Bank Watchdogs Snooze Before the Biggest Heists: Caroline Baum

Bank Watchdogs Snooze Before the Biggest Heists: Caroline Baum

Commentary by Caroline Baum

March 30 (Bloomberg) -- The U.S. Treasury and Federal Reserve are seeking enhanced authority to regulate and supervise a broad array of financial institutions.

Having missed the last 216 crises -- including the savings & loan crisis, the Latin American debt crisis and the current thank-God-it’s-contained-to-subprime crisis -- regulators, operating under a new framework, are almost certain to identify No. 217 before it blows up the entire financial system.

Treasury Secretary Tim Geithner has been rolling out the new regulatory framework to Congress, which can’t let go of the damage from the old one. That’s one good reason lawmakers should proceed slowly. Public outrage doesn’t yield sound legislation.

Geithner wants to ensure that the financial system is strong enough to sustain the collapse of a large institution; that large institutions hold more capital; that if all else fails, the government has the authority to seize and resolve teetering firms, or provide financial assistance.

The first counter argument to the need for a new regulatory structure is that the structure was in place; the regulators failed to use it.

The second argument has to do with human nature. We can imbue a regulator with broader powers to oversee large hedge funds, private-equity firms and insurance companies. We can require these entities to register with the Securities and Exchange Commission. We can shift the trading of over-the-counter derivatives, such as credit default swaps, to an exchange. And we can improve oversight, raise capital requirements and reduce their allowable leverage.

Human Nature

But none of these initiatives addresses the question of what constitutes “too big to fail.” Some regulator, a human being, will still have to make a determination whether a financial institution poses a “systemic risk” (clarification, please) and a decision on the advisability of seizing it. It would be nice if we had a guidebook.

Bear Stearns was deemed to big to fail. Ditto Fannie Mae and Freddie Mac. Lehman Brothers didn’t pass muster. American International Group made the cut.

Along the way TBTF morphed into “too interconnected to fail.” (Does a medium-sized, interconnected institution qualify? How about large and not interconnected?)

Last year, then-Treasury Secretary Hank Paulson wanted to consolidate what he said was an outdated, overlapping patchwork regulatory system -- consisting of the Fed, Comptroller of the Currency, Federal Deposit Insurance Corp., state banking commissioners, Office of Thrift Supervision, SEC, Commodity Futures Trading Commission -- into a centralized market-stability regulator. With the current fragmented system, banks’ excessive risk-taking and off-balance-sheet shenanigans somehow fell through the cracks, Paulson claimed.

In Residence

That claim rings hollow. If we had a single, centralized regulator at a time when the financial system threatened to implode, Treasury would have blamed a cumbersome, bureaucratic regulator for lacking the mobility and flexibility to address the problem.

The Office of the Comptroller of the Currency, which oversees all national banks, has some 50 to 60 designated regulators at the largest banks at all times. They practically live there.

Yet Citigroup, which has been reporting huge losses for the last five quarters, had to come begging for a third round of government support last month. You’d think the regulators would have gotten wind of the problems at the water cooler!

New and Improved

The idea that a new regulator “will be able to make a judgment of what’s too risky and what’s not is a joke,” says Allan Meltzer, professor of political economy at Pittsburgh’s Carnegie Mellon University and a Fed historian. “Volcker learned about Continental Illinois on a fishing trip from the CEO,” he says, referring to former Fed Chairman Paul Volcker and the 1984 bailout of the large Chicago bank.

Meltzer says the solution is to give bankers an incentive to make better judgments: “Tell them, you fail,” he says.

Or, if bigness carries a cost -- if banks have to hold more reserves -- they’ll be less inclined to gorge themselves.

In the Q&A following congressional testimony last month, Fed Chairman Ben Bernanke said the outcome of stress-tests on banks “is not going to be fail or pass.” Instead, it will be a numerical value: how much capital banks need to hold.

In the 1920s, banks held 20 percent capital-to-loan ratios, according to Meltzer. “In the 1920s, banks would put ‘capital in surplus’ signs in the window. After the 1930s, the signs said, ‘FDIC insured.’”

Failure Option?

And therein lies the problem, according to some economists. Deposit insurance, TBTF and other parts of the financial safety net may preclude bank runs, but they provide perverse incentives to banks to acquire risky assets without an adequate capital cushion.

Much of the financial safety net was put in place during the Great Depression. The rest -- TBTF -- has been conveyed through body language and behavior over the decades.

Nowhere in Geithner’s multi-faceted regulatory plan is there anything to disabuse financial institutions of the notion that TBTF is alive and well. In not allowing banks to fail, the government shifts the costs onto the public, Meltzer says. “They forget their job is to protect us from the banks, not to protect the banks.”