Regulators' Incentives

Name of Publication: 
Make Markets Be Markets

 

The financial debacle has caused worldwide pain and helped saddle Americans with an oversized public debt.  "And yet," to echo President Franklin D. Roosevelt's inaugural address, "our distress comes from no failure of substance.  We are stricken by no plague of locusts. . . Plenty is at our doorstep."  Our financial system got into extraordinary trouble - trouble not seen since the Great Depression - during a time of record profits and great prosperity.

This disaster had many causes, including irrational exuberance, poorly understood financial innovation, loose fiscal and monetary policy, market flaws, and the complacency that comes with a long economic boom.  But in banking the debacle was above all a regulatory failure.  Bank regulators had ample discretionary powers to establish and enforce high standards of safety and soundness; they faced no insuperable regulatory gaps.  They could, for example, have increased the required capital levels set during the 1980s instead of leaving those levels unchanged during two decades of prosperity and record profits.  They could have used risk-based capital standards to constrain excessive exposure to the largest financial institutions, limit investments in the riskiest subprime mortgage-backed securities, curb other concentrations of credit risk, and require systematically significant banks to hold additional capital.  Had regulators adequately used their powers, they could have made banking a bulwark for our financial system instead of a source of weakness.  In banking, as in the system as a whole, we have witnessed the greatest regulatory failure in history.

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Richard Scott Carnell is Associate Professor at Fordham Law School, specializes in the regulation of financial institutions and co-authors a leading textbook in the field.  His interests include bank soundness regulation, affiliations between banks and other firms, and financial institution failure.  As Assistant Secretary of the Treasury for Financial Institutions (1993-1999), he played a key role in securing legislation to authorize interstate banking and branching.  As senior counsel to the US Senate Committee on Banking, Housing, and Urban Affairs (1987-1993), he was architect and principal drafter of the FDIC Improvement Act of 1991, which tightened capital discipline on insured banks, required risk-based premiums, and ended for 17 years the practice of treating large banks as "too big to fail."  He also helped develop the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which reformed thrift regulation.  He holds a BA from Yale University and a JD from Harvard Law School.

The views expressed in this paper are those of the author and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors.