Avoiding the subprime siren song
As the subprime meltdown continues to roil the markets and rattle policy makers, many are considering what it means to be a "regulated" financial institution. Congress has been busy pummeling bank regulators for not extending their turf over unregulated mortgage companies and brokers. Lost in the commotion are two salient facts: regulated banks as originators of mortgages largely avoided the subprime catastrophe; and regulated investment banks served as a catalyst for the subprime industry by bundling and selling questionable assets originated outside the regulated banking industry. How could one segment of the financial services industry get it so right while another went so far astray?
Until recently, a consensus seemed to be forming around the notion that overregulation of domestic financial services firms had placed them at a competitive disadvantage vis-a-vis foreign firms and markets. It found its voice in several significant studies, including ones by the US Chamber of Commerce, Treasury Secretary Henry Paulson, and Senator Charles Schumer and Mayor Michael Bloomberg, both of New York. The studies pushed for "principles-based" regulation. Opponents were forced into the awkward position of opposing principles.
How policy makers from across the political spectrum arrived at the same conclusion can be traced to 1999 when President Clinton signed into law the Gramm-Leach-Bliley Act. It set the course for the industry's future by ratifying the notion that financial services firms of any stripe could come together under one corporate owner with one set of shareholders. Out of fear that the Fed would run amok as a central regulator, the notion of functional regulation was also enshrined in the law.
The events of 9/11 and the hastily enacted Patriot Act created a "Punch and Judy" relationship between banks and regulators. Massive fines and scalded reputations have been the industry's price to pay for millions of reports to the government, the value of which has yet to be proved. Enron/WorldCom begat Sarbanes-Oxley. Finally, Eliot Spitzer, in his role as attorney general of New York, pointed out the glaring industry practices taking place under the noses of the functional regulators (market timing, late trading, analyst conflicts, and finite risk insurance, to name a few). Regulators found to be asleep at the switch have adopted a stern "never again" mode of regulation, making life miserable for the firms they regulate, though handsomely rewarding for their compliance officers.
It is into this climate of regulatory hyperventilation that "principles" seems like a good way to turn down the heat. For a few observers, principles-based regulation is code for deregulation, a perpetually timely topic. For others, it is a Trojan horse for the creation of a monolithic domestic financial services regulator, a traditional nonstarter in Congress. Most, however, view the approach as a means of ensuring that significant regulatory actions are grounded in a consensus list of shared values. With the subprime crisis in full flower, the longing for regulatory principles takes on a new dimension.
In a recent study conducted by the Morin Center, we pointed out that agreeing on principles would be a hollow accomplishment if unaccompanied by a harmonization of the regulatory cultures that prevail among the major agencies. It is that regulatory disconnect that causes what is perceived as governmental overkill. Two steps toward achieving such harmony are: take the informational intimacy shared by banks with their regulators and adapt it to investment banks and their regulators; invite securities regulators to become members of the little-known council that has been harmonizing the activities of bank regulators for almost three decades. The Federal Financial Institutions Examination Council, expanded and emboldened, can serve as an ideal vehicle for requiring our financial services regulators to act in unison.
It is no accident that banks did not succumb to the subprime siren song. Questionable products and sales tactics would surely be picked up by the banks' regulators so there's every incentive for bankers to avoid bad deeds and self-disclose the ones already committed. There is a chance that investment banks, had they shared the same relationship with their regulators, may have shied away from these combustible products and been more transparent in their pricing. At the least, these measures would move us to a better place, one of regulation by supervision as opposed to regulation by enforcement.
Cornelius Hurley is director of the Morin Center for Banking and Financial Law at Boston University. 
