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Rethinking Banking’s Regulatory Framework

Regulators demand banking practices that are static and standardized, which hurts innovation, competition, expansion, and change.

By Jeremy Newell

In this issue of Banking Perspectives, we take stock of the post-crisis bank regulatory framework, with contributions from experts who identify aspects of the framework that merit rethinking. This fresh look at the post-crisis “big picture” seems appropriate, not only because nearly a decade has passed since the worst of the financial crisis abated, but also because of the rapid and fragmented way that picture was painted in the first place. Indeed, it is easy to lose sight of the fact that the post-crisis regulatory framework was not developed in any holistic, systematic way, but rather is an amalgamation of numerous new standards and policies that were individually designed through independent processes, by a wide range of domestic and international regulators, without the benefit of any comprehensive understanding of their collective and cumulative effects.

The capital reforms undertaken by the Basel Committee are perhaps the best example of this phenomenon. Since 2009, the Basel Committee has proposed or finalized a large number of  different changes to its capital framework, some of which have established new minimum ratios, some of which have redefined that ratio’s numerator (i.e., the definitions of capital), and many of which have redefined the many subcomponents of that ratio’s denominator (e.g., the separate risk-weighting frameworks for credit risk, market risk, operational risk, etc.). U.S. regulators have generally then taken those standards they negotiated internationally and made them more stringent (which they refer to as “gold plating”) for U.S. banks. All these changes have been pursued separately and iteratively, and the result is a capital adequacy regime that is not coherent in any real sense, but is simply the sum of numerous parts that have each been designed and calibrated in their own vacuum.

That conclusion is not intended to be overly critical – following the most pronounced financial crisis in nearly a century, the regulatory community was rightly on a war footing, and the rapid issuance of new regulatory standards was consistent with the urgency of the task of assuring the resilience of the banking system. But – especially now that such resilience undoubtedly is in place – it does seem fair to ask what all of these new regulatory parts add up to, and whether that sum is as coherent and sensible as it could be.

It is precisely this type of “big picture” assessment that is undertaken by this issue’s authors. H. Rodgin Cohen begins this journey by revisiting former New York Fed President Gerald Corrigan’s famous argument regarding the “specialness” of banks as the basis for bank regulation, and highlights the extent to which enforcement of banking regulation seems to have become untethered to the core safety and soundness objective that has traditionally guided it. Professors Julie Andersen Hill and Hal Scott focus on procedural problems in the existing regulatory framework – with Prof. Hill highlighting the ineffectiveness of the existing process by which material supervisory decisions may be reviewed and appealed, and Prof. Scott demonstrating how the Federal Reserve’s stress-testing exercise may run afoul of both the letter and spirit of the Administrative Procedure Act. The Heritage Foundation’s Norbert Michel takes on the broader objectives of bank regulation and explores the link between an expanded federal safety net for banks and greater (and more intrusive) bank regulation – and argues for rollback of both. And finally, Columbia University economist Charles Calomiris assesses the direction of financial regulation through the prism of two regulatory drivers of financial instability – government policies to protect bank losses and encourage real estate lending – and concludes their impact is important and growing.

Regulators and supervisors have come to effectively embrace a centrally planned banking system where it is they who do all the planning and define the criteria for compliance.

On a related front, my colleague Greg Baer follows up with some answers to the questions raised in our recent article, “How Supervision Has Lost Its Way.” Increasingly, we hear from banks of all sizes that problems with the generally secret supervisory process are just as significant for their ability to serve their customers as problems with the public regulatory process. We continue our efforts to explain what is going on and how it could be improved.

The subject matter of these articles is diverse, but they all share one trait: a willingness to rethink where the post-crisis reform process has landed. It is our hope that these articles provide ample opportunity for thought as to how to continue to improve and adapt our framework of bank regulation.

To this list of things worth “rethinking,” I would add an observation of my own, which is the emergence of  two mutually reinforcing and pernicious trends that cut across nearly all aspects of the new regulatory and supervisory paradigm: a regulatory demand for banking practices that are both standardized and static. Or, to put it more provocatively, regulators and supervisors have come to effectively embrace a centrally planned banking system, where it is they who do all the planning and define the criteria for compliance.

The first of these trends – the overwhelming reliance on standardization of banking practices through regulation – is easier to identify. It is most pronounced in the new framework of “balance sheet” regulation, where the complex and granular nature of new capital and liquidity rules has resulted in an unprecedented level of regulatory prescription around how nearly every aspect of a bank balance sheet should be constructed and managed. That regulatory prescription certainly has its benefits – chief among them, a vastly more resilient profile across the banking industry. But it also gives rise to a world in which bank balance sheets must, as a function of that regulatory nanoengineering, be organized and managed in an increasingly homogeneous and standardized way, with little room to stray from the mostly one-size-fits-all model enshrined in these new rules.

A similar trend toward standardization is observable across many other post-crisis rules: Resolution planning at every bank must meet a single, detailed set of regulatory preferences; leveraged loans must be underwritten, originated, and managed according to practices specified by regulators; all risk-taking must be managed and governed according to the Office of the Comptroller of the Currency’s detailed “three lines of defense” model; vendors must be vetted, approved, and managed according the agencies’ latest preferences; bank directors must adhere to a hundred pages of precise instructions from regulators on how they must perform their board duties. (On this last point, a recent Federal Reserve proposal gives reason for hope, at least at the holding company level.) The list is seemingly endless.

And this is to say nothing of all the additional supervisory prescriptions being written by examiners and supervisory policy staff outside of public view. As any banker can now attest, it has become depressingly common for bank supervisors to effectively invent their own standards for how banks should operate, in a process that is not transparent, let alone subject to public comment, and demand conformance to those expectations under penalty of examiner criticism or adverse action. As Greg Baer and I have detailed previously in this journal, the rise of such extralegal (and therefore illegal) banking rules is one of the great untold stories of post-crisis regulatory reform.

None of this is to say that the growing standardization of banking practices by regulatory fiat is without some social benefit. But it does mean that, as an overwhelming trend across the post-crisis regime, it likely has some social costs, too. Unfortunately, these social costs have not been much acknowledged by policymakers, let alone analyzed. As with any attempt at central planning, chief among them are the very real potential costs to innovation and efficiency that would seem to come with the regulatory “crowding out” of what ideally ought to be a rich, varied, and competitive marketplace of different ideas and perspectives on how best to run a bank. Also among them is the not immaterial risk that the regulators’ new one-size-fits-all model of bank management and operation may be revealed over time to include one or more deep flaws that endangers the core lending and other functions that banks perform, the stability of our financial system, or both.

The current supervisory dynamic operates as a substantial barrier to innovation, expansion, or change in the banking industry.

The trend toward regulatory standardization in banking is complemented and reinforced by a similarly pronounced regulatory preference for stasis in banking. Simply put, the current supervisory dynamic operates as a substantial barrier to innovation, expansion, or change in the banking industry. On the surface, this trend is less readily apparent than the push for standardization, as it is largely the product of the opaque supervisory environment rather than a transparent regulatory framework. But beneath that surface, the supervisory process has come to impose significant constraints on banks’ ability to make strategic acquisitions, open new branches, or develop and offer new products or services and otherwise meet the growing financial needs of their customers.

In some cases, these constraints are formal – for example, in 2014 the Federal Reserve issued a “supervisory letter,” referred to as SR 14-02, that identified a range of supervisory concerns that as a matter of Federal Reserve practice (as opposed to actual law or regulation) would, if present at a bank, preclude any acquisition or expansion by that bank. There is no requirement therein that the supervisory concern actually relate to, let alone reflect negatively upon, the proposed area of expansion – thus, for example, supervisory scrutiny of anti-money laundering practices in one’s wealth management business could well operate as a total bar on opening a new branch in an underserved community. The net result is a broad supervisory embrace of what might be called the Christmas-tree-lights theory of bank management – if one thing is wrong, then everything must be wrong. And therefore if one thing is wrong somewhere in a bank, then nothing can change anywhere in that bank.

The practical implications of that supervisory approach are predictable and significant – an enormous and systematic bias against innovation and change, both in individual banks and across the industry. Again, this is not to argue against robust and meaningful supervisory checks on banks’ ability to expand and grow – certainly, supervisors can and should be able to prohibit supervised institutions from undertaking acquisitions or activities where they lack the managerial expertise or other resources to do so safely and soundly.

But, ideally, such authority should be clearly articulated and vested in specific and accountable individuals. Unfortunately today’s supervisory dynamic seems quite far from that ideal – instead, it is increasingly the case that the number of individual supervisors that effectively possess a veto right on acquisitions or new activities across the entire supervised organization is not one or two but 10 or 20. We should not be surprised if a supervisory model that imposes such significant and diffuse obstacles to innovation and change should give rise to banking industry that is much less dynamic and adaptable than its customers would otherwise prefer and that international competitiveness demands.

About the Author:
Jeremy Newell is Executive Managing Director, Head of Regulatory Affairs, and General Counsel of The Clearing House Association. Newell has previously worked as counsel and policy advisor at WilmerHale, the Board of Governors of the Federal Reserve System, American Express, Natixis, and Sullivan & Cromwell. Newell received his J.D. from Yale Law School.