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Banking Regulation: Rules versus Discretion - Transcript

Panel Session Highlights with:
Willem Buiter, Citigroup
Andrew Haldane, Bank of England
Jason Kravitt, Mayer Brown
Erik Sirri, Babson College

Willem Buiter: So let me end up saying something very briefly about rules versus discretion itself. You know where it came from. It goes back to, like most things in monetary economics or in banking, to the debate of monetary policy, started really by Milton Friedman. But for it to make sense, both the word rule and the word discretion have to be interpreted in ways that depart utterly from their normal meanings, because rule is distorted to mean "fixed, noncontingent, inflexible, rigid rule," which does not permit the policymaker to regulate, to respond flexibly to news. Obviously, in that sense, rules are inherently silly. Discretion is identified as "lack of commitment, rampant opportunism, and myopia." And now who wants to be associated with that? In regulation we have a similar distinction. Interestingly, the word rules is used there as well, but rules in the regulatory sense, principles-driven versus rules-bound regulation. Rules actually mean discretion in the earlier thought, and principles are rules. Clearly, we will get to that because there are some important issues there, general rules versus specific and box-taking rules. It's the key issue. And I'd like to start by asking a question.

And my question is, what are the costs to the economy, not to the financial sector itself, to the economy, of the extensive and complicated rules which will become incredibly more intensive and complicated when Dodd-Frank and Basel III are introduced? This principle-based regulation, does it mitigate these costs or does it entail other costs?

Jason Kravitt: I had the following counted. The number of words in the moral code, which is supposed to control all human conduct throughout the history of time, that is the 10 Commandments, is 341 words. The Constitution of the United States, including the amendments, which has kept our country together and in not that bad of shape, everything considered, for over 200 years is 7,644 words. The number of words in the Qualified Mortgage Rule (the proposal, so it will be longer eventually) issued by the new bureau housed in the Fed is 250,778 words.

I would like to talk about a little more in depth is how working to rules prevents creativity of substance, how working to rules creates the search for arbitrage versus creativity on substance, how it creates unintended consequences, and really, how it creates a focus on political effort instead of economic effort, and finally, the loss of moral sense.

When risk-based capital in Basel I was fairly simple, what people came to me with to structure were ideas that were very clever on the substance. They came up with very valuable products for their clients, we would figure out how to do them, and we would do deal after deal. After the rules got more complicated, and finally with the rounds that occurred after the recession (I'm going to take an example: multiseller asset-backed commercial paper vehicles), I stopped doing rules. All people brought me were, "How do I do a structure that causes the conduit to be off balance sheet so I can get less capital?" Instead, they let younger, less experienced lawyers work on the transactions. The people that they valued the most, I spent all my time working on how to arbitrage those rules. And they spent all their time, the senior people, working on how to arbitrage those rules.

Unintended consequences: the CFTC [Commodity Futures Trading Commission] is increasing their regulation on commodities. Swaps were defined as commodities. Every securitization transaction has a swap in it. It may be an interest rate swap; it may be a currency swap.

The Volcker Rule: because there was no good way, no precise way to define a hedge fund or private equity fund, it was defined negatively as any entity that relies on 3C1 or 3C7 exemption from the Investment Company Act. Half the securitization vehicles in the world rely on those definitions, and so all of a sudden every securitization is a covered fund subject to the Volcker Rules, unless you can figure out a way around that.

Once you start to see your business as run, essentially, by regulatory rules instead of economic rules, you start to focus your effort on gaining a political advantage. That's what your resources go into; that's what your senior management's time goes into; that's what your in-house lawyer's time goes into; your outside lawyer's time goes into; and again there is a misallocation of resources into the political sphere instead of into the financial sphere.

If you have a 250,000-page rule on what to do, that's what you do. You comply with that rule. You don't think about whether it's right or wrong. If you have a quarter-of-a-million-word rule, that's the difference between right or wrong. If there's a hard question, we no longer develop the sense of how to solve it and we no longer have the sense of responsibility that we are responsible for our decisions on how to solve it because we have this all-encompassing rule that defines right from wrong for us. I would say that we should think more of ourselves.

Erik Sirri: On the other hand, they do have some benefits when you implement rules, not that I always believe that they are entirely the appropriate answer. So, for example, we learned that at times it is difficult because of political forces and other forces for people who are charged with implementing discretion to act.

That's why you have a rule. You don't have to make that hard decision, the rule tends to have an attribute like that. That's not to say that they are all right, but they do tend to facilitate a certain kind of process around which, in fact intentionally, there isn't discretion.

Talent is always an issue. It is hard to get the kind of talent that's required to get discretion to make decisions on a firm-by-firm basis when you see things that need tweaking or need adjustment. It's easy to get people to go in and tick boxes (and I'm not a fan of box-ticking, don't get me wrong), but it's hard to get people, senior people who can go into an asset management organization or an exchange and make a judgment that's reasoned and that's responsible, and say, "Yes, in this instance you can bend this rule, you can act in a particular way."

Andrew Haldane: There are reasons to be optimistic that we can on the regulatory front also achieve a better balance between rules and discretion, between credibility and flexibility, than we have had historically, and that which we have at present. I would argue at present our regulatory framework has found a pretty suboptimal point along the credibility/flexibility trade-off. Why is that? Well, it's the case, I think, for two reasons. The two characteristics of the regulatory regime that have led to that suboptimality. One of them has been complexity, which has been on the secular rise on the financial regulatory front for the better part of a century.

The second factor, which is more distinctive to financial regulation and indeed banking regulation, in particular, is that it has taken on increasingly with the advent and use of internal models a self-regulatory dimension. We have moved to a system where in large part we are asking the biggest banks to mark their own examination papers. A deeply discretionary regime.

We have created a system which has encouraged gaming, as do most self-regulatory systems. We have created a system with byzantine degrees of complexity, which means it's near impossible to generate a level playing field.

So if I am a small bank or a new entrant bank, say here in the U.S., I'll be on Basel I, which means from these numbers I'll be required to hold twice as much capital against an identical exposure than would an equivalent big bank if it is a loan to a company, if it's a mortgage, if it's an unsecured credit line. And of course, if anything, that's the opposite of what we would wish to have if we aim to lean against the too-big-to-fail problem.

Some have said that the quest for complexity comes from a desire to prevent banks from gaming the system. That too is a grade-one misthink. Complex frameworks, if anything, are easier to arbitrage, easier to game. In cross-country studies of the tax code (going back to that), the single biggest determinant often found for tax evasion or tax avoidance is the underlying complexity of the code. What is true of the tax code is once more true of the regulatory code.

Buiter: How can we be sure that regulators have both the discretion and the incentive to act appropriately? Apparently, in this last crisis they either didn't see it coming or they didn't care or they didn't have the power to act. But these conditions are clearly not satisfied. Who wants to go? Or do we incentivize the guardians, I mean, the sentinels?

Haldane: Currently, banking regulations may be underpinned by three pillars. The first, pillar one is the rules. Pillar two is supervisory discretion and pillar three is market discipline. And the problem is if you make pillar one as complex as pillar one currently is you make the rules incredibly complex and indeed self-regulatory. It emasculates the other two pillars. You cannot exercise supervisory discretion if you are being required by statute to check and second check a lengthy and complex set of rules.

Streamlining it provides them with more room for maneuver; more oxygen to exercise their discretion in meaningful ways. It also helps on pillar three, because a complex rule book is unfathomable not just for regulated firms but also for outside investors and therefore inhibits market discipline. My suggestions on simplifying pillar one, the rulebook, would also simultaneously strengthen pillars two and three, supervisory discretion and market discipline.

Buiter: The last question (likely the most popular), which has actually asked for your top simple three rules would be. Mine, for what's it worth to just give one, it is "Don't worry, be happy." (laughter) You can start, Erik.

Sirri: "Treat your customers fairly," that's essentially the rule, treat your customers fairly. Now, there is a body of case law that long on what it means, but the rule is "treat your customers fairly." Another example, and again it's not supervision with respect to banks, but it's "Don't engage in fraud," that's a rule, don't commit fraud. It's out of that that all of insider trading law develops, that all sorts of rules develop about market manipulation, and all these things. But those are two examples of very, very compact rules.

Kravitt: What you need to rely on (this is the rule that I will always keep going back to) is that bankers should take ownership of their actions, and when they look at a regulation they should ask themselves, "Am I doing something wrong or not?"

Haldane: I'd say to the financial industry, "Let's do a deal."

My deal to you has three simple elements. They are a leverage ratio set at levels north, possibly well north, of those currently prescribed in international regulation. It has a restructuring rule that compels you to organize your business in such a way through size, through activity restrictions, through refinancing, that enables you to be wound down safely. And thirdly, it comprises a resolution rule that gives effect to restructuring of your business mentioned under rule two. Have those three rules, and in return for that we back off; we won't plant 50 bank examiners in your shop at all times. We will leave you to run your own business, which is as it should be.