For Financial Watchdogs, Principle Counts More than Discretion

Is it good or bad that the Dodd-Frank financial reform law leaves much of the responsibility for fixing our financial system to federal regulators? Matt Yglesias makes a case for the necessity of giving government watchdogs a measure of latitude. Taking a dimmer view, Ezra Klein expresses concern about the wide discretion regulators have to set and enforce the new rules. They've failed us many times before, he correctly points out, noting their habit of folding like an accordion under pressure from bank lobbyists:

It's that dynamic -- an incredibly moneyed and politically sophisticated industry massed on one side, and pretty much no one on the other side -- that worries me about financial regulation. And that's why I'm skeptical of the approach the administration and the Congress eventually took. If it's overly vague and reliant on regulators now, what's it going to be like in 20 years?

That ship has sunk, of course. I think the question is less how much leeway regulators deserve to set rules than whether discretion, however exercised, emanates from clear regulatory goals and an institutional (and political) commitment to enforcement. Moored to such principles, discretion in the hands of the right regulator becomes a call to action; without them, it's a pretext for thumb-sucking.

And to be blindingly obvious, much also depends on who is applying that discretion. I'd be far more comfortable giving Elizabeth Warren room to run at the new Consumer Financial Protection Bureau than someone like, say, former OCC head John Dugan, the very picture of regulatory "capture." What remains to be seen is whether regulators are, in fact, committed to doing their job, and whether politicos have their back.

In other words, discretion can be your friend, or it can be your enemy. In the 1990s, for instance, regulators had enormous discretion to ignore the inherent risks of rampant financial consolidation, which foolishly razed boundaries between commercial and investment banking. Yet in the same era, regulators like Brooksley Born were given no discretion to question the wisdom of letting derivatives spread like weeds.

Same goes for the years leading up to the housing crash. Regulators willfully ignored the scary-ass tumor growing on the banking industry in the form of dubious mortgage loans. And virtually everyone, from the White House on down to the lowliest SEC pen-pusher, turned a blind eye to the systemic risks growing up through the financial pavement. It's not that regulators were restrained from blowing their whistles, however -- it's that they chose not to, in service of dangerously laissez faire ideas about the role of government.

Something should also probably be said about what we expect from regulation. As I've said before, financial rules are better at correcting past mistakes than at preventing future ones. For his part, Klein doesn't expect much:

As I see it, here's what happens next: We move to a very long rulemaking phase, as the financial regulation bill leaves an extraordinary amount undefined. That phase will probably go okay, as regulators still feel pretty burnt after the financial crisis. And then we enter a long retrenchment phase, in which giant banks just keep pushing and pushing and pushing, both against regulators and against Congress, and there are no similarly powerful interest groups pushing against them, and the public and the media are totally uninterested in the nuts and bolts of financial policy rulemaking.

But that doesn't mean regulators won't use their judgment to make the financial system moderately safer, fairer and more efficient -- for a time. For instance, one reason such supervisors failed so miserably to halt some of the practices that led to the meltdown was that regulation was deeply fragmented. Agencies shared responsibility for some areas of oversight, while other areas fell into a chasm.

Dodd-Frank helps by simplifying that structure and by divorcing regulators' focus on bank "safety and soundness" from the mission of protecting consumers. That's a good thing. What the law doesn't do is provide a framework for fundamental reform. That battle, perhaps to be fought after the next collapse, lies ahead.

Image from Flickr user Brooks Elliott
Related:

• Financial Reform: Four Reasons Stricter Financial Regulation Isn't Enough
• Funny Business: Why the Financial Reform Bill Has Become a Joke
• What Larry Summers Won't Admit About Financial Reform
• States Need Bigger Role in Halting Predatory Lending
• OCC Chief John Dugan: What, Me Worry?
• Bank Mergers and the "Curse of Bigness"
• Ex-Citigroup Chief John Reed Admits Deregulating Banks Was a Mistake