Recent steps by the Congress and the Treasury, Federal Reserve Board, Comptroller of the Currency and the Federal Deposit Insurance Corp. suggest a welcome departure from the trend of one-size-fits-all rules — and a return to principles-based regulation anchored in regulatory common sense and sound financial judgment. This is not just about eliminating rules — it is about actually making regulation more effective and efficient.
Financial regulation has always been a dynamic process coexisting in a complex financial ecosystem of variables that neither Congress nor regulators can control. These variables include evolving markets, financial products, competition, developing technologies and accounting principles. When one of these factors changes, the others are often impacted, triggering unanticipated, reactive financial adjustments by institutions and markets. This chain reaction increases the possibility of unintended economic consequences and economic distress. As such, the more effective and efficient that regulation is, the better financial institutions are able to serve the needs of their constituents — and the less likely it will be that unintended consequences will arise. In this regard, effectiveness equates to maximizing the safety and soundness of financial institutions. Efficiency requires finding the straight line between that safety and soundness and the least costly oversight. Principles-based regulation relies first on establishing and enforcing sound regulatory policies, and then imposing static rules only when necessary.
Congress has taken a significant step in this direction with its enactment of the Economic Growth, Regulatory Relief, and Consumer Protection Act. The law attempts to recalibrate regulation to reality by raising the threshold for bank holding companies to be considered systemically important, creating a capital “off-ramp” for community banks based on their leverage and risk profile, establishing higher thresholds for application of the Volcker Rule, easing risk weighting for high volatility commercial real estate exposures and reducing periodic reporting requirements. Financial regulators have also been busy outlining steps to employ a more common-sense approach to regulation. In June 2018, the five Volcker agencies issued a proposed revision of the Volcker Regulations aimed at reducing what the agencies consider to be unwarranted compliance burdens. And the Treasury Department recently made a series of practical recommendations to improve the designation of systemically important financial institutions, including the weighing of the expected benefits and costs of such designation.
The Federal Reserve Board is focused on the development of a more efficient capital requirements. Large institutions are currently subject to more than two dozen capital and liquidity requirements, including Basel III, stress tests, comprehensive capital analysis and reviews, counterparty default rules, global market shock components, total loss-absorbing capacity standards, counter-cyclical and capital conservation buffers, primary and supplemental leverage ratios and standard and advanced risk-weighting.
This regulatory spaghetti of overlapping quantitative and qualitative U.S. and international financial standards often creates internally inconsistent and contradictory results which may encourage low-risk institutions to take on more risk because they are being surcharged for higher risks they don’t have on the balance sheet.
The Fed has proposed new and more customized capital and stress test rules that would potentially reduce the total number of capital requirements from twenty-four to fourteen. This change would simplify and customize the path to capital adequacy, not eliminate or reduce the importance of achieving capital adequacy.
The OCC and FDIC are also reevaluating a host of regulations and policies to improve regulation and make it more practical. For example, the OCC is seeking to modernize the Community Reinvestment Act to more effectively and efficiently distribute dollars throughout banking communities which have been unalterably redefined by the internet and technology. If it is successful, this should get more financial services and lendable dollars to places where it is needed most.
These are all great first steps to make regulation a better and more efficient guarantor of safety and soundness. But there is much more rehabilitation that can be achieved to correct the over-reliance on fixed rules and ratios that has developed over the last few decades. The quality of regulation is not determined by the number of rules and restrictions that apply. Commonsense principles-based regulation is the more effective way to maximize safety and soundness, lessen the chances of future financial crises and provide customers with the best financial products at the lowest cost.
While many argue that increased regulation has improved institutional and systemic safety and soundness, there is scant empirical proof of that — and there’s no analysis, even if true, at what economic cost. At the very least, we should know the answers to those questions before regulatory policies are created and implemented for the largest and most significant financial system in the world. The challenge before Congress and the regulators is finding the right balance and being able to achieve it.
