Lax Regulatory Enforcement and Monetary Policy Ineffectiveness

Just as lax enforcement standards at the SEC have recently become apparent in light of the Madoff affair and other recently revealed scandals, lax enforcement has permeated the banking industry. But while that at the SEC is now in the open, that in the banking industry continues to be supported by massive expansionary monetary policies that are merely attempting to inflate asset values beyond the losses that now paralyze bank lending. That inflationary policy, however, will have to be accompanied by better bank supervision before the crisis will end. Hence, while various attempts at regulatory reorganizations are laudable, they cannot substitute for restoring regulatory power and discipline whose laxity allowed regulated financial institutions to engage in all manner of unreported risky investment strategies that are now coming to fruition.

Most telling in this regard – and scarcely acknowledged by the press – was the recent Office of Inspector General’s November 25, 2008, Material Loss Review of ANB Financial, National Association (OIG-09-013). Overall, the report reminded me of the auspicious moment when – back at the Office of the Comptroller of the Currency in the mid-1990s – the last senior examiner ever to have closed a bank in the Thrift Crisis retired. We all knew at the time that, given the difficulties inherent in the unpleasant task of closing banks, the institution would be moving forward devoid of a tremendous stock of knowledge and expertise – but I didn’t realize the true extent until the OIG report.

While much has been made by the FDIC of ANB’s reliance on brokered deposits and the FDIC’s recent policy proposal to restrict brokered deposits on that justification, the OIG pointed out that OCC policy guidance “…did not provide benchmarks or more specific guidance as to when examiners should start to raise concerns with bank management about the use of brokered deposits and other non-retail deposit funding sources,” ostensibly because FDICIA’s Prompt Corrective Action rules already limit use of brokered deposits for institutions judged to be anything less than well-capitalized.

The Federal Deposit Insurance Corporation Improvement Act requires that acceptance of brokered deposits can only be made by well-capitalized institutions that exceed the minimum PCA requirements. … “OCC identified most of ANB’s problems in 2005; however, it took no forceful action until 2007.” (p. 13) Since OCC downgraded ANB’s capital level to adequately capitalized as a result of the formal agreement issued only in June 2007, PCA Rules were technically followed but the bank remained “well-capitalized” only because OCC examiners did not take action on bank assets in a timely fashion.

Today, similar results are being reported with respect to OTS and IndyMac. Hence, the OIG’s statement with respect to ANB, “OCC did not issue a formal enforcement action in a timely manner, and was not aggressive enough in the supervision of ANB when problems first arose.” (p. 13), could likely be applied to IndyMac as well, meaning that the IndyMac failures was not due to an indiscriminate bank run, but a rational investor reaction to adverse news that had previously been suppressed by supervisors as Sen. Shumer alleged at the time. Investors of all types are right to avoid financial institutions in a world where regulators cannot be relied upon to enforce regulations already on the books.

In closing, we must look hard at the OIG’s conclusions regarding OCC’s performance in the ANB failure and OTS’s performance with respect to IndyMac. In the ANB case, the OIG maintained that examiners crucially need to follow problem bank policy (“Re-emphasize to examiners that examiners must closely investigate an institution’s circumstances and alter its supervisory plan if certain conditions exist as specified in OCC’s Examiner’s Guide to Problem Bank Identification, Rehabilitation, and Resolution,” p. 27) need to take action quickly when warranted under that policy (“Re-emphasize to examiners that formal enforcement action is presumed warranted when certain circumstances specified in OCC’s Enforcement Action Policy (PPM 5310-3) exist.” p. 27) and that the majority of the roots of the current crisis lie not in new innovative financial instruments, but in the basic principles of bank management and supervision and examination (“…the examiner-in-charge …stated that by looking back, examiners needed a stronger tool to address loan concentration limits.” p. 22). In my own view, a vast majority of the problems that led to the crisis can be remedied by enforcing existing regulations. New regulations, per se, – while certainly needed to keep up with innovation – will not prevent a similar crisis in the future if they, too, are not enforced.

I will be taking the next two weeks off for the Holidays. My best Holiday wishes to all of you and may we avoid financial panics in the New Year.