Define the Role of the Regulators Clearly

Some thoughts on regulation as Congress takes up the issue in June after the Memorial Day recession. A major component of the build up to crisis was Washington D.C.’s implicit guarantee of protection for banks considered too big to fail. While not expressly stated, the general feeling on Wall Street was that, given the interconnected nature of the financial system, the government wouldn’t allow a major bank or investment house to fail. The logic was reasonable, stemming from the Federal Reserve’s orchestrated bailout of Long-Term Capital Management in 1998, and justified by the Fed and Treasury’s scramble to aid J.P. Morgan Chase in a bailout of Bear Stearns in 2008. (See my 2008 article “Too Big to Fail” for more on the history of federal bailouts.)

Bad regulatory practices coupled with an implicit to big to fail guarantee created conditions where banks and investment firms took on large amounts of risk. They became highly leveraged with billions in subprime loans on their balance sheets because the upside was massive profit. The downside was running to Washington D.C. for a loan if their bets went sour. The excessive risk taking behavior was rational on the part of the banks, and lays blame on the government for not clarifying their role. (Responsibility also goes to the banks for taking on too much risk, but they have been bailed out and not held accountable for their actions.)

Clearly defining the oversight role of regulators helps companies determine their best course of action. Clarity would have also helped guide the risk management of government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac who operated with an implicit open line to taxpayer funds.

Banks hate regulatory ambiguity because they don’t know what is permissible and what will be condemned—imagine the confusion of Lehman Brothers, allowed to fail, after the bailout of Bear Stearns and then AIG.Banks can develop systems and policy to adhere to regulation. If they do it well it can be a competitive advantage.

Clarity on roles, responsibilities, and expectations of the regulators is helpful for investors, so the market knows where the government is going to step in and where it won’t. This will help determine how to diversify a portfolio and how to assess the risk of the investment.

The transparency also allows for public critique of government created rules. Clearly stating bailouts would be policy in a crisis would have allowed for a debate and suggestions of a better strategy before the recession hit. It is furthermore helpful for the regulators so that risk management doesn’t happen on the fly like it has for the past 18 months. Clarity and reorganization would also reduce duplicative regulation and overlapping enforcement responsibilities.

The operative word in all this is “clearly”—in case that point has been missed.