I think this, from Mike Konczal, is the exact wrong way to think about regulatory discretion in the context of prompt corrective action (PCA):

So this risk council [in the Dodd bill] will come up with rules, and the Federal Reserve will carry them out. Can these rules change on the fly? I’m not sure, but I assume from the bill that they can. Can these rules change in a crisis? I don’t see why not – there’s complete discretion over how they are created by the regulators.

But this is the exact opposite spirit of the 1991 FDICIA bill that created prompt corrective action. When the time comes to resolve a firm, the “ok, you’ve done the best with your discretion, but it’s time to call it” is written right into the bill itself: “The level specified under subparagraph (A)(i) shall require tangible equity in an amount—(i) not less than 2 percent of total assets.”

This is crucial.
The biggest criticism of the current PCA regime for commercial banks (which was established in FDICIA) is that the triggers are outdated, and generally don't come into play until it's too late. The reason they can't be easily updated to accurately reflect the different stages of a bank's deterioration is precisely because the relevant metric (tangible equity to total assets) is set at the statutory level. Why would we want to make that mistake again? If we've learned anything from 18+ years of PCA for commercial banks, it's that we need realistic triggers that can evolve along with the financial sector.

Mike's concern about the systemic risk council changing the PCA triggers on the fly during a crisis is entirely misplaced. Any changes to the PCA rules would undoubtedly have to go through the normal APA rulemaking process, which requires a notice-and-public-comment period (lasting at least 30 days, and likely much longer) before changes to the rules can be made. The choice is absolutely not between setting the PCA triggers at the statutory level, and giving regulators unfettered discretion to change the PCA rules on a moment's notice.

Setting PCA triggers is simply not something that Congress can do. But if you somehow disagree, and think that the PCA triggers can and should be hardwired into the Dodd bill, then surely you have some well-defined set of PCA triggers in mind, right? By all means, I'd love to see them.

This is serious business, because we've made this mistake before, and I don't think anyone who knows this area is keen to make the same mistake again. PCA is not an area where you can set hard-and-fast rules at the statutory level, like the 15:1 leverage cap*. PCA triggers are exceedingly complicated, and they need to be formulated by regulators who have sufficient expertise — and who have sufficient flexibility to update them as the financial sector's funding profile changes — if we want the new PCA regime to stand the test of time.

-----------------
* On a side note, I'm completely fine with a hard leverage cap at the statutory level. I'm not sure 15:1 is necessarily the right number, but I'd be comfortable with anything ≤ 20:1. I'm not sure how a leverage cap would fit in with Basel III though, which could pose problems.

18 comments:

JCH said...

Very helpful series of posts.

Had they had resolution authority (the financial reform package currently emerging from congress) at the time, at what approximate date would AIG have gone into resolution?

2007? Spetember, 2008? Never?

I say never.

csissoko said...

Agreed. At this point, I'm wondering whether FDICIA wasn't the cause of all of the off-balance sheet exposure of banks. That is, once the rule had been set, a lot of forces convened to find a way around the rule -- always of course in the interest of promoting "economic efficiency".

Nothing seems to generate financial innovation faster than a firm rule. This story is as old as the original rules vs discretion debate that resulted in the UKs Currency Act of 1844 -- and the checking account to circumvent it.

Like you, it's not that I think we shouldn't have rules -- I just think that it's also important not to expect the rules to remain effective over time.

anne said...

Writer here, not a numbers person. Why are companies allowed to shift crap off the books anyway? Just wondering! Seems a great way to gum up the works. See Enron, Lehman, et al. as examples.

Still struggling to understand when/why debt became an asset to trade and sell.

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