Can members of a mutual admiration club really tell each other the truth?

I refer to “The progress, pitfalls and persistent challenges of recent regulatory reform” by Sheila C. Bair, former FDIC Chair, and Ricardo R. Delfin, former Executive Director, Systemic Risk Council. It appears in “A force for good: how enlightened finance can restore faith in capitalism” edited by John G. Taft, 2015. 

I agree with many of the recommendations put forward, such as the need for less regulatory complexity, and of a system that could allow for the orderly liquidation of large complex financial institutions. 

But the authors also refer to “the Financial Stability Oversight Council (FSOC), an interagency body made up of the heads of the federal financial regulatory agencies, state regulatory representatives, an independent insurance representative and the head of the new Office of Financial Research. The FSCO is tasked with identifying potentially systemic risks…”

And here I must ask: Is FSCO structured in such a way as to be able to identify systemic risks arising from bad regulations?

Since the inception of the Basel Accord in 1988, the pillar of banking regulations has been credit-risk-weighted equity requirements for banks. These basically translate into offering banks better risk-adjusted returns on equity on what is perceived as safe, than on what is perceived as risky. By this the regulators approved to pay the managers of one of the societies most important retirement accounts, what is generated by means of bank credit, higher commissions for whatever returns coming from activities perceived as safe, or defined by regulators as safe, than from activities perceived as risky. That guarantees an excessive risk aversion that will lead to few jobs and very low retirement incomes for the whole of society.

And if that is not a monstrous systemic risk that has been embedded in current bank regulations what is? I doubt an FSCO, as just another member of the regulator’s mutual admiration club, can do anything about it.

But I might be wrong. Perhaps some “state regulatory representatives” will suddenly ask: Why on earth do our state chartered banks need to hold more equity when lending to our local SMEs and entrepreneurs than when lending to some distant borrowers?

On risk-taking, retirement accounts, and lousy bank regulations.

What would have happened with anyone’s retirement plan if, when a young professional and starting to save, his instructions would have included paying his investment manager much higher commissions on returns produced by safe investments, than on returns produced by riskier investments. 

There is no doubt that in such circumstances, his investment manager would have played it overly safe, and he, the beneficiary, would probably have had to retire on a very meager income.

But, by means of their credit-risk weighted equity requirements, which allow banks to earn much higher risk adjusted returns on their equity when lending to something “safe”, than when lending to something “risky”, the regulators are instructing the banks to act in precisely this way.

Whether we like it or not, banks have a very important role to play as investment managers for our economies. And the reason we taxpayers implicitly agree to support banks, is not for them to avoid risks, but to, with reasoned audacity, take intelligent risks on our behalf. 

And so, even if we have to pay banks high commissions, we need them to act much more like aggressive growth funds taking risks but looking to produce for us investors better returns; and for our economies sturdier growth; and for our young better good future employment opportunities.

So let's get these regulators out of our way!