Institute for Financial Transparency

Shining a light on the opaque corners of finance


Financial regulators not up to task of preventing next crisis

For several years, I have been saying a reliance on financial regulators to prevent the next crisis only guarantees we will have a next crisis.  Instinctively you know this to be true because sooner or later any system with a single point of failure will see this point of failure fail.

When our financial system was redesigned in the 1930s, policymakers could have chosen to make it dependent on financial regulators and their not only having the right mix of regulations, but also enforcing them.  Policymakers made the deliberate decision not to do this.  Instead they based the financial system on transparency.

In Transparency Games, I discuss long form why financial regulators are not fit for the purpose of preventing the next financial crisis.  One of the reasons I discussed is regulators are subject to political pressure to both change how stringent their regulations are and how aggressively they enforce them.

The Volcker Rule provides an excellent case study of this.

In theory, the Volcker Rule prevents banks from taking proprietary bets.  For financial regulators to achieve this in reality, they came up with approximately 900 pages of regulation and explanation of the regulation.  The financial regulators then set about enforcing this regulation.

Enter the Trump Administration that wants fewer regulations and less stringent enforcement of the regulations that do exist.

As reported by the Wall Street Journal,

Top U.S. policy makers are set to offer Congress significant ways to ease regulation of banks, according to testimony released Wednesday ahead of a Senate hearing Thursday.

Federal Reserve governor Jerome Powell and Keith Noreika, acting comptroller of the currency, said in prepared testimony they are studying how to simplify the Volcker rule, which aims to prevent banks from making overly risky bets with their own money….

Their testimony is the latest evidence that bank overseers are taking a deregulatory tone following the election of President Donald Trump.

No matter how you look at this testimony, there is no reason to think the existing regulation and its enforcement won’t be relaxed.  By definition, relaxation of the regulation and its enforcement increases the chances of another crisis.

Compare and contrast this with what the Volcker Rule would look like if there was transparency and banks disclosed their exposure details.  The Rule could be written in 2 paragraphs: thou shall not make proprietary bets and thou shall provide exposure detail disclosure to confirm there are no bets.

Notice how simple the rule is.  Notice how easily enforced the rule is.  Every bank knows there are traders who would recognize if the bank was taking a proprietary bet and these traders would position themselves to minimize the profitability of this bet and maximize any losses from this bet.  Knowing this, bank traders wouldn’t take proprietary bets.

Notice how enforcement of the regulation also wouldn’t be subject to political pressure.  The financial market doesn’t care if politicians want the financial regulators not to enforce the rule.  The financial market would continue to exert financial discipline and enforce the rule.