Institute for Financial Transparency

Shining a light on the opaque corners of finance


Overhauling financial supervisory framework

Paul Volcker spelled out the need for reforming our financial supervisory framework.  Talking about the need to reorganize and consolidate the financial regulators he said,

I think the financial crisis has exposed just how rickety and out of date our supervisory framework is … It’s just a lousy system, … inconsistencies, overlaps, and gaps, differing priorities, squabbling over turf, lack of oversight of the so-called shadow banking system and other problems.

If you are going to reorganize and consolidate the financial regulators, you need to have a picture of the global financial system.  The Bank of England’s Andy Haldane provide a central bank centric description of this macro-financial system of systems. He lays out the global financial system as having four layers:

Layer 1: Micro-prudential policy (individual banks)

Layer 2: Macro-prudential policy (financial system)

Layer 3: Monetary policy (economic system)

Layer 4: Global economic/financial system (international financial architecture)

Let’s being by focusing on Layer 1 with its focus on regulation and supervision of financial firms.  In the US, we have many different regulators involved in regulating and supervising banks. These include the Federal Reserve, the OCC and the FDIC.  Of these three, only one, the FDIC, has its interests aligned with the taxpayers.  The FDIC has an incentive to minimize any losses incurred by the deposit guarantee fund and potentially the taxpayers.  As a result, the FDIC is likely to be proactive in closing troubled financial institutions. This is important as the threat of closure provides investors an incentive to exert market discipline to restrain risk taking by the banks so the banks don’t get in trouble.

The Federal Reserve and the OCC have historical reasons why they are involved in bank supervision and regulation.  For example, the Federal Reserve was involved because of its lender of last resort role. However, neither of these entities needs to be involved with bank supervision and regulation in the 21st century.  In a financial system where banks provide transparency, the Federal Reserve can find out anything it needs to know about a bank or the quality of the collateral it pledges for a loan using modern information technology.

The bottom line in the US is all bank supervision and regulation should be consolidated under the FDIC. The Federal Reserve and the OCC should be stripped of any involvement in bank supervision and regulation.

So far, we have focused on banks, but what about firms like insurers and asset managers?  Regulation of these should be separate from regulation of the banks.  Why?  You want to preserve competition among financial intermediaries and not run the risk of regulatory capture hurting competition.  For example, imagine the Federal Reserve setting capital requirements for insurers.  Who do you think has more influence at the Fed, banks or insurers?  If you think the banks have more influence (and they do), clearly the Fed will end up promoting capital requirements that tilt the playing field in the banks’ favor. (By the way, the Fed is in the process of doing just this).

Earlier I said Mr. Haldane’s description of the global financial system was central bank centric.  I said that because macro-prudential regulation has effectively been put under central bank control.  In the UK, macro-prudential is under the Bank of England.  In the US, macro-prudential is arguably under the Federal Reserve as it dominates the Financial Stability Oversight Council which technically has the responsibility for macro-prudential regulation.

But does this actually make sense?  Answering this question is up to politicians to decide.

In Transparency Games, I discuss how the banks’ regulatory capture of the Fed enabled the banks to also hold monetary policy hostage.  Under the banks’ guidance, the Fed chose to pursue the Japanese Model in response to the financial crisis.  Under this model, it implemented monetary and regulatory policies that favored Wall Street over Main Street.  Specifically, it tried to save the banks.

Imagine how different the policy response would be if the Fed didn’t have bank supervision and regulations and therefore wasn’t captured by the banks.  Instead it would have had an incentive to choose to pursue the Swedish Model and adopt policies that favor Main Street over Wall Street.