Financial Regulators Protect the Monopoly and Prevent Competition

Regulation on Financial Institutions

Introduction

The regulation of financial institutions in the US is a controversial subject, as there are arguments both for and against regulation. However, regulation for the most part is an accepted way of life and most people assume that without regulation banks would cause untold problems for themselves and the world. Ironically, it appears that the reality is just the opposite. Regulation tends to lead to reckless behavior, and then intervention is needed by the central banks to prevent collapse (Prosner, 2014; Wallison, 2005). This paper will discuss why banks are regulated, the history of bank failures, steps policy makers have taken to address those failures, lessons learned, why bank regulators are concerned with capital adequacy, what the responsibilities of various bank regulating agencies are, and how US regulation compares to European regulation overall and in spirit.

Why Banks are Regulated

Conventional reasons for why banks are regulated include the risk of bank instability, deposit insurance, the need for a central bank to be a lender of last resort, and the role of the central bank in monetary policy and large-dollar payments (Wallison, 2005). However, there are risks on the other side of regulation that are often assumed or accepted, and history shows that they are not insignificant. For example, there was the savings-and-loan industry scandal that hurt taxpayers and the economy. The banking and savings-and-loan industries had been heavily regulated prior to its collapse in the 1980s/90s; and regulation, rather than mitigate risk, quite possibly intensified that collapse (Barth, Trimbath & Yago, 2006; Wallison, 2005). Investors can be lulled into a false sense of security when they believe that sufficient or effective regulation is in place. Yet regulation can go sideways and lead to an environment in which risk is ignored and unethical practices encouraged. The decision of the Financial Accounting Standards Board (FASB) to allow fair value accounting is one such example of regulatory standards opening a Pandora’s Box of problems, seen in companies from Enron to Lehman Brothers, where mark to market accounting was not only used but exacerbated by auditing firms like Anderson, which were permitted to act in an advisory role and not just as independent auditors. The problem became a major issue in 2008, as Young (2008) notes: “As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary complexity of the instruments provided a significant impediment to insight into the underlying financial data” (p. 34). The FASB sought to serve various interests at once—economic interests, financial interests, and accounting interests—and in doing so its regulation became ineffective (Flegm, 2008). Wallison (2005) blames market discipline, but regulation can have an impact on market discipline, too.

In short, regulation is not a one-size-fits-all solution. There are effective regulations and there are ineffective regulations; there are regulations that promote stability and there are regulations that trigger instability. Wallison (2005) gives the example of how the best regulations are sometimes those that apply to the regulators themselves: “The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) added significant new regulations, including draconian penalties for violating the regulations or the orders of bank and S&L supervisors. Ironically, however, the most successful elements of FDICIA were rules governing the behavior of the regulators themselves” (p. 14-15). The conclusion that Wallison (2005) draws is that banks are regulated not so much out of necessity but because there is an interplay between private and public organizations, which results in government attempting to leverage control over private institutions in the form of regulation. The control is never total, and loopholes always tend to be found that enable firms to skirt regulations or bend the rules to their favor. Regulation can often be seen as much as a punitive measure against banks as a friendly peace offering. Some regulations promote laxity in terms of capital restraints; others are restrictive. One of the reasons for the Federal Reserve’s liquidity injections since 2019 (criticized as the start of QE-4, i.e., the fourth round of what has become known as conventional unconventional monetary policy referred to as quantitative easing) was that banking regulations had caused big banks to be forced to tie up capital to ensure that they could withstand stress like that which collapsed some firms in 2008 (Mauldin, 2020).

History of Bank Failures in the US

As the Federal Deposit Insurance Corporation (FDIC) notes, there were 559 bank failures between the years of 2001 and 2020 alone (FDIC, 2020). The vast majority of these failures occurred between the years 2008 and 2014 and resulted from the global economic crisis in the wake of the housing market bubble implosion in the US. The main highlights of bank failures in US history are the following: The Panic of 1819; the Panic of 1837; the Panic of 1873; the Panic of 1907; the Great Depression; the savings and loan crisis of the '80s and '90s, and the financial crisis of 2007-2009 (Manuel, 2020). In 1930, the first year of the Great Depression, more than 1300 banks failed (Manuel, 2020). The FDIC was established three years later via the Glass-Steagall Act. The FDIC was meant to provide insurance on deposited money in banks to prevent ban runs and collapses.

What causes bank failures? The answer is simple: banks fail when their assets fall below the market value of their liabilities. This is one reason banks faced dire straits in 2008 as the mark to market accounting in use led to exacerbated moves in pricing in the market place and caused book values to plummet (Flegm, 2008). Traditionally banks have sought to borrow money when failure risk rises. If it has to sell its liquid assets to cover obligations it will do so, but if the assets are underpriced the loss can be catastrophic. This is why the central banks around the world have adopted unconventional monetary policy of late, also known as quantitative easing (QE).

Steps Policy Makers Have Taken to Reduce Failure

Policies that have been implemented to reduce the risk of bank failures include the stress tests used by the Federal Reserve. The stress test requirements of the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) program include assessing the largest bank holding (i.e., with assets of $10 billion+) companies in the US to see if they have sufficient capital for operations in times of economic and financial stress. These same companies are also supposed to have forward-looking processes for capital planning that address the risks they face (Federal Reserve, 2020). The Federal Reserve assesses specifically “capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions,” which include dividend payments or stock buybacks (Federal Reserve, 2020). Dodd-Frank Act stress testing is done to complement CCAR by focusing on whether these same companies have the ability to absorb losses and maintain operations in an economic downturn. However, as Smillie, Epperlein and Pandya (2014) note, stress testing also has to consider risk management systems, including methods for address fat tails and tail correlation risk that simple model-based approaches to managing risk can overlook.

With the CCAR stress test, the Federal Reserve submits a scenario to the firm in which a macroeconomic situation is presented and the firm has to show how the bank would handle any shock arising from that situation. The goal of the bank is to be well-capitalized throughout the length of the situation with a minimum Tier 1 common equity ratio of 5%, even in the worst of all possible economic situations. The CCAR test requires the bank to provide the Federal Reserve with a capital action plan that covers four quarters from the point of the introduction of the macroeconomic event. The Federal Reserve determines the bank’s health with regard to its ability to maintain capital requirements to meet obligations and withstand losses. The bank is scored in terms of its financial strength and ranked accordingly.

The three main areas the Federal Reserve assesses are: 1) the bank’s data, 2) the bank’s management procedures, and 3) the bank’s requirements. These areas are assessed against the stress test’s baseline, adverse and severely adverse scenarios to see any penetrating weaknesses in the bank’s plans and processes over the course of the ensuing year. The four quarter report should indicate the bank’s projected losses, revenues, reserves and capital ratios for each scenario. Both the bank and the Federal Reserve use their own models for evaluating outcomes.

The bank’s capital plan must address the following areas:

1. It must assess the anticipated uses and sources of capital for the ensuing four quarters, and the plan should take into consideration the bank’s assets, risk profile, complexity and scope of operations.

2. It must provide an explanation of how the bank defines its own capital adequacy.

3. It must depict the capital policy of the bank.

4. And it must describe any changes to the business activities and operations of the bank that have been planned that might have an effect on the firm’s liquidity or capital.

The Federal Reserve then assesses the plan using its model for evaluating capital adequacy. By also looking at risk management and the objectives and size of the firm, the Federal Reserve can determine how well the bank would hold up in an even of macroeconomic stress, similar to what the world saw with the arrival of the coronavirus, which led to a shutdown in the global economy.

Lessons Learned from Bank Failures

The central banks have learned that to prevent bank failures liquidity injections are needed. This has led to the expansion of the Federal Reserve’s balance sheet since 2008. This year alone the Federal Reserve has added trillions to its balance sheet to help prevent bank failures and system wide collapse caused by economic shutdowns from COVID 19. So far the policy seems to be working as there have not been any major banking failures: the Federal Reserve has been providing ample liquidity through the purchase of debt—national, corporate and mortgage-backed securities. It has also routinely stress tested the major banks to ensure that they have sufficient capital on hand to withstand any credit crunches caused by the economic downturn. For example, it recently requested that Wells Fargo slash its dividend to shareholders following the bank’s stress test performance, the purpose being to ensure that the firm has sufficient capital (English, 2020).

Evaluating the Plan from Success to Failure

Evaluating the plan from success to failure is important and can best be accomplished by employing enterprise risk management (ERM) strategies. Since ERM is about centralizing risk management, two ways in which auditors can incorporate ERM into the company’s audits are: 1) develop risk based auditing procedures; and 2) targeting risks instead of processes in auditing. As Hall (2007) points out, “by communicating detailed audit reports organized by risk rather than process, internal audit can emphasize the ability of the organization to effectively or ineffectively manage that entire business risk (i.e. the vertical view)” (p. 10). For banks, the audit report could include a section on policy risk, with risk management analysis and proposed solutions, while discussing the residual impact, the inherent risk, and the effectiveness of the risk management proposed solution with a target date for implementation. That would be a way to improve the audit report around developing risk based auditing procedures. Targeting risks instead of processes in auditing would entail looking at risks and the processes associated with those risks instead of the other way around. It helps to orient the audit process towards a risk-based approach instead of a process-based approach in which risk is the afterthought. The forethought here is risk, and processes are developed in response to risk. It is a proactive way to audit from an ERM perspective and Wells Fargo would be able to prevent departments from taking actions like putting customers into forbearance when the customers have not actually asked for forbearance and are actively paying on their loans.

Why Bank Regulators are Concerned about Capital Adequacy

Bank regulators are concerned about capital adequacy because it is their mandate to be so: they are meant to prevent bank panic and contagion from spreading in the financial system (Posner, 2014). As Posner (2014) puts it: “A bank with a high ratio of capital to assets will, all else equal, be better able to withstand a sudden loss than a bank with a low capital-asset ratio. As a result, such a bank is less likely to be thrown into insolvency or subject to a run” (p. 2). Capital adequacy has thus always been the focus of bank regulators. However, it was not until the 1970s that regulators began to think more systematically about capital adequacy and particularly about minimum ratios. Gradually in the latter half of the 20th century, regulators established explicit capital adequacy rules with an explicit definition of capital adequacy. They then adopted strict minimum capital-asset ratios, and coordination among banks followed (Posner, 2014). It was important for there to be coordination for the same reason it is important to achieve herd immunity in the face of a flu or to achieve 80% coverage with a vaccination: if the standard is only met by half it will be ineffective at preventing contagion. Bank regulators are concerned about capital adequacy because that is how they manage to stave off contagion, moral hazard, and so on.

Ironically, as regulatory rules began to spread and become standardized, regulators justified the adoption of these rules on the grounds that they would affect very few banks. As Posner (2014) points out, “the only clear idea that emerges from an examination of the regulatory documents is that the regulators believed that the regulations would affect very few banks, on the order of 5 percent or fewer. Thus, a major theme that emerges is that regulators defended their regulations in part on the grounds that those regulations did not inflict costs on most banks” (p. 3). Thus, regulators were interested in regulating the industry in a way that, surprisingly, benefited the big banks. This benefit suggests that the nature of the relationship between the regulators and the banks, which control powerful lobbies that have one objective—to impact regulatory agencies so that they regulate in their favor. In fact, US regulators have never conducted a high quality cost-benefit analysis of US regulation on US banks. Only one study, conducted in 2011, has been done of a high quality cost-benefit analysis, and it was conducted by an international organization rather than by a US agency. The finding of that study was that capital requirements were too low. In effect, regulators in the US were issuing softball regulations to the big banks (Prosner, 2014). The purpose of banking regulation with regard to capital adequacy in the US, Prosner (2014) argues, is to oblige smaller, weaker banks to change by raising capital or going out of business. Regulation of banks in America is meant to support a monopoly of the industry by the big banks—that is the sole function of regulation with regards to capital adequacy (Prosner, 2014).

Responsibilities of Various Bank Regulatory Agencies

First there is the Federal Reserve Board (FRB) and it is tasked with implementing monetary policy via open market operations, which impact the purchase and sale of Treasury securities. The FRB determines the federal funds rate, the interest rate for institutional deposits. The FRB also oversees the banking system to ensure stability in the financial system. Its stress tests of major banks are conducted to that end. Its injection of liquidity, i.e., QE, is conducted to make sure there is enough capital in the system.

Then there is the Office of the Comptroller of the Currency (OCC), which oversees and regulates charters for US banks. The OCC operates within the Treasury Department and it is tasked with oversight essentially. Its mission is to “ensure that national banks and federal savings associations operate in a safe and sound manner, provide fair access to financial services, treat customers fairly, and comply with applicable laws and regulations” (Schmidt, 2020).

The FDIC insures funds deposited into banks. The Commodity Futures Trading Commission (CFTC) regulates the futures and options markets. The Financial Industry Regulatory Authority (FINRA) oversees and regulates public companies and settles disputes between brokers and clients. State bank regulators operate like the OCC. The Securities and Exchange Commission (SEC) enforces federal securities laws (Schmidt, 2020).

US Banking Regulation Compared with European Banking Regulation

US banking regulation under the Trump administration has softened regulatory restrictions for small and mid-size banks while tightening constraints for large banks in terms of capital adequacy, stress tests, and so on (Cabrera, 2020). European banking regulations are less stringent, but essentially the same problems that exist for US banks exist for European banks. As Ayadi, Arbak and de Groen (2012) note, “Despite unprecedented levels of state aid and liquidity support provided to them by the European Central Bank, EU banks are still undercapitalised and exposed to potentially large future losses. Furthermore, structural vulnerabilities that were at the core of the 2008 crisis have not gone away: high leverage, excessive reliance on unstable funding and large derivative positions remain intrinsic features of the largest EU banks' business model” (p. 2). In other words, the same regulatory pitfalls that exist in the US also exist in the EU. The nature of the problem is also the same: it is one in which the relationship between regulators and big banks is impacted by conflicts of interest, as the banks are the ones lobbying for stricter or laxer regulations as the case may be. As noted before, not all regulation is “bad” for the business model of big banks; some of it is “bad” for small banks that cannot reach capitalization requirements. At the same time, capital adequacy is a risk that central banks have shown themselves willing to mitigate by use of unconventional monetary policy. Thus, the purpose of regulation appears to be null and void, other than to keep smaller banks out of the industry. The central banks backstop the capital illiquidity of big banks and the regulators act as gatekeepers to prevent smaller firms from entering into the market. The case is the same in Europe as it is in the US in this regard.