Leonhardt in the NYTimes Magazine, The Uses of Discretion with PCA

David Leonhardt has a good writeup of where financial reform stands in his Sunday magazine article Heading Off the Next Financial Crisis. Let’s look at the uses of the word “discretion” in the piece (my bold):

It would be foolish to imagine that we could come up with just the right mix of rules and regulations to prevent this from happening again. If regulators are entirely bound by rules and the private sector remains flexible, regulators will never be able to keep up. This is why some amount of discretion is a vital part of re-regulation…

All of this new regulation depends on the wisdom of regulators, who are, of course, human beings with the potential to be swept up in the enthusiasm of a bubble. And Obama administration officials — especially Geithner, the main architect of re-regulation — are sensitive to the idea that they are asking too much of human discretion. Their solution is to depend on capital requirements to prevent another financial crash. They refer to these requirements as cushioning or foam on the runway. So long as a firm has enough hard assets — and can get access to their cash value — it can survive a lot of bad investments and a lot of ineffective oversight….

Their approach has the advantage of keeping technicalities free of Capitol Hill horse-trading, much as setting interest rates is a process left to the Fed, not Congress. Vagueness also allows American regulators more freedom to coordinate with regulators in other countries. On the other hand, by remaining out of the public eye, capital requirements become yet another issue that will ultimately depend on discretion. Wall Street firms will have a chance to persuade the Fed that maybe they do not need as much capital as people first thought. No doubt, the firms will offer some highly sophisticated mathematical models to make their case….

It is a crucial step, as are many of the other new regulations in the plan. But it would be easier to have confidence in them if the administration and Congress took a few steps away from discretion and toward clarity. “Rule-based regimes,” Kevin M. Warsh, a Fed governor, said in a recent speech, “are inevitably crude and imperfect.” But Warsh suggested that they may be better than a system in which banks accept micromanagement under the assumption that they will be able to co-opt their micromanagers.

Barry Ritholtz lays out the case that AIG is the result of specific deregulation carried out in 2000. Two things about discretion.

1) People talk a lot about the “unregulated” shadow banking market, but it is important to remember that they were (poorly) regulated by the SEC. And the SEC gave an exemption to 5 firms – Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley – to leverage up further in the 20-40 to 1 range, while commercial banks were still leveraged in the 8-12 to 1 range. The more leverage means the bigger the returns, but the harder the falls. This increased the regulatory arbitrage of the shadow banks, because these five firms could act as if they were commercial banks but could be significantly more leveraged, offering better deals and crowding out the market.

There is nothing in the Dodd Bill that would have stopped this other than the hope that regulators at the Federal Reserve are smarter, more resistant to lobbying, and will let their actions be more transparently monitored, critiqued and subject to democratic review by the public and the general community of investors than the SEC. Maybe this is true today, and maybe this is even true on a medium term time frame. By why take the chance, when we can simply put in a hard line of 15-to-1 like in the Frank Bill?

Prompt Corrective Action and Discretion

2) Ok, stay with me on this one. It’ll get rough but it is worth it.

Resolution authority is predicated on the idea of prompt corrective action; this goes back to Gary Stern and others thoughts about resolution authority at the Minneapolis Fed (my bold):

Enhanced prompt corrective action. PCA works by requiring supervisors to take specified actions against a bank as its capital falls below specified triggers. One of its principal virtues is that it relies upon rules rather than supervisory discretion. Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way. If a bank’s failure does not impose large losses, by definition it cannot directly threaten the viability of other depository institutions that have exposure to it. Thus, a PCA regime offers an important tool to manage systemic risk. However, the regime currently uses triggers that do not adequately account for future losses and give too much discretion to bank management. We would augment the triggers with more forward-looking data, outside the control of bank management, to address these concerns.

There’s a clear quantitative trigger that says “Ok bank you are in trouble now we are watching you” and a worse trigger that goes “Ok game over we are resolving you.” In between those two triggers, regulators have discretion to use their smarts as to how to deal with the situation (their smarts have guidance, as to act towards a “least cost” solution, but put that aside for now).

For the largest systemically large firms these triggers will be determined internally by the Federal Reserve and a Financial Stability Oversight Council. From the Dodd Bill (giant pdf, page 101), which calls prompt corrective action “early remediation requirements”:

2 (a) IN GENERAL.—The Board of Governors, in consultation with the Council and the Corporation, shall prescribe regulations establishing requirements to provide for the early remediation of financial distress of a nonbank financial company supervised by the Board of Governors or a bank holding company described in section 165(a), except that nothing in this subsection authorizes the provision of financial assistance from the Federal Government.

So this risk council will come up with rules, and the Federal Reserve will carry them out. Can these rules change on the fly? I’m not sure, but I assume from the bill that they can. Can these rules change in a crisis? I don’t see why not – there’s complete discretion over how they are created by the regulators.

But this is the exact opposite spirit of the 1991 FDICIA bill that created prompt corrective action. When the time comes to resolve a firm, the “ok, you’ve done the best with your discretion, but it’s time to call it” is written right into the bill itself: “The level specified under subparagraph (A)(i) shall require tangible equity in an amount—(i) not less than 2 percent of total assets.”

This is crucial. Here’s one of the fathers of prompt corrective action, Richard Carnell, writing in the Regulatory Incentives chapter of the Make Markets Be Markets conference (my bold):

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.

Carnell and others came up with this regime in 1991, way before “nudges” and the whole behavioral arsenal became trendy, but it is a regulatory approach that acknowledges the fact of regulatory procrastination while also allowing for the fact that regulators will have on the ground expertise that can be used for good. It saves the best parts of what regulators can do while limiting the worst part of what they can do. Imagine how easier it is for a regulator to face an angry congressman who is very upset that a powerful local community bank is going to be resolved. “What could I do? My hands are tied, it is what the law requires.” is a great response for him.

Now picture that for trying to resolve a multi-trillion dollar institution who will shamelessly lobby with hundreds of millions of dollars. Suddenly clear rules look a little bit better, don’t they?