Warsh's Challenges: Financial Regulation
This is an oped at the Washington Post, the second in a pair on Warsh’s challenges. The first was about monetary policy. This one covers financial regulation. Full version in a month.
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New Federal Reserve chair Kevin Warsh wants to make fundamental reforms to the central bank. Fixing financial regulation should be high on his list.
The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run. Financial institutions lost some money on their assets. People ran to pull their deposits and other short-term investments, leading to a wave of failures. Only a $475 billion bailout from the Treasury Department kept the biggest banks from failing and avoided complete financial collapse.
In the wake of this disaster, leaders had the decency to admit that regulation failed and reforms were needed. But the resulting changes — the Dodd-Frank law and the Fed’s subsidiary regulation — simply piled on the previous approach that focused on managing asset riskiness.
The focus should instead have been on run-prone liabilities. Corporate assets such as data centers and rockets are far riskier than bank assets such as loans and debt securities. Why are the safer assets so much more heavily regulated? Because tech companies are financed by equity. When shareholders lose money, it is not a systemic crisis. Banks are financed with short-term debt (deposits) that can suffer contagious runs and invite government rescues.
The Dodd-Frank reforms were supposed to end bailouts. But in the turmoil of 2020, skeptics were proved right when the Fed and Treasury undertook a second bailout. The central bank intervened in Treasury markets, bailed out money market funds, lent directly to cities and states, and put a floor on corporate debt prices.
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The rest here, and full version in a month.
"The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run"
Was it? Lehman Bros. wasn't a bank supervised by the Federal Reserve. Neither was the American International Group (AIG). In what way was this a failure of the U.S. financial regulatory regime?
Seems like we have been playing regulatory cat & mouse forever. Regulations get written, clever people find ways around them or the regulators get captured by the industry they are charged with regulating. Financial institutions take risks, that’s part of business. When the risks pay off the C-suite is richly rewarded, if they blow up the C-suite rides off with their millions intact. And that is the problem - in too many cases leadership has no skin in the game. So how about replacing thousands of pages of complex regulations with something simple. You take an imprudent risk that results in your institution suffering a loss that requires public intervention and you are rendered destitute. Bank account, portfolio, retirement, real estate, toys - gone. Applies to the C-suite. Maybe with skin in the game these people will start managing these institutions like it was their money - because in a way it will be.