Klein: Don't Trust the Financial Regulators

Here's my problem with the financial-regulation package that Sen. Chris Dodd has proposed: it hands the very regulators who failed us in 2005 and 2006 and 2007 and 2008 the responsibility for saving us next time. If you tried to work backward from the bill to an account of the meltdown that produced it, you'd come up with something like "We have a wise and brave class of regulators who did not have quite as much information or power as they needed to stop the financial crisis."

Anyone who remembers Alan Greenspan and Ben Bernanke dismissing the housing bubble knows that's not quite right. But regulator failure is a fact of life, or at least of bubbles: it's pretty much in the definition of a bubble that the relevant regulators don't believe there is a bubble. Otherwise they'd pop it. The trick is building protections that work even when the people in charge don't realize they're needed.

The most successful example of this is federal deposit insurance. Before the Great Depression, bank runs were an all-too-common occurrence. There were dozens in the years leading up to 1929. FDR's response wasn't to create a Commission on Bank Runs tasked with watching banks and stepping in to insure their deposits if they got into trouble. He insured all consumer deposits. It didn't matter whether the chairman of the Federal Reserve thought your bank was playing nice. Your money was safe even if he got it wrong.

If you want proof of how well it worked, ask yourself this: did you line up outside your bank to close your account after Lehman collapsed?

The corollary today is capital requirements. When Lehman went down, its leverage was at about 30:1. That means it had borrowed $30 for every dollar it had in assets. Leverage that high does a few things: First, it gives the bank more money to take risks, which banks like because it means higher profits. Second, it means that the bank has less money to pay back creditors if a bunch come calling at once, making failure more likely. Third, it means that if the bank does go down, it does more damage to the system be-cause there are more people counting on the bank's paying them back.

Keeping capital requirements at manageable levels is financial regulation's strongest tool. But Dodd's bill doesn't spell out manageable levels. Instead, it leaves that up to regulators (mostly at the Federal Reserve) and gives them a bit more power to impose such requirements. But it's hard to put too much faith in that. In most cases, they have that power today. "The story the regulators want to tell," says Richard Carnell, a former assistant secretary of the Treasury for financial markets, "[is] that they just needed more tools. But they can set capital requirements now. They had ample tools, and they lacked the prescience and will to use them."

Consider this from the regulator's perspective: you think a bank is in trouble and needs some harsh regulations or, worse, to be shut down. Suddenly you're inundated by shareholders, bank executives, lobbyists, and legislators from whichever state the bank is based in, all of them demanding you back off and assuring you that nothing is wrong. And who's on the side of shutting the bank down? Well, no one. And if you get it wrong, or you lose the internal battle at your agency, it's a huge blow to your career.

The bill that Rep. Barney Frank passed out of the House of Representatives took a more promising approach, setting capital requirements at a modest 15:1. That gives regulators a simple ratio to enforce rather than relying on their ability to figure out the right capital ratio to impose.

Another approach relies on the market: the University of Chicago's Luigi Zingales and Harvard's Oliver Hart note that the much-maligned credit default swaps (essentially, bets that investors placed on various market outcomes) did a better job than regulators at predicting which firms would fail, and when. Zingales and Hart note that the credit default swap market had gotten anxious about Bear Stearns all the way back in August 2007—long before the company's collapse in March 2008. If you made some changes to the credit default swap market (like putting it on exchanges so it's transparent), you could use it to trigger automatic regulatory action.

However you do it, you need something more objective, and less easily influenced, than individual regulators. They do their best, but their best has not been good enough.