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 Just before the inauguration of President BarackObama, a subcommittee of the G30, a privateorganization of international financial experts,published a report setting out a series of recommen-dations for regulatory reform in the wake of thefinancial crisis.
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Because the head of the subcommit-tee was Paul Volcker, an adviser to President Obama,the
Washington Post
immediately suggested that itsrecommendations were a forerunner to what theObama administration would propose, calling it “thefirst hint of the kind of changes to the financial sys-tem President-elect Barack Obama might push for inthe coming weeks and months.”
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We should all hopethat greater thought and imagination goes into theObama administration’s proposals on financial regu-lation, whatever they may be.The report is unusual in that it consists almostentirely of background discussion and recommenda-tions, without any underlying analysis or justificationfor its proposals. The idea that far-reaching recom-mendations can be made without any analyticalsupport—based, apparently,solely on the credentialsof the authors—is disconcerting. And the recom-mendations are indeed far-reaching. Among them:•Special regulation of “systemically importantbanking institutions”•“A framework for national-level consoli-dated prudential regulation and supervisionover large internationally active insurancecompanies”•Reorganization of money market funds as“special purpose banks” if they offer transac-tion features•Special prudential regulation of “systemi-cally significant” private pools of capital(such as hedge funds and private equity)•A special legal regime that would provideregulators with “authority to require earlywarning, prompt corrective actions, andorderly closings of regulated banking orga-nizations, and other systemically significantregulated financial institutions”These are recommendations that could pro-foundly reshape the U.S. financial system—and notfor the better.
   F   i  n  a  n  c   i  a   l   S  e  r  v   i  c  e  s   O  u  t   l  o  o   k
1150 Seventeenth Street, N.W., Washington, D.C. 20036202.862.5800www.aei.org
Regulation without Reason:The Group of Thirty Report
By Peter J. Wallison
For months, the media have been predicting that a strong new regulatory flux would emerge from the financialcrisis. Now, with a new report by the
dirigiste
wing of the Group of Thirty (G30), we know what the future couldlook like. A good summary is that bank-like regulation would be spread beyond the banking industry. But there’s a problem: banks have been tightly regulated for years, both in the United States and Europe, and of all the institutionshurt by the financial crisis, they are in the most trouble. How do the bankers, academics, and financial policymakerswho make up the G30 deal with this? They don’t. In the wake of this report, the principal question that Congress,the Obama administration, and the American people should ask is why regulation should be extended to most of themajor players in the financial system when it has been a consistent failure for banks.
 January 2009
Peter J. Wallison (pwallison@aei.org) is the Arthur F. BurnsFellow in Financial Policy Studies at AEI.
 
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The Elephant in the Room:The Failure of Bank Regulation
The weakness of the banking industry—the most heavilyregulated part of the financial system—is the central andmost obvious problem in the current financial crisis. This isnot a new development. The current regulatory regimefor commercial banks and savings and loans (S&Ls) wassubstantially tightened after the S&L debacle in the late1980s, in which the S&L industry col-lapsed and 1,600 commercial banks alsofailed. This gave rise to the Federal DepositInsurance Corporation Improvement Actof 1991 (FDICIA), which significantlyincreased the powers of bank and S&L reg-ulators. FDICIA was adopted to make sure,as is always said, “this won’t happen again.”Yet, only a few weeks ago, the federal gov-ernment had to commit several hundredbillion dollars for a guarantee of Citigroup’sassets, despite the fact that examiners fromthe Office of the Comptroller of the Cur-rency (OCC) have been inside the bankfull-time for years, supervising the operations of this giantinstitution under the broad powers granted by FDICIA tobank supervisors.Ordinarily, confronted with this dismal narrative, any-one recommending more regulation—covering yet more of the financial system—would at least feel the need toexplain why the new regulation would be different andbetter than before. To be sure, there is an effort to advance“improvements” in prudential regulation and supervision,but these are weak and pedestrian. There are also somevague recommendations for reducing regulation’s obviousprocyclicality, but for the most part, these are superficialand unimaginative. Fundamentally, the report seems toreflect a judgment that the financial crisis makes the needfor new and broader regulation self-evident. In reality,however, the opposite is true; the financial crisis shows thatregulation is no better than market discipline at preventingthe failure of financial institutions and that even inthe dire circumstances of the current crisis, systemic risk—the only justification for extending regulation beyondbanks—has not appeared.Apart from its multinational approach, the report’s rec-ommendations for improving regulation and supervisionhave all been around the track in ages past: “Countriesshould reevaluate their regulatory structures with a view toeliminating unnecessary overlaps and gaps in coverage”(there were no “gaps” in coverage, however, in the OCC’sunsuccessful supervision of Citi); countries should “reaffirmthe insulation of national regulatory authorities from polit-ical and market pressures” (it is doubtful that this meansfreedom from congressional oversight, but if not, it has nomeaning at all); the central bank should have supervisoryresponsibility over systemically significant firms (the Fed-eral Reserve has had such authority over the holdingcompanies of all the major U.S. banks since the 1970s, tono apparent effect); and there should bemore international cooperation and coordi-nation (the Basel Committee on BankingSupervision, consisting of the bank regula-tors of all the developed countries, has alsobeen operating without notable successsince the 1970s).The recommendations for how supervi-sors are supposed to deal with procyclical-ity are somewhat more insightful. There isa recommendation for increasing bankcapital requirements in periods of exuber-ance and a recommendation for greaterrisk disclosures, but no discussion of howprocyclicality might have contributed to the failure of bank regulation in the current crisis or in the past. Thereis veiled criticism of Basel II’s new model-based approachto credit risk (“Benchmarks for being well capitalizedshould be raised, given the demonstrable limitations of even the most advanced tools for estimating firmwiderisk.”), and there is an important gesture toward changingthe focus of fair value accounting so that it more closelyaligns with an institution’s intermediary role (“[T]heaccounting principles and approaches applicable to regu-lated financial institutions whose primary purpose is tointermediate credit and liquidity risk need to be betteraligned with the firm’s business model. A pure mark-to-market accounting model is generally preferred for tradingactivities and most elements of market risk.”). The balanceof the recommendations, however, is uninspiring. Forexample: “conducting periodic reviews of a firm’s potentialvulnerability to risk arising from credit concentrations,excessive maturity mismatches, excessive leverage, orundue reliance on asset market liquidity” (If this has notbeen part of regular bank supervision, it is unclear whatthe regulators have been doing.); “international capitalstandards should be enhanced” (The Basel Committeespent the last ten years trying to develop an enhancedinternational capital standard for banks, which went intoeffect just before the collapse.); and “supervisory guidance
The weakness of thebanking industry—themost heavily regulatedpart of the financialsystem—is the centraland most obviousproblem in the currentfinancial crisis.
 
for liquidity standards should be based on a more refinedanalysis of a firm’s capacity to maintain ample liquidityunder stress conditions” (According to the chairman of the Securities and Exchange Commission [SEC], two daysbefore its rescue, Bear Stearns had $12 billion in liquidsecurities;
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how would “refinements” have addressedthis?). In other words, there are few new ideas underlyingthe G30’s move to impose more and broader regulation onthe financial system—just the same old impulse for moreregulation when the regulation already in place has failedonce again.
The Deficiencies of FinancialRegulation—and When It Is Needed
Even if regulation had been successful in the past, therewould be many reasons not to impose it more widely—none of which can be found in the report:•The very existence of regulation—especially safety-and-soundnessregulation, with which the reportprimarily deals—creates moral haz-ard and reduces market discipline.Market participants believe that if the government is looking over theshoulder of the regulated industry,it is able to control risk-taking, andlenders are thus less wary that regu-lated entities are assuming unusualor excessive risks.•Regulation creates anticompetitiveeconomies of scale. The costs of regulation are more easily borne bylarge companies than by smallones. Moreover, large companieshave the ability to influence regulators to adoptregulations that favor their operations overthose of smaller competitors, particularly whenregulations add costs that smaller companiescannot bear.•Regulation impairs innovation. Regulatoryapprovals necessary for new products or servicesdelay implementation, give competitors an oppor-tunity to imitate, and add costs to the processof developing new ways of doing business ornew services.•Regulation adds costs to consumer products.These costs are frequently not worth the addi-tional amount that consumers are required to pay.•Safety-and-soundness regulation in particular pre-serves weak managements and outdated businessmodels, imposing long-term costs on society.These deficiencies—together with its regular failure asa protection for the taxpayers or the economy—suggestthat regulation should be a last resort, employed only whenabsolutely required. There are several circumstances thatmay meet this standard:• When a company or an industry has the back-ing—implicit or explicit—of the government.Explicit backing exists, for example, with com-mercial banks. Implicit backingexisted when Fannie Mae and Fred-die Mac were allowed to continueoperating with government chartersand other benefits that signaled tothe market that they would never beallowed to fail. In these cases, thewariness of creditors is impaired, andmarket discipline is reduced, allow-ing more risk-taking than wouldnormally occur. Because of itsadverse effect on competition and itstendency to create taxpayer liabili-ties, government backing—explicitor implicit—should be avoided. Butwhere it occurs, regulation is theonly option.• When the failure of a particularcompany or financial institutionwill have systemic effects by weakening or causingdefaults by its counterparties, depositors, or credi-tors. As discussed below, there are elements here of self-fulfilling prophecy. If we designate companies as“systemically significant,” we will certainly makethem so. The designation itself reduces or eliminatesmarket discipline and enables them to grow fasterthan their competitors. In normal markets, it is verydifficult for companies without government backingto become systemically significant, and currently,the only companies that can be so considered arealready regulated as banks. As discussed below, a
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Ordinarily, confrontedwith this dismalnarrative, anyonerecommending moreregulation—coveringyet more of thefinancial system—would at least feelthe need to explain whythe new regulationwould be different andbetter than before.
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