Financial Industry Should Be Its Own Knight in Shining Armor

Were we to let the financial industry make its own way during ordinary times — a way that certainly would not be without shareholder and creditor losses and firm failures — the industry would be much better equipped to handle crises on its own.

A favorite children's book of mine is Robert Munsch's The Paper Bag Princess. Its twist on the traditional fairy tale is that the courageous and quick-thinking princess rescues the prince from the dragon. The ungrateful prince derides the princess for her unbecoming rescue outfit and disheveled appearance. So the princess responds by ditching the prince and presumably living happily ever after. The book offers valuable life lessons — but it also helps us to take a fresh look at financial regulation.

We often tell ourselves stories about regulators riding to the rescue when the financial industry gets into a bind. According to this tired narrative, in times of trouble, the dim-witted and over-indulged financial industry sits, waits, hopes, and pleads for strong, smart, powerful regulators' assistance. After each rescue episode comes the quid pro quo as the regulators tighten their hold on the financial industry, which clearly cannot survive without the regulators' superior wit and insight. This story gets into our blood, and we all start believing it.

The power of this storyline was evident in the last crisis. As companies failed, the financial industry — rather than crafting its own remedies — called loudly for help from the same regulators that wrote the rules that drove them into crisis. They had been conditioned by a long history of government bailouts to rely on the government for help. Regulators, in turn, believed that only they were capable of acting as the knight in shining armor.

True to the storyline, the regulators heeded the rescue calls in 2008. In exchange, the government extracted a commitment — memorialized in Dodd-Frank's micro-managing regulatory structure — in which regulators would call the shots and financial companies would complacently submit to their wise mandates. Employees of two different regulated entities recently told me how grateful they are for regulatory risk-management mandates, because without them their firms and others just would not manage their risks.

It's time to rewrite the storybook. In the new narrative, the financial industry will be more self-reliant. It will realize the folly of looking to regulators — who invariably are wrapped up in regulatory checklists and other superficialities — to guide industry decision-making or get firms out of trouble when they make bad decisions. Financial companies will not live and die based on the competence of the regulator, but based on their own risk-management savvy and ability to satisfy customer demands.

Of course, changing the way that the financial industry operates requires more than telling a new story. We need to empower financial firms to be active problem-solvers before and during crises. This means puttingan end to regulatory micro-management and firm complacency. It means placing the responsibility for risk-spotting and risk-management squarely on firms' shoulders by making it clear that failure in these areas will result in their shareholders losing money and perhaps losing the whole firm.

To convince them of the real potential for such dire consequences, we should replace regulatory micro-management with shareholder capital. We should revisit Federal Reserve Act section 13(3), the provision that empowers the Fed to make emergency loans and was used during the crisis for, among other things, AIG's rescue. Dodd-Frank's attempt to pare it back was half-hearted.

Convincing firms that failure is an option requires eliminating Dodd-Frank's orderly resolution authority, a legally hazy substitute for bankruptcy that offers the government an avenue to inject money to prop up failing firms. It might also mean requiring financial companies to buy insurance contracts that will pay out to the government if the government bails the company out. During a crisis, the insurers' calls against bailouts might be able to drown out the voices of those clamoring for a rescue.

Financial regulators, fresh off their rescue of the financial industry and confident in their superior abilities, have taken to micromanaging the industry. The industry puts up a fight here and there, but largely seems content to be guided and directed by the regulators who rescued it once and are ready to do so again. The truth is that regulators are not particularly skilled at managing the financial industry. Their imperious commands, delivered with great bluster, often end up driving the industry right into harm's way.

Were we to let the financial industry make its own way during ordinary times — a way that certainly would not be without shareholder and creditor losses and firm failures — the industry would be much better equipped to handle crises on its own. The regulatory prince would play a supporting role in the new narrative — a helpful influence, but not the center of attention or locus of all our hopes. The star of the narrative would be the financial industry. It is neither flawless nor perfect, but periodic failures are part of what make it strong, careful, and adaptable. This princess is capable of handling financial crises in her own, albeit sometimes messy, way — without looking for the regulatory prince to ride to the rescue.