Rules, Discretion

I like Steve Waldman’s post getting between the arguments of The Epicurean Dealmaker (TED) and Yves Smith over the issue of rules versus discretion in resolution authority. TED: “But I continue to maintain that the law authorizing the resolution authority—as opposed to the confidential working documents, plans, and intentions of the authority itself, which can and should be as specific as possible (and subject, of course, to constant review and revision in response to changing circumstances)—should be drafted at a very high and determinedly vague level.”

I’ve been thinking a lot about this issue lately, so I’ll use this as a prompt to write out some thoughts.

Prompt Corrective Action

This is a high-level discussion, so it might be helpful to lay out specifics on what I think is the most important item for this debate and resolution authority – prompt corrective action. These are quantitative triggers in terms of the bank’s balance sheet that force regulators to act. I’d want the broad outline codified in the law, as they were when it was created. These can be supplemented later, by regulators reacting to situations on the ground. But if a firm trips the first measure of being “undercapitalized” according to PCA, there should be clear written rules related the time available to get out of the situation, and under what conditions it would escalate to the next level. I think TED is with me here.

Economics of Contempt thought that having PCA was essential to Resolution Authority. Here’s one of the creators of PCA, Richard Carnell, writing in the MMBM report about how it can subvert the perverse incentives of regulators:

Banking Statutes Impose Inadequate Accountability

Properly framed statutory standards can heighten regulators’ accountability and counteract perverse incentives. Congress did employ such standards when requiring regulators to take “prompt corrective action” to resolve capital deficiencies at FDIC-insured banks. Such banks face progressively more stringent restrictions and requirements designed to correct problems before they grow large and in any event before they cause losses to the insurance fund. A regulator can accept an undercapitalized bank’s capital restoration plan, and thus permit the bank to grow, only by concluding that the plan “is based on realistic assumptions, and is likely to succeed in restoring the institution’s capital.” If the bank’s capital falls so low that the bank has more than $98 in liabilities for each $100 of assets, the FDIC must take control of the bank unless the regulator and the FDIC agree on an alternative approach that would better protect the FDIC. 12 U.S.C. § 1831o. These standards have teeth. They limit regulatory procrastination and provide clear consequences for capital deficiencies.

I think this is the compromise TED would be in for – there’s discretion with what constitutes realistic plans and expectations of success, but there’s also a clear line when efforts have failed. I want to note two things:

1. There’s a book about treating alcoholism called “I’ll Quit Tomorrow.” I worry that without a clear rule triggering resolution escalation, with too much discretion, we can call the next book “I’ll Resolve You Tomorrow.” The regulator’s incentives are asymmetric – if the problem goes away between now and tomorrow, their job is easier and no powerful and connected campaign donors are going to be mad at them and try to get them fired. If it gets worse, well the taxpayers are ultimately on the line. Setting up rules to supplement discretion takes into account these “behavioral” inclinations of actors, and also start attacking the problems earlier with the taxpayer in mind than later.

2. Everyone knows what Miranda Rights are for people being arrested? “You have the right to remain silent…” There’s a knee-jerk assumption that these rights protect suspects. They do, but they also protect the police officers themselves. As long as they follow the clearly written rules, the discretion they choose to use in questioning is all within bounds. Discretion has no real authoritative power unless it is exercised within the constraints of rules.

PCA gives regulators the same type of cover. If a connected Congressman wants to know why a bank in his district is being told to raise more capital, or is being closed, the regulator can say “my hands are tied.” And they were. Again the regulator had a lot of discretion in-between, but there were clear rules when it was out of his hands. Lots of regulators have said being able to say that and to have it be true has made their jobs significantly easier in the age of massive campaign donations.

The real problems with resolution authority are going to be (a) international, particularly when it comes to information sharing and free-riding and (b) coordination. If we now accept the biggest 6 banks are all systematically risky, they will also all get into trouble at the same time. So there’s an incentive to be the last one approached for painful resolution corrections, since if the first two get resolved/bailedout/whatever, the last 4 will have it much easier on their books. So there’s an incentive to delay as much as possible.

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6 Responses to Rules, Discretion

  1. chris says:

    ISTM that in the modern era, the rules governing any regulatory agency need to be drafted with the assumption that sometimes, perhaps as much as half the time, the head of the agency will be actively trying to sabotage the agency’s mission, and to the extent possible, appointing personnel who are also dedicated to that goal.

    That seems to me to be a strong argument for less discretion, because it will often be used *against* the purpose of the agency rather than for it.

  2. Mike says:

    Couldn’t agree more Chris.

    One of the neat things about growing up during the Bush years is that there’s often been a huge amount of confusion about whether government officials are acting incompetently or maliciously. “Is what that Secretary just motivated because he is evil? Or stupid?”

    I’m still confused looking back.

    With rules, you take a lot of that off the table. And with rules for escalation and fully resolving there’s an endgoal people will work back from.

    The question now is whether or not the books of the biggest players are so complicated and opaque even to themselves that these kinds of test, tests designed to monitor the George Bailey bank, will add any light to the situation.

  3. MattJ says:

    The problem with resolution authority is that it is being used as an argument against larger restructuring of the financial system, breaking up of too big to fail institutions, and limitations on the activities of taxpayer backstopped banks. The problem with that, is that I can’t imagine resolution authority actually being used against such an institution.

    Mike – if a resolution authority existed in the way you would like, how do you think the current financial crisis would have played out? At what point would Bear, Citi, Lehman, BoA, Morgan Stanley, Goldman Sachs, and/or JP Morgan have been resolved rather than bailed out? Which resolutions in what order would have kept other banks from having to be resolved?

    Personally, I can’t see resolution authority being used against very many of the current survivors other than (maybe) Citi, so the government would still have found a way to bail out the politically too connected to fail institutions. Believing that, I would rather see the large banks broken up, and the backstop limited to utility-type banks with very restricted capabilities.

  4. Ed says:

    This is a very basic problem of oversight. It is one of those situations in which Congress needs to understand (but won’t) that oversight will never be effective unless it’s independent and well-defined with minimal bureaucratic discretion. There is some precedent for Congress being smart enough to take decision-making power out of their own hands to prevent individual members from meddling – BRAC comes to mind – but I won’t hold my breath for a similar move here.

    And they found ways to fuck with BRAC eventually anyway.

  5. chris says:

    There is some precedent for Congress being smart enough to take decision-making power out of their own hands to prevent individual members from meddling

    The Fed seems like both an example and a cautionary tale, in that regard. It’s clear that it could have done much more than it did to prevent the current crisis, but IMO it’s a good example of an agency whose mission was sabotaged by its own head. Greenspan poured gasoline on the flames of the “Bush boom”.

    Deregulation always leads to rapid growth in one industry: fraud. All others may appear to grow, but due to the growth in fraud, it is often difficult to determine until years afterward whether they actually grew at all. Greenspan was badly off in his estimated split of fraudulent vs. genuine growth, because he was a deregulation ideologue who saw what he wanted to see.

  6. csissoko says:

    Given the banking industry’s recent history, I think you also need to take into account the fact that rules are always subject to the discretion of regulators. It seems to me that the FDIC’s investigations into bank failures have turned up far too many cases of “discretionary” boosts to bank capital that served to hide growing problems.

    I’m sure the rules help — but I think it’s more a matter of rules + discretion vs pure discretion.

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