With all eyes on Congress pending the first sightings of financial reform, strategic planners are missing the big story about the way the Administration and its regulators will redesign the largest U.S. financial institutions. Administrative change can often do wonders or wreak havoc within the boundaries of the law – or at least those policy-makers choose to acknowledge. Another case in point: for financial institutions hoping for less burdensome supervision and supervisors seeking a more streamlined way to ensure proper practice, a top-to-bottom review of U.S. supervisory-and-examination practice could lead to a lot of change without a bit of new law. Here’s how, along with a critical point: nothing I’m suggesting is designed to lead to “light-touch” or “principles-based” regulation. We know all too well from the hard lesson of the crisis that neither of these works. What I’ve in mind is “accurate-aim” supervision – that is, supervision that reliably and quickly obliterates its target without collateral damage.
Let me first reassure my regulatory friends (not to mention clients) that I know they have made changes since the crisis due to findings that the agencies then were slow to act or perhaps even captive to the industry. However, most of these changes built out new divisions to implement new rules rather than restructuring the fundamental way banks are or are not found to be safe and sound beyond throwing the gigantic post-crisis rulebook at them.
What do I mean by “safe and sound” beyond simple repetition of this regulatory mantra? Safety is straightforward – no threat to the deposit-insurance system, undue calls on the FRB, or challenges to financial stability. “Soundness” is another matter. As I noted some years ago, soundness means a bank that does no damage to its constituent and consumer interests and has a resilient franchise as measured by the market. A bank can be totally, totally safe, but profoundly unsound if its market capitalization tells you it’s doomed to fade away. Safety by regulatory lights then leads to unsoundness first in the market and then right back in the regulators’ laps. Effective supervision must thus weigh the benefit of safety against the cost of any damage done to soundness.
Immune from statutory cost-benefit analyses, the banking agencies do not consider their actions in this light. Instead, they measure supervisory costs in terms of assessment or taxpayer dollars and benefits in terms of how many exams are done and how few banks fail. Both of these measures are faulty, but even their limited value hasn’t been realized. After hundreds of banks failed or would have failed without taxpayer support, the supervision-and-examination engine chugs on, fueled by higher assessments without any guarantee that banks are in fact not only safe as measured by all the new rules, but also safe against emerging risks and sound enough to sustain long-term franchise viability.
What would work better in terms of identifying the marginal benefits of costly supervisory standards atop all the new rules? I’ve some ideas, but the only way to know would be for the federal agencies to commission a ground-zero study akin to the one initiated earlier this week by the European Supervisory Authority. It asked for comments on how the EU’s supervisory framework is working and what could be done better.
A few baseline questions the agencies have yet to asked themselves or been demanded of them by the industry include:
- Could new disclosures along the SEC’s proposed lines accomplish the market discipline the agencies seek through their stress tests? A recent FedFin report shows how this might be done.
- Would challenging CAMELS ratings make a difference, especially if final ones are disclosed? A new appellate decision allowed one small bank to challenge its CAMELS. Why not make that a go-to option and then ensure that regulators are held to account if CAMELS stray from the caravan. What about disclosing CAMELS in a timely fashion so that market discipline is enhanced along with regulatory accountability?
- How will agencies know if by-the-book examination correlates risk across the industry by requiring banks to meet standards set not by the market, but rather by the agencies’ own rulemakings?
- How will agencies know when to stop issuing one after another corrective demand with no teeth and proceed to meaningful sanctions so that bad doesn’t turn worse? In my work as an expert witness, I’ve been shocked by the details of how much the agencies knew about banks along the way to the dumpster and how little was done to salvage the banks.
- Whatever happened to plans to revise prompt corrective action and implement the Dodd-Frank early-remediation standards? Congress keeps mandating these threshold-triggered interventions, but the agencies seem very reluctant to use them. Why? Is it the thresholds or the agencies that require remedy?
- What metrics meaningfully judge supervisory acumen? CAMELS might, but they don’t because they are secret. Do we just have to wait for banks to fail or their holding companies to be acquired in desperation deals? If not, what would work to hold both bankers and regulators accountable?
Given the paradigm-shifting potential of the next round of regulatory-agency appointees, now’s the time to ask these questions. Unless the industry is happy with the supervision-and examination framework – and it certainly isn’t – and supervisors are comfortable that they’ve got the paradigm just right – and they shouldn’t be – this is an ideal time to stress test supervisory protocols and make them fit for purpose. They’ll be sorely needed, perhaps sooner than we think.