The Bank Regulatory System's a Nightmare, and It's Not Going to Change

WASHINGTON — Redesigning the financial regulatory system to make it simpler and more efficient is the kind of idea that policymakers tend to get wistful about.

Just last weekend, President Obama was asked whether the Dodd-Frank Act was too complex.

"Would I have greatly preferred a blank canvas in which to design financial regulations post-2008 and consolidated agencies and simplified oversight? Absolutely," he told The Economist. 

Obama's remarks followed those of former Sen. Chris Dodd, who last month listed the failure to streamline the regulatory agencies as his biggest regret about the landmark reform law that bears his name. The Connecticut Democrat tried to radically revise the system, initially proposing to strip the Federal Reserve Board and Federal Deposit Insurance Corp. of bank supervisory responsibilities and giving those to a super-powered national bank regulator.

It was a bold suggestion that, like similar proposals, is popular among a diverse range of interests including bank executives and many reform proponents.

"It might come back again at some point, now that people have thought a little longer about it," Dodd said.

Dodd is undoubtedly right that the idea is going to resurface, and probably often, for one simple reason: the current U.S. regulatory system makes no sense.

As former Comptroller of the Currency John D. Hawke Jr. was fond of pointing out, nobody in their right mind would design a system where four regulators share oversight of banks and thrifts, and in which two financial markets regulators and 50 state agencies can weigh in.

Rather than simplifying the system as Dodd or Obama wanted, Dodd-Frank arguably made the situation worse.

It eliminated the Office of Thrift Supervision, but created the Consumer Financial Protection Bureau, which has direct supervisory oversight of banks with more than $10 billion of assets and large nonbank institutions. The law also added the Office of Financial Research, which can request information from the largest banks, and the Financial Stability Oversight Council, an interagency collective that in its brief history has already clashed with the Securities and Exchange Commission over reform of money market mutual funds.

As a result, the calls to simplify the system have begun to bubble up again, even from the president.

But for all the attention to the issue, regulatory restructuring isn't going to happen anytime soon, if ever. Here's why:

1. Few Agree On Specifics
Saying you're in favor of regulatory restructuring is like being in favor of tax reform. Everyone likes the sound of it, but nobody can agree on what to do.

Dodd's proposal was the last serious restructuring plan on the table, and it died because a lot of people hated it. The small banks strenuously objected to the idea of taking the Fed or FDIC out of banking supervision, fearing a single, powerful agency would focus its attention on — and cater to — the largest institutions.

The agencies also fought back, by noting instances in which disagreement among the regulators helped delay a potentially harmful regulation. A recent example is Basel II, which would have allowed the largest banks to rely on internal calculations to determine risk-based capital requirements. If it had been in place before the financial crisis, banks would have had less capital at a time when they needed far more. The Fed favored Basel II, but the FDIC successfully fought off and delayed its implementation.

"You want to make sure you replace the current system with something better and not worse," said Sheila Bair, a former FDIC chairman and now a senior adviser at Pew Trusts. "The Dodd proposal - though that isn't what he intended — would have weakened regulation. It would have taken some of the strongest voices out of regulation."

There have been other proposals than Dodd's over the years. In 2008, then Treasury Secretary Henry Paulson unveiled a blueprint that called for just three regulators: a souped-up Fed to oversee bank holding companies, a safety-and-soundness agency to regulate subsidiaries and a "business-conduct" regulator to monitor conduct across all firms. That plan, issued late in President Bush's second term and coming just ahead of the worst of the financial crisis, never gained traction.

But regulatory reform proposals stretching all the way back to the 1930s have fared little better. To be sure, some changes have been made. The Federal Home Loan Bank Board became the OTS, which was later merged with the Office of the Comptroller of the Currency. The Office of Federal Housing Enterprise Oversight and Federal Housing Finance Board were merged in 2008 into the Federal Housing Finance Agency. But these steps fall far short of the massive streamlining that most supporters of regulatory restructuring are seeking.

2. Opponents Are Easier to Find than Supporters
The interesting thing about the various reform proposals is how much they are, at their core, an academic exercise. They start from scratch and try to re-envision the system as if it were being created today, without regard for political realities.

Paulson's blueprint was filled with these kinds of ideas, including merging the credit union and bank charters, an idea so toxic to credit union executives it had them effectively foaming at the mouth.

"When you move boxes, you get into major turf wars," said Wayne Abernathy, the executive vice president of financial institutions policy and regulatory affairs for the American Bankers Association. "You can get some changes, but the changes you get are almost never worth the capital spent to get them."

While it's easy to find people opposed to a reform proposal, it's far harder to find anyone in favor of it. Multiple administrations have witnessed their restructuring proposals wither and die as various players, including the industry, consumer groups and others, pick it apart.

Even a merger of the Commodity Futures Trading Commission and the SEC, an idea widely viewed as sensible, has struggled to find enough supporters that would overcome the constituencies arrayed against it. Among those opposed are many lawmakers, because the Agriculture committees in the House and Senate want to retain oversight of the CFTC.

"Getting congressional committees to give up their jurisdiction is almost impossible," said Jaret Seiberg, an analyst at Guggenheim Securities. "If you are on the Ag committee, you don't want to give up oversight of the CFTC. That's partly for funding reasons, partly for prestige reasons. The political hurdle that regulatory restructuring would have to cross is always going to be too big."

Ultimately, any restructuring plan would have to have a substantial cheerleading section to have a prayer in Congress - and that's very unlikely to happen.

"Even if there is broad public benefit to it, there are specialized constituencies that generally favor constructions that weaken, not strengthen, the process," said Bair. "You're not going to get any money or lobbying behind it just because it's good government."

3. Every System Has Its Flaws
The final nail in the coffin of regulatory restructuring is that it's just not apparent it would make any difference.

The primary problem with the current system is fairly easy to see: it's inefficient. It takes far too long for regulators to come to agreement and the more agencies involved, the worse that problem is. The Volcker Rule, which had to be approved by five regulators, took more than three years to complete.

Presumably having a single regulator would speed up the process. However, the drawback is that faster doesn't necessarily mean better. Indeed, there is something to be said for multiple jurisdictions tangling over a rule, because it forces a broader discussion of the issue, according to most observers.

"You mostly get benefits by bringing another perspective," Abernathy said. "From time to time it slows it down, but for every time it's slowed the process down, there are probably two or three or more times when there's been a real benefit of different set of eyes looking at the issue."

Another flaw of the current regulatory system is the fear that banks and other institutions can attempt to play agencies off of one another. The now defunct Washington Mutual, for example, appeared to have outsized influence over the OTS in part because that agency drew so much of its funding from exam fees paid by the massive thrift.

Yet single regulators also may run into similar problems. When Dodd's proposal was still being debated, small banks feared their priorities would perpetually take a back seat while a single agency focused most of its attention on the largest institutions.

And while the U.S. regulatory system has come under criticism for its handling of the crisis, other countries with a single regulator fared little better. Indeed, the United Kingdom opted to split up its single regulator, the Financial Service Authority, after the crisis, creating two agencies - the Prudential Regulation Authority and the Financial Conduct Authority.

"You need a few different cooks," Bair said. "If you have a monolithic regulator, it's like a dictatorship. If it's a benign regulator, that's great. But if it's not, you run into trouble. In a case like the U.K., a monolithic regulator did not perform."

Ultimately, the sheer political cost of restructuring combined with the lack of clear benefit from doing so ensures that it is likely to never happen.

"It's just not worth the political fight that would ensue," Seiberg said.