Uncertainty in Financial Regulation 10 Years On

Uncertainty in Financial Regulation 10 Years On

Writing in the Journal of Economic Perspectives, Daniel K. Tarullo offers a history of the changes made in financial regulation from the New Deal era to the post-crisis regulatory regime:

This article assesses the accomplishments, unfinished business, and outstanding issues in the post-crisis approach to prudential regulation. After briefly reviewing how the ongoing integration of capital markets and traditional lending channels undermined the New Deal regulatory framework, I explain how the post-crisis regulatory approach of instigating changes across a range of bank activities and practices brought about a steady improvement in the resiliency of the financial system, especially in the largest financial institutions. Next, I turn to an evaluation of how durable this regulatory approach will prove over time. The answer will depend on how financial regulators can and will respond to what will surely be the highly adaptive behavior of financial market participants to changes in regulation, technology, and the overall market environment. The hurdles to doing so, both political and institutional, are substantial. While regulators have ample legal authority to contain risks at prudentially regulated banking organizations, over time they may lack the will or organizational capacity to exercise those authorities effectively. It is doubtful whether they have adequate authority to address threats to financial stability that may arise outside the perimeter of prudentially regulated firms. In particular, there is reason for concern about appropriate regulation of liquidity and short-term finance, which would likely be at the center of a future crisis. Thus, while the resiliency of the financial system is likely to remain fairly high in the near term, the medium- and longer-term prospects are hazier than one might hope. [Emphasis added]

Tarullo’s summary of the policy changes made over the past 80 years is worth a read, as are his policy recommendations for improving the financial system, but this passage on the complexity of the post-Dodd-Frank rulemaking process is of special interest for those interested in rent-seeking in the financial sector:

[A]gency discretion need not always result in more stringent financial rules. Discretion works in both directions, and could allow the rigor of the regulatory system to be substantially reduced without legislation. Rationalization of excessively complicated or unnecessarily burdensome regulation, which nearly everyone agrees is needed to a greater or lesser degree, could morph into a troublesome deregulation. While Congress legislated some changes to Dodd–Frank in early 2018 that eliminated regulatory requirements for small and mid-sized banks, the banking agencies have moved toward relaxing regulation for the largest banks as well.

The point he’s making is closely related to what Steven Vogel called “deregulatory capture.” When a collection of alphabet soup agencies (often with overlapping jurisdictions) is responsible for drafting countless rules to govern the financial system, there is bound to be heavy input from the regulated bodies, often to the detriment of good macroprudential policy.

Of course, a lack of clear, consistent and (relatively) simple rules to govern the financial system can come back to bite those regulated. In the face of a financial sector that can evolve around command-and-control-style regulations (as Tarullo highlights in his article), more robust capital requirements and liquidity coverage ratios provide a cornerstone that addresses the root cause of most financial crises: debt and insolvency.

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By |2019-02-04T12:47:05-08:00February 4th, 2019|Blog, Financial Regulation|