Blunt Rules

| Mon Mar. 29, 2010 9:15 AM EDT

Everyone agrees that excessive leverage was one of the core causes of the 2008 financial crash. So how do we fix this? Stronger capital requirements for banks is the usual answer, but that supposes that regulators can be trusted to impose tough standards on an industry that will fight tooth and nail to resist them. David Leonhardt:

In a way, this issue is more about human nature than about politics....“When things are going well,” Paul A. Volcker, the former Fed chairman, says, “it’s very hard to conduct a disciplined regulation, because everyone’s against you.

....One way to deal with regulator fallibility is to implement clear, sweeping rules that limit people’s ability to persuade themselves that the next bubble is different — upfront capital requirements, for example, that banks cannot alter....“We don’t know where the next crisis is going to come from,” Geithner told me. “We won’t be able to foresee it.We’re not going to pre-empt all future bubbles. So we want to build a much bigger cushion into the system against those basic human limitations. I don’t want a system that depends on clairvoyance or bravery.” He added, “The top three things to get done are capital, capital and capital.”

Sounds good! So what are Geithner & Co. planning to do about it?

Their solution is to depend on capital requirements to prevent another financial crash. They refer to these requirements as cushioning or foam on the runway. So long as a firm has enough hard assets — and can get access to their cash value — it can survive a lot of bad investments and a lot of ineffective oversight.

....But there is reason to wonder whether the capital cushions, at least in their current form, will be enough to overcome human limitations. The administration and Congress have been deliberately vague about what the capital ratios will be. They have not given out numbers or explained a myriad of details: how the ratios will vary by firm size, for instance, or how they will deal with so-called off-balance-sheet assets. Their approach has the advantage of keeping technicalities free of Capitol Hill horse-trading, much as setting interest rates is a process left to the Fed, not Congress. Vagueness also allows American regulators more freedom to coordinate with regulators in other countries. On the other hand, by remaining out of the public eye, capital requirements become yet another issue that will ultimately depend on discretion. Wall Street firms will have a chance to persuade the Fed that maybe they do not need as much capital as people first thought. No doubt, the firms will offer some highly sophisticated mathematical models to make their case.

....What is the alternative? Canada offers another telling lesson. It relies more on blunt rules than the United States does. Canada requires any mortgage with a less than 20 percent down payment to be insured, and those mortgages are much less common there. It also sets a standard leverage ratio of no more than 20. As Julie Dickson, the chief financial regulator in Canada, told me, “We become nasty when banks get close to it.”

Blunt rules inevitably have their problems. But they also send signals that can outlast a given administration or a given moment in the business cycle. In Canada, the well-publicized conservative capital rule not only restrained Canadian banks, but it also served as an immutable reminder to regulators and kept them from falling under the sway of bubble thinking.

At the risk of being branded one of those liberal haters of American exceptionalism, sign me up for the blunt rules approach.

It's not that blunt rules are any kind of panacea. Wall Street bankers dedicate their lives to figuring out clever ways to circumvent regulations, and they'll keep doing that no matter how blunt the regulations are. What's more, Leonhardt is right: the last thing we want is Congress micromanaging the regulation of risk in the financial system.

But that's the whole point of blunt rules: they may not be perfect, but they don't require Congress to do anything more than set them in the first place. You still have to trust regulators to act reasonably, but even if they don't you at least have the backstop of statutory limits that are hard to get around. Not impossible to get around, but blunt rules at least require a little bit of noise and public attention to overcome.

The big question, of course, is that even if you support this approach, just what should those blunt rules look like? They have to apply to all sources of leverage in all kinds of big financial firms, but how do you define that? What limits should regulators labor under? What's the simplest way of making sure that leverage can't just be hidden in someplace that no one anticipated when the orginal rules were written? Etc.

I'm not sure. But there are reasonable answers to these questions, even if they aren't perfect. The first step, though, is agreeing that we need blunt rules in the first place.

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