Ring Around the Regulators

While members of Congress take their spring break, the debate over financial reform and, most relevantly, Sen. Chris Dodd's omnibus bill simmer here in Washington. Dodd's bill has raised any number of questions -- starting, most fundamentally, with "Are you with the banks or the consumers?" -- but perhaps the most confusing debate right now is over the previously obscure issue of prudential standards. (If you're just joining this debate, read my primer on the effort so far.)

In order to ameliorate risk and avoid bank runs, federal regulators set certain rules for banks: how much they can borrow relative to their assets (leverage), how much capital they need to set aside to pay their debts, what forms that capital can take, even how large they can be. Some of these rules are set by international agreements, but mostly they require the discretion of U.S. officials.

These rules, known as prudential standards, were ridiculously lax prior to the crisis. Regulators allowed some banks to borrow $32 for every dollar they had and turned a blind eye to accounting tricks -- like the infamous "Repo 105" at Lehman -- that masked risk. When the system blew up, even technocrats like those who make up the Obama administration's economics team decided enough was enough. While they weren't interested in breaking up the banks, they promised to make big banking safer and less profitable (that's essentially what less leverage and more capital means) to protect the economy and encourage bankers to take their risk to smaller institutions.

Strangely, though, the administration won't specify what those standards should be. Ostensibly, this is because it's tough to set these rules: While prudential standards sound simple, the complexity of modern finance and accounting makes it hard to determine, for example, which assets count as safe capital. Congress, in general, agreed with the administration, passing a bill in the House that instructed regulators to increase standards but did not specify by how much. (Rep. Jackie Speier managed to sneak in an amendment limiting leverage to no higher than 15 to one; until a 2004 change, the limit was 12 to one.)

In Dodd's bill, which will come to the floor next month, no outer bounds have been specified for prudential standards -- no ring has been drawn around what should fall under the purview of regulators. Instead, the Federal Reserve is ordered to raise prudential standards for systemically risky banks -- basically, banks with more than $50 billion in assets whose failure could hurt the rest of the economy -- higher than those for smaller, commercial banks. Critics are skeptical, though, reminding us that regulators have had the authority to raise standards on banks for almost any conceivable reason since 1983.

"The bill doesn’t say they may raise standards; it says they shall," Kirstin Brost, Dodd's communications director, told me of the new law. "They don’t have a choice."

This means that, hypothetically, Goldman Sachs would be forced to borrow money at less advantageous rates than the regional bank where you have your savings and checking accounts. However, the pressure from the financial industry to stop regulators from doing this, especially during a boom when risk should be reined in, will be enormous. Critics are skeptical that regulators, whose recent history does not display much in the way of independent judgment, will be effective.

While lawyers are split on the efficacy of Dodd's legislative language (the bill is liable to change in the coming weeks as well) the one strange point on which both the Treasury Department and Dodd's office agree is the inadvisability of setting these limits by statute. While neither party would comment on why they felt this way, a letter from Geithner to Rep. Keith Ellison offers a few reasons: flexibility while negotiating international agreements on financial regulation in the coming years and the need to adapt prudential standards to the economic climate.

None of this should stop legislators from setting the outer bounds of these standards, though, and defining where regulators can use discretion and where they can't. There is no need for banks to borrow at a one-to-15 rate, and capital reserves can surely be drawn at some percentage -- say, 10 -- and you can easily imagine concentration limits that draw a boundary at banks having, say, more than 10 percent of the liabilities in the system. That doesn't seem to be in the cards, but as you may imagine, whenever political officials decline to give a policy justification for a decision, look to the politics.

That's where you'll find the answer: Moderate Democrats and Republicans in Congress are skeptical of regulation and reliant on the financial-services industry; they may not vote for a bill that comes down too hard on the banks. Conspiracy-minded observers will suggest that the folks behind this legislation, principally Dodd, Rep. Barney Frank, and the Treasury Department, are also allied with the banks and trying to pull the wool over the eyes of the public.

Should policy-makers' equivocation around prudential standards be a deal breaker? Keep in mind that the regulators Obama has appointed thus far have generally been tougher on the banks than their predecessors. While Obama reappointed Ben Bernanke as Fed chair, the Fed's Obama-appointed bank regulation chief, Daniel Tarullo, has pushed back against the worst bank practices. If Dodd's legislation passes, Obama will also be able to appoint the president of the New York Federal Reserve, the most direct supervisor of the big banks. These new regulators may well enforce the spirit of the law.

Though these prudential rules are critical, it's also worth keeping in mind that they are still a small part of a much larger reform bill. Progressives won't get everything they want on any one issue and are best served by getting as much as they can everywhere. Prudential standards may not rise as high as we'd like, but derivatives reform will prevent banks from hiding risks from regulators, size and scope constraints will limit danger, consolidated supervision will hinder arbitrage, and resolution authorities will shut down failing banks instead of bailing them out. The factors that created the financial crisis need to be attacked from all angles.

Still, it's disappointing to see Geithner, Frank, and Dodd back down from making statutory rules. There is a balance to be had between hard lines and regulatory discretion, and there's not much of an argument for not placing firm limits around risk. Geithner et al. aren't doing themselves any political favors by playing coy with prudential regulation. Guys: If you like it, then you should have put a ring on it.

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