On self-regulation in banking

I spoke to Max Keiser recently about a number of issues in a wide-ranging interview featured below. In the video, Max and Stacy Herbert talk about some of the hot button issues of the day like the banking sector in Ireland and the lack of criminal prosecutions in the US for the first 13 minutes or so. In the last half of the video I talk to Max about a lot of topics including gold, mortgage fraud, WikiLeaks, currency revulsion, and sovereign debt.

Let me focus on one: fraud. It is astounding when you think that the US suffered the worst financial crisis in three-quarters of a century after an epidemic of fraud and it hasn’t yet seen any major prosecutions. And, yes, in 2004 the FBI warned of a mortgage fraud ‘epidemic’ and sought to head off the ‘next S&L crisis’. So let’s get that straight.

The financial commission tasked with looking into this has devolved into a partisan shambles, with the Republicans pre-emptively releasing its own version of events scrubbed of any anti-banking connotations in terms like "Wall Street" and "shadow banking" or the words "interconnection" and "deregulation". What is likely to happen if the mortgage and foreclosure crisis becomes a systemic legal problem?

My take: We will see efforts to fix the problem by changing the rules much as the end of mark-to-market fixed the credit writedowns problem in 2009.  That’s America’s idea of bank regulation.

Apropos regulation, I like Ron Paul but I believe he goes overboard when he says:

"I don’t think we need regulators. We need law and order. We need people to fulfill their contracts. The market is a great regulator, and we’ve lost understanding and confidence that the market is probably a much stricter regulator."

How would I have phrased it?

"I don’t think we can count on regulators because they are often captured by industry. We need law and order too. We need people to fulfill their contracts. And the market is usually a great regulator too, and we’ve lost understanding and confidence that the market can probably be a much stricter regulator."

See the difference?  The difference is that, while I don’t trust regulators to do their jobs any more than Paul, I don’t trust the banks to self-regulate. Self-regulation is to regulation what autoeroticism is to eroticism.

Let me run my parable of self-regulation in banking by you again. It’s called "Ms. Watkins, why does Charlie have lit dynamite?

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

Here’s a tale that goes the other way. In Germany, for years riders on public transportation have self-regulated, meaning there are no police officers around to over-police Germany’s subways, trams, and trains. You can enter the tram from the back. When you get on the Pendelzug (commuter train), no one is checking tickets. They don’t even have turnstiles. But, every once in a while the police do come through to check – so that the potential of getting caught is a deterrent to would-be free riders. Germans generally respect law and order and this system functions well. This is the best example of self-regulation. But notice, the Police are still active. They still have a presence at major subway stations and central train stations. It isn’t the kind of self-regulation that Ron Paul seems to advocate in his quote.

Here’s something I think Ron Paul can get behind, though. Banking is a cartel and the price one pays for insolvency is seizure by the regulator. Risk capital takes the hits first, and only afterward does the taxpayer. There is no reason companies like Lehman should not fail. But you have to have the pre-conditions to do so without excessive amounts of contagion. That’s where too big to fail is still a problem. See my post "Replacing market failure with regulatory failure" where I go a bit more into this.

In any event, there was an epidemic of fraud and we did in fact have the next S&L crisis – and I would argue it was because of criminally low interest rates and a lack of regulatory oversight. So where are the civil and criminal prosecutions, where are the perp walks? How do you enforce self-regulation, if the biggest players have virtual immunity from prosecution? It doesn’t make any sense to me.

For those of you who like a little venom, Max delivers in the video. This is not the BBC.


  1. Matt Stiles says


    I agree with your rephrasing of Dr. Paul’s statement. I want rules and regulations too. I just don’t trust “regulators” to be the ones enforcing it. I’d far prefer, however, “standards” or “generally accepted principles” and more balance sheet transparency to “regulation.”

    In other words, I think the question should be, “how can we enable the market to be a better regulator,” rather than, “how do we force these regulators to do a better job?” I don’t think they can. And my reason for that belief is rooted in the very foundations of human action – people cannot consistently be expected to act contrary to where profit motives are directing them. But also note, that I am only asking for the market to be a “better” regulator. Not a perfect one. That is also impossible. However, the subjects of market failures have a far more ethical distribution than do regulatory failures.

    Allowing for more diverse ratings agencies would obviously be one way to accomplish this. The current cartel-ized system is very obviously captured, yet no new entrants were allowed to take their place, “officially,” that is. Newer agencies would have, undoubtedly, required more balance sheet transparency as the securitization revolution exploded.

    Would uninsured depositors have had as much tolerance for the kinds of leverage ratios we witnessed? Likely not. But thanks to FDIC blanket insurance, that kind of discipline was not even encouraged.

    These are the kinds of morally hazardous regulations Dr. Paul advocates eliminating. And as we can see, their elimination would actually result in more “regulation,” yet merely by different people – with different interests. But it seems that Dr. Black is implying, through his vitriolic hate of “anti-regulation,” that Dr. Paul is advocating the free reign of fraud. It is a kind of political hyperbole that I find particularly distasteful and unbecoming of an intellect of his stature.

    1. Edward Harrison says

      Hi Matt. I’ll agree with you nearly 100% on this one. I do think Dr. Black was more measured in his comments about Dr. Paul than you do. But on the whole, where I agree is that it is misguided to rely on ‘experts’ to do the work that markets generally do better. Time and again we see that market-oriented approaches achieve better results.

      In fact, I would argue that the ‘expert’ orientation that Tim Geithner has shown with his quote about the need for the Obama Administration to do “deeply unpopular, deeply hard to understand” things to cravenly bail out the financial sector is exactly the problem.

      We should ASSUME regulators will be captured AND that markets can fail but structure a system with four or five points of reinforcement against failure instead of one or two. You need good laws, proper enforcement, knowledgeable regulators, a good legal system, and undistorted market. How many of those things does the US have? I am surprised that I can look back and say none of them. As cynical as I am, I hadn’t expected to compile a list and see the US fail on every level.

      Where would I invest money first? In constructing a framework for a market that can withstand failures. And that probably means limiting bank size.


    2. Edward Harrison says

      Here’s Will Wilkinson making the same argument today.


  2. Matt Stiles says

    Resilient markets require many preconditions:

    – abolition of legal tender laws to prevent inflationary bias
    – abolition of FDIC
    – abolition of rating agency cartel
    – separate chartering of full and fractional reserve banks
    – separate chartering of investment banks

    Liberated markets for rating agencies and deposit insurance would better allow for a more efficient banking system. There would be more failures, but they would be small failures. For a depositor at a 100% reserve bank (reserves denominated in whatever they chose) – a failure would result in loss by only a few percent. At a fractional reserve bank, it would result in a much larger loss. 100% reserve depositors would have to pay for their protection through low (or negative) interest rates. Fractional reserve depositors get the benefit of positive interest, but only at the cost of increased risk and higher fees for insurance. No free lunch for anyone. And no exogenous inflationary biases goosing implied future returns for higher risk sectors.

    There will be failures in this system too. But they will be more ethically distributed among those that took higher risk. Those that would do best would be whomever was able to keep their money in the most stable, responsible, well-managed fractional reserve bank. It is a positive reinforcing incentive for depositors to do more careful screening.

    I think without state deposit insurance, and the clear separation between bank charters, there is even less justification for a state guarantee of all operations – thus the incentive to attain size to become TBTF is gone. If international interconnectedness is a systemic problem, the rates of private insurance should reflect this. As for regulators, I think they could equally be termed “auditors” or “watchdogs” under this construct. I’d prefer they be independent of each other. And as numerous as is necessary.

    I am aware of the implications of these policies: lower growth (contraction at times), politically destabilizing failures at inopportune times, and even the odd irrational panic. But the key is the ethical distribution of profit and loss among those who take risk and those who don’t – without the coercive forces that seek to skew risk taking (or “time preference”, or whatever the term is).

    For a market to withstand failures, they have to expect them to occur regularly. Any system that assumes away the role of failure in any marketplace will inevitably induce the kind of risk-taking that sows the seeds of its own destruction.

    I’m fine with lower growth if it means a lengthening of time preferences – a return to entrepreneurial focus on increasing productivity and away from short-term, inflation-beating speculation. I know you’ve mentioned political instability as a side-effect to liquidationist resolutions, but I really think the instability that results now from haircuts on bondholders is surpassed by any future instability that results from an inflationary destruction of the middle and lower classes.

    I’m not sure what you’ll think of my construct, but I’m sure we’ll both agree that getting from here to there is implausible…

    Ok, off my high-horse for the day…

  3. DavidLazarusUK says

    Markets are not always right either. They missed the property bubble till the very end. As Keynes said markets can remain irrational for longer than anyone expects. So market based solutions are not a good way to go.

    So what would be better is simple rules that even regulators cannot ignore or abuse. The risk based system basically allowed banks to say we are taking no risk, therefore we should be allowed to lend even more. Then when these were found to be false the tax payer had to bail them out. It was called the Global Financial Crisis.

    Fixed multiple ratios of capital would be be better, and even allow the average investor to regulate the banks. It would mean that banks would have lower lending and lower profitability, but otherwise they would just grow and become a burden on society. If the rules were fixed then ordinary citizens could take the regulator to court, for failing in his or her duty. If the rewards of a successful prosecution was doubling their money, subject to a cap, how many of you would decide that it was a great way to make money and do it full time? If the regulator was then found guilty they could be disqualified from working in any financial enterprise for life, even as a mere bank teller. A regulator who cannot work in the industry is not worth capturing.

    The ending of deposit insurance is a guarantee to have runs on banks. For most people without the FDIC they would hide their money under the mattress. That could cause problems for the tax authorities, and fuel a black economy. Scrapping the FDIC is a way of sophisticated speculators laying the risk of on the average person. The average person does not have the skills to read through every financial document that banks will produce in order to assess the safety of their money. You only have to see how banks have proliferated the clauses on credit card contracts to hide fees and charges. Most people simply only read the main points. And how many of us pay lawyers to check every legal document/credit card application that is place in front of us? Lower the cap to $50 000. That will leave the vast majority of depositors still 100% protected. That will increase the incentive of sophisticated investors to watch their banks. Also add a whistleblower clause that can guarantee payment in full for any company that discovers a problem bank. If a small business with deposits above the cap discovers a problem then after the FDIC protected deposits are paid out then the whistleblower can get paid in full with the remaining depositors and shareholders bearing the cost of the bank failure.

    What should happen is that a bank default should be be dealt with by the FDIC and the FBI. They should be treated as potential criminal actions, unless proved otherwise. We might have seen far more white coiler criminals behind bars if that had happened.

    I do agree with Matt Stiles on the separation of investment and commercial banks, though his other suggestions would not work. The UK had well regulated banks until the “Big Bang” allowed banks to enter merchant/investment banking markets. Fractional reserve banks had been successful with the UK central banker that demanded deposits from banks that had over lent. This meant that overall lending could be controlled without needing to raise interest rates. That could work again. Central bankers could demand deposits from any bank that lent too much to any sector or was becoming a systemic risk. This could be done behind closed doors without alarming the markets. It worked before. It could work again. Banks need to become a boring business again. Investment banks need to be kept well away from tax payers money. Failures are not necessary to regulate banks. The UK had not had any bank runs for more than 130 years prior to the financial crisis. Banks failed but without impacting the taxpayer.

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