Regulation Can Work–Capital is Responsible for its Ills

April 10, 2014

Anyone reading my recent posts will predict that I want regulation, because deregulating is one of the key precepts of the neoliberal economic philosophy, and from earlier posts, it is clear that I am among those who feel the broad set of neoliberal principles has served us poorly in recent decades, and needs to be re-balanced.

Indeed, I recognize a need for regulation in a number of areas in this increasingly complex world, regulations assuring food and chemical safety, medicine, architecture and construction in seismic zones, the environment, and banking certainly need regulation, as well as other areas.

However, I am in many respects a critic of regulation. Regulation has extended in many areas to a highly burdensome level, with little gained. People in many fields report that a very significant amount of their time is now dedicated to filling out reports, and that it is not evident from many of them that there is any significant improvement in safety. Some of this comes from fear resulting from an incident (overcorrection), some comes from lack of experience in the field (such as banking) by those constructing the solutions, and some may come from other motivations such as I describe below in the banking example.

Let’s take banking, a field I understand better than some others, having spent a career in it. If anyone reading this has taken out a mortgage in recent times, you know there now are numerous documents you are required to address. There are others the bank must provide and submit behind the scenes. And, there are regulations that slow the process and likely often prohibit many banks from making creditworthy loans they used to make, and most certainly make the banks very slow in meeting customer needs.

We could live without a number of those burdensome documents and rules.


For example, let’s consider just a few rules which would provide far greater protection than the burdensome and time consuming reports and rules:

1.  Let’s separate even more clearly the fundamental banking process serving consumers and businesses from the trading and other speculative activities some of the larger banks participate in. If the latter activities are spun off entirely into separately owned entities, shareholders and depositors in the fundamental bank will be far less at risk.

2.  There is no good reason for banks to be allowed to speculate in commodities, such as food products, or in minerals and chemicals. This activity can be left to entities which do not accept deposits.  For customers who want to participate in such speculative activities, they should have a minimal net worth and acknowledge the risk they are taking. There should be no bailouts for failures of such entities.  Some of these protections are included in Dodd-Frank, but with far less clarity than I recommend.

3.  Capital requirements of banks have been raised. They can be raised further.

4.  For deposit taking institutions, a minimum down payment on mortgage loans is appropriate–at least 15 or 20%.  Private entities not allowed to take deposits can offer more aggressive mortgages, and we should not bail them out, if they fail.

5.  Simple rules requiring retention of a significant portion of every loan made–e.g., 25%, will do wonders to better assure the underwriting is carefully done. Sometimes it’s just too easy to sell a weak loan to others, and with only 10% retained on the books of the originating bank, that bank can afford to lose a few of those. But, 25% retained is sufficient to assure that the pain of a loss will be anticipated and will hurt.

This list of five is not intended to be a comprehensive proposal for regulating banking, to replace the Dodd-Frank legislation, the regulatory version of which is now approaching 20,000 pages. However a few dozen rules like this can provide far greater protection to depositors and the financial system of the US, and can save billions of dollars being wasted on burgeoning compliance departments of banks, expanding bank regulatory agencies, and hordes of accountants, lawyers, and consultants, as well as improving and simplifying the lives of all of us being regulated or on the other end of that process. These kinds of rule require very little paperwork and compliance personnel–either in the banks or in the regulatory agencies.  They don’t require lawyers to interpret them.

The irony of the conservatives complaining about regulation is two-fold in my opinion:

First, the economic disaster which precipitated the latest round of banking regulation was initiated in both Democratic (Clinton) and in Republican (Bush) administrations. It exploded under Bush. Had we not experienced that huge economic disaster, we likely would not have had the 20,000 pages.

According to economists, the neoliberal policies expounded mostly by Republicans or Neoliberals do indeed tend to result in periodic booms and busts–more so than the policies of Democrats or Keynesians.

Second and even more interesting is this–faced with the political demand from such crises that the system be better secured, financial capital is motivated to work through lobbyists to avoid the simple kinds of solutions described above, in favor of the complex solutions of such bills as Dodd-Frank. Of course, they’d like to avoid all additional regulation, but faced with the political certainty of more, they scramble to minimize the profit or return on equity expense of it.

The likely reason is that the actions described above are perceived by financial capital to have a more significant impact on profits and return on equity than the burdensome regulation.

After all, if minimum capital must be increased, the leverage of banking decreases, and it is the leverage of banking which enables the huge profits. Return on equity will decline as equity is increased, of course.

Similarly, if a bank is required to keep 25% of a loan they originate, sell off no more than 75% to other banks, preferring to sell 90% of it, they forego the profits on the additional 15% they would like to sell. Selling loans to others has two benefits to banks–there is often a “spread” or a fee financial advantage.  My loan at Prime + 1% can be sold to other banks at P + 1/2 and possibly a fee to me (after all, I did all the work to originate it). Thus, my gross yield on the 10% retained may climb from P+1% to P+5%. Another benefit is that selling off portions of loans I make helps to diversify my risk–I end up with smaller exposures, so that if something unexpected goes wrong with the borrower, I only have to suffer only a small portion of the loss.

However, when the portion retained is very small, the motivation to be careful and underwrite to avoid loss, is somewhat reduced.  Financial capital would argue that there is no significant diminution in underwriting and that the additional profits from selling off most of the loan are appropriate and deserved by the underwriting bank. But, if not at the loan officer level, then perhaps at the CFO or CEO level where the aggregates are calculated and where underwriting direction emanates, such structural exposures matter.

In these ways, I argue that financial capital (the equity interests and the top management of banks), lobbies heavily to avoid such simple forms of regulation, in favor of regulation which is costly and burdensome–the net result being more profits to bank shareholders and most likely more remuneration to bank CEOs.

So, when bank CEO’s and bank investors complain about the cost of regulation, bear in mind that there are indeed far less burdensome alternatives, alternatives far less expensive in terms of staff and consultancies and lawyers and accountants, much better for customers–but, perhaps a bit more expensive in terms of a little reduction in return on equity and perhaps top management compensation.

By the way, this is one of the ways we can enjoy a gradual redistribution of income and wealth in a nation approaching the highest levels of inequality in the world.  A little less for capital improves the balance.

I argue that the system would be much better off with a little less return on equity, a little less compensation to bank CEOs, and a substantially less burdensome regulatory structure.

I welcome your comments

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