrite a lot of the rules under current law. We’ve seen Sen. Levin do this before, using his formidable investigative staff to embarrass the living daylights out of the bank regulators. In response, they rush to act on revelations to show they are, in fact, ahead of whatever curve confronts them. So, what could the remaining regulators do to counter the devastating evidence and how much will it hurt?

A lot of the substantive testimony Friday focused on how OTS viewed its charges as “constituents.” We also recall the even more egregious term of “client” OTS threw around in its heyday. This of course derived from OTS’s dependence on its assessment revenue and its increasing reliance on a few big thrifts as the S&L industry contracted. OTS did a number on Countrywide to persuade it to convert from a national bank to a thrift, leading to still-secret protests from the OCC and the FRB as they found themselves powerless to block a clear case of charter arbitrage in the run-up to the crisis. After it, the regulators have agreed among themselves to poach no more and, just in case, the legislation bars them from doing so.

However, even if charter conversion is effectively stymied going forward, advantageous charter selection remains possible under both current law and the pending legislation. In the wake of recent, painful history, though, we expect a lot more up-front scrutiny of who is choosing which regulator why during mergers, acquisitions or start-ups. These choices aren’t “conversions,” but they are carefully crafted by any strategic institution to build the best deal it can. In future, that will be harder because any regulator that thinks it’s getting short shrift will howl. Given the continued scope for federal preemption provided in the bill, this will continue the push for national charters.

Will the OCC then turn comfy? We don’t think so. One of the less-publicized aspects of the Levin hearing was clear in the testimony from the Inspectors General (IGs). They told the Permanent Investigations Subcommittee that none of the regulators – not just OTS – said boo to any of the big banks before the crisis. This is all too evident from the record, which shows enforcement actions filed only a day or two before institutions hit the fan and, often, not even then at the very biggest, troubled firms like Citigroup. This has been an under-current in the debate to date, but we think it’s going to get a lot louder as investigations advance and embarrassment ensues.

But, we don’t think the casualties from the hearings will end with just a few big institutions forced to endure higher legal and reputational risk. Chairman Bair’s testimony suggests that the rough going-over she got will also affect U.S. implementation of the Basel capital and liquidity rules.

In her statement, Ms. Bair opens with withering criticism of Basel II, arguing that it would have dropped mortgage risk-based capital by eighty percent or so. At the time, this wasn’t good enough for some big mortgage banks – we distinctly recall reading a letter from WaMU that argued that mortgage capital should in fact be zero because no mortgage ever posed credit risk. That was, to say the least, wrong, but the Basel rules Ms. Bair attacks weren’t much better.

The reason for this isn’t, though, the lack of a leverage standard. Ms. Bair’s testimony suggests that this is why the Basel rules got mortgages so wrong, but we don’t think so. It was, in fact, that the Basel II rules as initially drafted didn’t stress test the risk-based capital conclusions. Instead, the rules blew gently on the capital charge, judged it against the past five years and then pronounced all secure. Of course, doing a five-year stress test on U.S. residential mortgages in 2006 meant that the market was judged at the height of the boom. That is procyclicality writ large, as we’ve now learned all too well.

We’ll see where the U.S. comes out after the Basel process advances. But, if we read the FDIC Chairman right, she’s going to be a strong, loud voice for the toughest possible rules as quickly as possible. That Basel II got a lot wrong is right. That Basel III should be a pile-up isn’t, though, the correct conclusion to draw from this costly lesson.

 

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