It's Springtime in Washington, and Regulatory Reform Blossoms

This spring’s regulatory reform discussions will only succeed if they explore ways to effectively regulate the financial system without relying on regulatory micro-management as our current regulatory framework does.

It’s springtime in Washington. The cherry blossoms have lost their premature bloom, but talk of financial regulatory reform is in full flower. Let’s hope that these reform discussions are longer-lived than the cherry blossoms. There is reason to worry, however, that we will not succeed in more than superficially disentangling ourselves from Dodd-Frank’s seductive embrace.

On the promising side, we are hearing some calls for reform from people who were central in shaping Dodd-Frank implementation. For example, as Federal Reserve Governor Daniel Tarullo packed his bags, he made an important concession: The Volcker Rule—which prevents banks from engaging in proprietary trading and operating investment funds such as hedge funds—is not working well. He admitted that a seemingly simple concept had contorted itself into a costly exercise for banks and their regulators. Moreover, he noted, the rule might be harming some markets in the process.

In a recent speech, William Dudley, president of the Federal Reserve Bank of New York, seconded Tarullo’s call for a reexamination of the Volcker Rule. He too raised the possible harmful effects on market liquidity and called for flexibility in its application.

A regulatory reform white paper released last month by academics at New York University’s Stern School, whose past research served as support for Dodd-Frank, also called for the repeal or significant remaking of the Volcker Rule. In their estimation, “Without an anchor to risk, the Volcker Rule makes artificial and superficial distinctions across credit markets” that have “already lead to confusion and regulatory arbitrage.”

Calls for reforming the Volcker Rule are grounded in a recognition that having regulators micro-manage bank activity to determine whether it is prohibited proprietary trading is neither efficient nor effective regulation. As Tarullo explained, regulators have the “time-consuming” and difficult task of applying “context-specific, data-heavy judgment” to determine what banks can and cannot do under the rule.

But these Volcker critics continue to favor an intense, ongoing role for subjective regulatory judgment in other contexts. They reject simple, easily enforced rules in favor of complex regimes that rise and fall on regulators’ ability to make difficult decisions about bank risk-taking. For example, they embrace risk-weighted capital, through which regulators’ ex ante assessments of the relative riskiness of assets shape bank balance sheets. The argument goes that a simple leverage ratio, which could be based on liabilities or assets, does not afford regulators a sufficiently granular control mechanism. Thus, the NYU Stern School explains, “a private investor would rarely make a decision based on a single ratio, and neither should a regulator.” But regulators are not private investors; regulators have a different knowledge base and a different set of incentives than investors.

As another example, although the Volcker critics mentioned above also favor streamlined Fed stress testing, they continue to look to these stress tests to embed regulators’ judgments into bank decisions. President Dudley, for example, insists that “appropriate capital and liquidity standards ... must be augmented by a supervisory regime that can assure the quality of a firm’s governance, controls, risk culture and compliance with applicable laws and regulations.” An outside regulator is better able to set and enforce clear rules than to make a constant stream of necessarily subjective judgments about bankers’ activities and attitudes.

It is wonderful that people are beginning to recognize that asking bank regulators to make fact-specific judgments in the context of the Volcker Rule is consuming lots of regulator and bank resources. But the analysis cannot stop there. Dodd-Frank requires the same sorts of judgments and ad hoc regulatory interventions in other contexts, too. This approach has surface appeal—a financial system that is guided down to its minutiae by regulators allows the rest of us to sleep at night, at least until we are jolted awake by their inevitable failures.

Simpler approaches that impose clear standards and do not require continuous, nuanced regulatory judgment offer great promise for financial regulation. These reforms must be paired with elimination of government subsidies and other inducements for banks to engage in risky activity, a problem Professor Charles Calomiris discussed in a recent paper. This spring’s regulatory reform discussions will only succeed if they explore ways to effectively regulate the financial system without relying on regulatory micro-management as our current regulatory framework does.