David Min on Banking Regulation

Why does the banking industry need better regulation?

In the absence of regulation, banking is inherently prone to bubble busts. During booms, banks tend to take on too much credit risk and then when the economy goes south, they're prone to banking runs, as we saw in our own country's history prior to the 1930s.

What the banking reforms in the 1930s attempted to do - successfully - was to implement a strict risk regulation on banking and also provide regulators with a means to allow banks to fail in an orderly fashion without taking down the entire banking system.

What happened in the last few decades was, due to regulation and regulatory inertia, banks or financial institutions developed what was called, shadow banking, which is derivatives, asset-backed securitization, the whole alphabet soup of financial instruments, activities and institutions that we saw during this last crisis, which effectively emulated the activities of banking, but outside of the regulations of banking. As we saw, this was prone to the same problems that unregulated banking has always been prone to. It took on too much risk during this last bubble, and then it was prone to that banking panic that we saw in the Fall of 2008.

How will legislation currently in Congress provide this oversight?

So what the Dodd legislation would do is basically impose greater risk regulation on the shadow banking system. It would allow regulators to regulate non-bank financial activities that pose risk to the banking system. Derivatives would be covered, asset-backed securitization, all of these activities that cause such great risk to the system, to the balance sheets of firms like Merril Lynch and Morgan Stanley, would be covered and regulated explicitly under this legislation. This legislation would also provide regulators with resolution authority similar to that already enjoyed by the FDIC. Instead of being faced with that "Sophie's Choice" of having a bank fail without any supports and possibly cause a massive banking panic, or alternatively give bailouts to these banks - this would allow the regulators to take down banks in an orderly fashion, much like the FDIC now does.

This bill would also significantly improve the transparency of many financial activities that are now very opaque. Derivatives in particular would be much more transparent. One of the real problems that we saw in the last crisis was nobody really knew where the risks lied. And that created conditions for massive panic. It also made it harder for regulators to do their jobs in ascertaining who held what types of risk and how much capital should be forced to be held against those risks.

This bill would also improve consumer protection. One of the last problems we saw in the recent crisis was due to a number of misaligning incentives, there are just a proliferation of predatory lending practices. Mortgage originators in particular were paid more to originate bad and unsustainable loans and not surprisingly, we saw a lot of predatory and fraudulent practices occur. By creating a consumer financial protection agency, this bill would basically protect consumers from these types of practices and ensure that consumers are in power to make good decisions.

Will this legislation be able to prevent future crises?

This bill would certainly empower regulators to have the tools that they need to significantly prevent the likelihood of a future crisis from happening. Does it go far enough? It's an open question I think a lot of people would like to see further legislation occur. One thing I would point out is that in the 1930s, the banking and securities regulations that we all take for granted today, really didn't happen all at once. They happened over three or four different traunches. That might be a blueprint for today. It regulates too big to fail, it imposes a strong risk regulation on the shadow banking system, improves transparency and provides regulators with the resolution authority they need to shut down failing firms in an orderly fashion without costing taxpayers any money.