The Enforcement Problem with Regulation Reform

In addressing regulatory challenges posed by the financial crisis, a central question will be how much effort should be allocated to creating new rules for financial institutions and how much effort should be allocated to enforcing existing ones. To date, the principal focus has been on the creation of new rules – new rules on mortgages and predatory lending, new rules reorganizing the federal financial regulators, even new rules returning banks to the Glass-Steagall era. At the same time, government’s efforts to refine programs intended to unfreeze the banking and credit markets have continued at a rapid pace, which has contributed to the number of new and changing rules for financial institutions.

Not nearly enough attention has been paid to enforcement issues, which will be extremely significant, particularly in the months to come right after any new rules are finalized. What are some of the pitfalls of new rulemaking and what will implications will new rules have for regulatory enforcement going forward? My principal reservation about creating new rules stems from the currently charged political environment, in which competing interests are asserted with inadequate restraint.

When enacting more and more legislation is a primary goal, the clash of competing interests can end up undermining desired outcomes. There is no better example of this than recent experience with the Troubled Asset Relief Program (TARP)’s Capital Purchase Program. As conceived, the Capital Purchase Program seemed to be a reasonable response to the events of the fall of 2008. Because of the difficulties posed by constructing a workable program to purchase troubled assets from bank balance sheets, TARP money was instead allocated to shoring up bank capital in the hope that such increased capital would spur lending. But because the national economic outlook severely darkened after the Lehman Brothers bankruptcy, TARP money did not bring with it an expansion of lending – banks generally followed another desired path and instead chose to reduce balance sheet risk.

At the same time, the fact that public funds were involved drew greater legislative scrutiny of executive bonuses within the financial community, driven by an adverse public reaction to the amounts received. Public anger was ultimately channeled into what many in the industry considered to be punitive legislative proposals capping executive pay. The net result was to create suspicion on the part of the financial industry, parts of which continue to need public assistance in some form, against public assistance as a matter of principle. In the same vein, the asserted immigration policy behind the TARP requirements for H-1B visas was not necessarily congruent with a policy of rapidly restoring banks’ fiscal health.

Similar pitfalls could crop up in efforts to rationalize and further empower the nation’s banking regulators. In a charged political environment, the core competencies of regulatory agencies may be obscured by their perceived stands on issues that resonate with sections of the country and their representatives, such as foreclosure relief. The results of enacting new rules in such circumstances may be counterproductive: a banking agency whose mission has historically been limited may find itself with new powers but with inadequate resources to wield such powers effectively, all because the agency has put to the forefront one or more popular policy proposals. This is hardly a recipe for increasing the safety and soundness of the nation’s banking system.

Another consequence of new rule creation is the consequent diversion of resources – monetary, systems and human capital – into compliance with the new rules. On this score, experience with the US Patriot Act of 2001 and the Sarbanes-Oxley Act of 2002 is highly instructive: both required the financial community to make considerable compliance efforts in the years immediately following their passage. Although it is difficult to say with certainty, the fact is that financial institutions, like all corporations, have to ration their resources. Herculean efforts in elevating compliance in these areas almost certainly had the effect of reducing time spent in other important ones. A similar truth applies to the nation’s financial regulators themselves, whose resources are currently stretched extremely thinly. Diverting resources to new rule enforcement, therefore, may result in inappropriate attention being paid in other key areas, such as monitoring credit quality and other factors directly related to a bank’s health.

The enforcement of existing rules, by contrast, if properly constrained, does not raise the same risks. In the current crisis, weakness at the nation’s banks was joined contemporaneously by a rise of investor frauds and Ponzi schemes, some of the oldest tricks of the criminal trade. Such schemes were clearly punishable under existing laws, and in the case of Bernard Madoff, suggested to relevant regulators. No new rules would have been necessary to respond to these abuses, but rather a more considered allocation of resources to investigating and prosecuting them. Investigations and prosecutions under existing legislation were precisely aligned to the evils at issue.

Banking institutions in particular are subject to a wide range of rules, many of which allow bank regulators considerable enforcement discretion. Banks are regularly examined and rated in key areas: capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. As the Government Accountability Office recently pointed out, banking regulators have a variety of tools to address risk management weaknesses:

• Citing weaknesses in supervisory letters or examination reports,

• Meeting with senior management, and

• Requiring corrective actions to be taken and policies and procedures adopted.

In addition, a weakness at a subsidiary bank can call the bank holding company’s “financial holding company” status into question, thus preventing the growth of certain holding company businesses until those weaknesses are corrected.

The principal reason for these enforcement actions was perceived weaknesses in the regulators’ approach to anti-money laundering before September 11, 2001 (which generated considerable after-the-fact congressional criticism). But it is not clear that the regulators’ “new” approach produced tangible benefits in anti-money laundering compliance, and indeed, the “new” approach may have detracted from supervision in other important areas, like risk management.

Rules versus institutional goals

Second, in terms of enforcing existing rules, thought should be given to whether certain competing rules may have actually have a tendency to undermine the most important functions at a banking institution. For example, bank regulations require banks to set aside reserves for loan losses, and permit banks some discretion in setting those reserves because predicting future credit losses is a matter involving a certain amount of judgment. In the past, the Securities and Exchange Commission, acting under its enforcement powers, has suggested that certain banks’ loan reserving practices resulted in manipulated financial statements because the size of loan loss provisions taken has a direct effect on the amount of net income the banks report. By taking large reserves when profits are high, a bank can smooth its earnings over time. However, given the recent past, when the economy rebounds, banks should not be influenced to take an unduly liberal approach to loan reserves because of SEC concerns about their year-over-year financial statements.

So too, under the Community Reinvestment Act (CRA), banks have an obligation to meet the credit needs of low- and middle-income communities. In using their examination powers in the current environment, however, bank regulators should consider whether particular institutions have recently inappropriately sacrificed credit quality to CRA concerns and act accordingly when undertaking CRA evaluations.

Third, in enforcing existing rules, bank regulators should take a more focused approach to the “too big to fail” problem than is being currently suggested by some critics of Administration proposals. Noting the conundrum that in addressing the “too big to fail” issues posed by Bear Stearns, Washington Mutual, Wachovia and Merrill Lynch, the bank regulators increased the size of JPMorgan Chase, Wells Fargo and Bank of America, these critics have argued that such systemically significant institutions should be broken up and effectively made to operate on a public utility model. It is not at all clear, however, how such a legislatively mandated break-up would be effected, nor what the effects of such a break-up would be on a financial system that has moved more and more to a universal banking model.

On the other hand, existing rules under Section 3 of the Bank Holding Company Act, allow for growth by acquisition to be checked if a bank holding company’s financial and managerial resources are not satisfactory. Until bank balance sheets and risk management systems perform better, the Federal Reserve Board could make this a standard with sharp teeth. Outside of the acquisition context, the quality of bank balance sheets is regularly reviewed by the regulators, who have the authority to push institutions to dispose of problem credits and assets. Current rules also empower regulators to influence a banking institution’s capital structure by taking the view, for example, that the institution relies too little on core capital elements and too much on hybrid capital.

To call attention to the enforcement of current rules is not to suggest that all reform legislation is currently undeserved. Substantial arguments have been made that the lack of mortgage broker regulation and of formal controls over systemically significant financial institutions and the risks they pose contributed significantly to the current crisis. And so, to some degree, there is room for Congress to act. But Congress can also act appropriately by recognizing the extent of laws currently on the statute books and the conflicts that those laws and their underlying policies at times impose for financial institutions. Congress can also act appropriately act by considering whether regulators have the resources to comply with their current legislative mandates and granting additional resources when necessary; this too is also a worthy legislative goal.

Author bio

Arthur Long is a member of Davis Polk & Wardwell’s Corporate Department, practicing in the Financial Institutions Group. He advises domestic and foreign banking organizations on the regulatory implications of mergers and acquisitions transactions; private equity and fund investments; the offering of new financial products, including derivatives; compliance and enforcement issues; bank insolvency issues; and, in the case of foreign banks, establishing U.S. branch and other offices.