Congress and Regulators Are Still Clueless


Earlier this month, I couldn't resist reading story after story marking the five-year anniversary of the Lehman Brothers bankruptcy. After soaking up all the missives and retrospectives I could get my hands on, I found myself scratching my head at the lack of progress and, fundamentally, leadership over the past half-decade.

Evaluating progress
First, let's very quickly take stock of how the world has changed since September of 2008. The positives:

  1. The stock markets have recovered, the S&P 500 briefly eclipsing a record 1,700, but it's yet to be determined if these gains are based on fundamentals or easy-money monetary policies.

  2. The housing market appears to have bottomed and started to recover, evidenced by rising home prices amid a resurgence in demand, particularly evident in the markets most affected by the crisis.

The negatives:

  1. Growth, in terms of GDP, is lackluster at best. The Department of Commerce puts GDP growth for the second quarter at 2.5% annualized, after revising the first-quarter number down to 1.1%. This compares to the historical average in the U.S. closer to 3.5%

  2. The labor market is frustratingly slow in its recovery. See the chart below -- a picture is worth a thousand words.

US Unemployment Rate Chart
US Unemployment Rate Chart

U.S. Unemployment Rate data by YCharts.

These final two points, slow growth and a lackluster job market, have extended the pain of the recession, which technically ended in June 2009. For the everyday American, life has not recovered from the storm that began in 2007.

The world is no longer on the precipice of a complete financial implosion, and there are positive signs, but progress has been disappointing. Why is that?

A failure of leadership in Washington, D.C.
It is my observation that there are two root causes to this "new normal." First is the failure of government to implement sufficiently pro-growth policy.

As a result of the squabbling over the "sequester" and "fiscal cliff," our policy makers have raised taxes on capital. A better, more pro-growth policy would be a streamlined and efficient tax system, allowing capital to flow uninhibited by taxes, allowing for more investment, less friction in the economy, and ultimately higher growth.

This policy would promote freer movement of capital across borders, which is a positive environment for all firms -- from the small manufacturing company in your town that exports its products overseas with help from the Small Business Administration, to major international companies like Citigroup, who saw emerging market profits drive net income 42% higher last quarter.

The fiscal situation in the U.S. is also far worse today than it was in 2008, with public debt more than doubling relative to the economy over that time. For households, corporations, and governments, debt's most prudent use is to fuel growth via investment. Today's policies have doubled the debt burden but completely failed to fuel growth.

Our policymakers must find fiscal discipline despite the culture of pork and special interests. Government spending must be focused on results and investment -- not driven by lobbyists.

A failure in regulation
The financial crisis was born in banks and insurance companies, two of the most highly regulated industries in the U.S. The second failure is that of regulators and regulations to appropriately address the root causes that led to the crisis in the first place.

Let me clarify one point before moving on: I believe banks need regulations and regulators. Banks are too critical to international, national, and local economies. Banks oil the gears of the economy. Their role is too critical to be left unchecked.

But regulations must be prudent, with obvious and measurable benefits. They cannot be onerous in terms of implementation, management, or cost. Regulations must never impede providing fairly priced capital and financial services to individuals or businesses. Sensibility must prevail.

In 1932, Congress passed the Glass-Steagall act. It was 37 pages. Fast forward 50 years to the passing of the first Basel Accords in the 1980s. That agreement was 30 pages. Basel II in 2004 upped the ante to 347 pages. Basel III in 2010 topped out at 616 pages. Dodd-Frank, also passed in 2010, is 848 pages.

And that's just the legislation. Estimates vary, but most put the implementation rules and procedures that supplement Dodd-Frank at north of 2,000 pages.

With such complexity, such onerous and costly implementation rules and procedures, what is the obvious benefit to the financial system? "Too big to fail" remains an unresolved issue. By many accounts, it's more difficult to get a mortgage today than ever. Capital rules, while well intended, are overly complicated with accounting minutia.

Source: FDIC.

Why is the banking system safer today? Because credit quality has improved. Because banks have improved capital and liquidity management practices. Because of the extraordinary interventions and bailouts put in place at the 11th hour in 2008 and 2009. With the exception of higher capital requirements, it is unclear to me how these new regulations are improving the system -- especially when compared to their cost and complexity.

The result is a challenging medium-term future for banks
Unfortunately, no matter the cause, slow growth and weak employment are our reality today. Assessing the implications of this reality favors the big banks, even with the higher capital requirements for those systemic "too big to fail" institutions.

For the nation's largest banks, the simple scale of the business will make the changes less impactful. As the chart below from the FDIC's Quarterly Banking Profile shows, the largest institutions have an increasingly high ratio of total assets to total employees. These banks can afford to hire the back office staff and build the compliance programs to handle the burden. For the regional and community banks, the challenge is much greater.

Take People's United Financial , a regional bank in the northeast. Since 2009, the company has steadily improved its efficiency ratio from about 74% to 62% at year-end 2012. With total assets just north of $30 billion and 4,847 full time employees at year-end, the impact of adding an entire department of new compliance employees could be very significant to both the bottom line and the company's ability to originate loans in the communities it serves.

For context, Reuters reported that JPMorgan Chase has added 4,000 staff to better manage its internal controls since 2009 -- while this comparison is certainly not apples to apples, it is a staggering number that would represent a doubling of staff for People's United.

Think for a minute -- what will the impact on for the community banks in your town? How will the banks most closely tied to your community adapt? I'm talking about those banks with less than 200 employees, compared to the thousands at regional banks and hundreds of thousands at mega banks.

A middle road
Politicians and regulators should seek to find a better path. The financial system needs reform, but it cannot be haphazard, expensive, and ineffective. Regulators should strive for simplicity and transparency, prioritizing results over political posturing.

The nation needs and deserves better leadership. I hope that when we mark the 10-year anniversary of Lehman's fall in 2018, the stories we read will be much different than what we read this past weekend.

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