Limited Progress on Banking Reform and What is Needed

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Banking regulators, supervisors and politicians have failed to do their job for implementing reforms to limit damage from financial crises.  This failure of political will enabled stakeholders to pursue bad practices, and suggests a roadmap for reform.  Enforcing a reform agenda marked by simplicity is plausible, and would avoid much of the collateral damage that comes from many hundreds of pages of complex, costly and misguided mandates that typically act as substitutes for credible reform.

This is a case presented by Charles Calomiris in a recent VOXEU communique (Jan. 8^th) called Meaningful Bank Reform and Why it is Unlikely to Happen.

He notes that regulators and supervisors consistently failed in three key areas: (1.) they did not measure banks’ risks accurately or capital buffers needed to absorb losses; (2.) they failed to enforce the capital requirements and identify bank losses; and (3.) they failed to design or enforce intervention protocols for timely resolution of the affairs of weakened banks.

The failure to prevent the crisis was not a failure of thinking, but a failure of will on the part of our political system.  Politicians and regulators have found it expedient to offer hidden subsidies for risk taking to bankers through safety net protection and ineffectual regulation.  Overall, the cause for pessimism is a simple reason: politicians don’t really have strong incentives to solve the problems of banking regulation; they have strong incentives to pretend.

Deficiencies are supposedly remedied by ever-more-complex sets of rules for measuring risk, by granting increased supervisory discretion to a variety of new government officials with varying mandates, by scores of new research initiatives pursued by increasingly fragmented research and supervisory divisions at central banks and supervisory agencies, by the creation of new international study groups. Is it too cynical to see this exponential increase in complexity of rules, and of the regulatory and supervisory authorities charged with designing and enforcing them, as deliberately designed to reduce accountability by dividing responsibility and by making the regulatory process less comprehensible to outsiders?

The need is not for more complex rules, and more supervisory discretion, but rather for rules that: (1.) are meaningful in measuring and limiting risk; (2.) are hard for market participants to circumvent; and (3.) are credibly enforced by supervisors.  These qualities are best achieved by constructing simpler rules that are grounded in an understanding of the incentives of market participants and supervisors.

The keys to effective reform in all these categories are, recognizing the core incentive problems that have encouraged excessive risk taking and ineffective regulation and supervision, and designing reforms that are ‘incentive-robust’ – that is, reforms that are likely not to be undermined by the self-seeking regulatory arbitrage of market participants, or the self-seeking avoidance of the recognition of problems by supervisors.

This program of reform would be effective in addressing the real challenges that threaten the financial system.  This approach must avoid the collateral damage that comes from the many pages of complex, costly and misguided mandates that are substitutes for credible reform. Politicians dislike simple ideas, based on observable criteria, since they work by removing the discretionary control that politicians, bankers, and regulators enjoy and abuse over the enforcement of regulatory standards. Overcoming that challenge will require more than good economic thinking and a simpler, credible approach for risk management

www.voxeu.org/article/meaningful-banking-reform-and-why