The Regulatory Triangle (Not to Be Confused With the Bermuda Triangle)

We’re about to get a major dose of regulatory overhaul and the first conclusion we can all make from the drips of details on the overhaul already public is that the reform will fall far short of what is necessary.

Lawrence Summers and Timothy Geithner today presented in The Washington Post their five-point guidelines for regulatory reform. There was nothing inherently wrong with their five points. Consider No. 5: “We live in a globalized world, and the actions we take here at home — no matter how smart and sound — will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.” That is true. The only problem is that the Obama administration will apparently leave most of the existing structure of the current regulatory infrastructure in place. Not exactly a global example to follow.

Currently, five regulatory agencies policy banking institutions, not including the 12 regional Federal Reserve Banks that carry out the Fed’s regulatory wishes in their districts. We’ve heard a lot of talk recently about the possibility that one regulator could supplant these five, and I am actually not in favor of such an approach. Rather, there should be three regulatory bodies and the focus of each should be different than it is today.

Four Points We Can Agree On

Before I can share my plan, there are some basic principles we have to agree on. First, savings banks are not different from commercial banks. Many years ago, savings banks and commercial banks were different organizations, mainly because thrifts concentrated their risk in mortgages. Even the few thrifts remaining today employ a hodgepodge of strategies and products today, just like commercial banks. I would argue that we should rid ourselves of the FSB charter altogether – but that is for another blog.

Second, monitoring systemic risk is, in fact, different from monitoring whether a particular institution is at risk. As the administration has indicated, an agency needs to be guardian of the forest and not just the trees to make sure the whole house of banking cards doesn’t collapse under the weight of systemic risk. We should define what that means. When I refer to “systemic risk” I refer to the dynamic whereby one institution, because its risk burden has grown so substantial, must be rescued by the government because the institution’s failure will cause so many knock-on failures of other firms. It’s mass economic failure by financial nuclear implosion. From a practical standpoint, there is a big difference between stress-testing whether a particular bank will fail vs. modeling the extent to which that particular bank’s possible failure will cripple the overall economy. There are many different inputs for each modeling effort.

Three, it is a worthwhile endeavor to eliminate the shopping around for regulators by banks. The very notion implies varying degrees of enforcement – and there can be no variance in regulatory strength, period.

Four, along the lines of No. 3, no bank can be allowed to “fall between the cracks,” and operate without strictures and adequate monitoring. It should be noted that the regulators did not, in fact, allow one particular bank to fail because of faulty oversight. Rather, the regulators whiffed on all banks, by assuming that the banks were booking a nominal quantum of risk when in fact it was anything but nominal.

Here’s What to Do

With that in mind, we can consider the current regulatory landscape and what to do about it. Here’s my plan, in a nutshell: After shutting down the Office of Thrift Supervision and relocating the National Credit Union Administration within the Office of the Comptroller of the Currency, the remaining three regulators – the OCC, the Federal Reserve Board, and the Federal Deposit Insurance Corporation – each would have jurisdiction over every financial institution, but for different reasons. Then, instead of this ridiculous new government office to monitor consumer financial products, the Federal Trade Commission would continue to do what it has always done, namely monitor financial products, perhaps with additional funding, guidance and authority.

How would this triangle of the OCC, Fed and FDIC work? Each of these organizations would monitor financial institutions from three fundamentally different angles. The OCC has the most straightforward mandate: charter, regulate, and supervise US and foreign banks. The OCC is looking for bread-and-butter safety and soundness at banks – and that is necessary. One regulator should be looking at financial institutions without anything but their safety and soundness in mind.

Unlike the Fed and the FDIC, the Fed should monitor systemic risk, as the Obama administration has suggested. The Fed is already looking at macroeconomic issues; adding macro risk monitoring makes sense. Theoretically, the Fed should monitor each and every financial institution in the US for concentrations of systemic risk (of course, the Fed won’t bother itself with banks outside, say, the 30 largest in the US). The FDIC should – and does – monitor financial institutions with another concern in mind: for potential losses to its Deposit Insurance Fund. Monitoring financial institutions for deposit loss differs from the OCC’s safety-and-soundness oversight I mentioned above. When the FDIC needs to replenish its Deposit Insurance Fund, it must get funds from either the industry or Congress. Neither is a particularly fun prospect, which is why the FDIC is the most entrepreneurial of the regulators.

The FDIC actually maintains internal incentives that end up benefiting the financial performance of banks, rather than simply maintaining their safety and soundness. In 2007, for example, before the credit crisis truly took hold, the FDIC had a program aimed at “reducing the regulatory burden on the banking industry while maintaining appropriate consumer protection and safety and soundness safeguards.” Granted, at the same time, the FDIC was seeking to bone up enterprise risk management at banks, but the truth was a lesser “regulatory burden” would have helped the average bank lower its compliance costs and presumably improve its financial performance – which is good for the FDIC, because financially sound banks protect its Deposit Insurance Fund. Just the fact that the FDIC has internal performance targets says something about the agency’s disposition.

Staying Aggressive

Still, the FDIC surely aggressively monitors the banks under its jurisdiction, and I would expect that to continue under this new framework. But the Deposit Insurance Fund colors the FDIC’s eyeglasses. Those eyeglasses are different from those that will be worn by the Fed and the OCC. Each will be looking into the heart of a bank for a different deficiency: for systemic risk, for safety and soundness, or for losses to the Deposit Insurance Fund. Because each deficiency is somewhat reliant on the other, this triangular regulatory model will create a natural interdependence among each agency – which will eliminate some of the turf wars we have seen recently (ahem, Mr. Dugan).

The FDIC should still manage bank-seizure Fridays. It does a good job managing banks in receivership, and there is no need to create a new resolution infrastructure. That’s really the theme of this entire thesis: fix what is in place today, without skimping on the degree of change needed. Surely, banks today are vastly more complex since these regulatory agencies were formed. That is why resources need to be concentrated to address all the regulatory and supervisory nuances of a wide menu of financial products within the average banking institutions. A more refined regulatory structure will deliver.