The Financial Regulators of Tomorrow

One of the natural by-products of the 2008 financial collapse was a reassessment of how we regulate our biggest banks. To me, the LIBOR scandal perfectly summarized the biggest problem we face when confronting the issue of financial regulation. Yes, I know it happened across the pond, but Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Citigroup  (NYSE: C  ) all help set the U.S. dollar LIBOR. Here was an interest rate that served as global benchmark, a rate that could move billions with a few basis points, and it was set by the largest banks in the world with barely a shred of oversight. How does that come to be?

Well, essentially, the British Bankers' Association would just call up 18 banks each morning, record which rates they would be willing to borrow at, average out the middle 10 estimates, and voila: the London Interbank Offered Rate is set for that day. It was a process built entirely on trust and an outdated notion that bankers are serious men in gray suits whose only interests lie in preserving a sound banking system. The world where that existed, if it ever really did, became obsolete when investing became a core activity of commercial banks. Speculative trades, absurd leverage, and off-balance sheet assets have made it impossible for banks to ignore their corporate instincts to maximize profits. 

So what's my point?
Mainly, the LIBOR scandal exposed a mind-set that some regulators may have. There are those who have previously worked in the private sector and feel a sense of camaraderie with investment professionals, and ultimately take a conciliatory tone in negotiations.

On the other hand, you have the happy warrior who is more adversarial when dealing with the banks. Understanding which mind-set our regulators have can serve as a window into what regulation will look like in the future. Here are the likely regulators for the not-so-distant future.

Eric Schneiderman, attorney general for the state of New York
Schneiderman will run for reelection in 2014. It's a common misconception that financial regulation is reserved for the federal agencies. In fact, an obscure statute in New York's general business law allows the state attorney general to aggressively pursue perpetrators of financial fraud. Schneiderman has earned plaudits for the use of his office and is likely to be rewarded with a second term. 

Schneiderman was instrumental in securing the National Mortgage Settlement, a $26 billion settlement with five of the nation's biggest lenders over charges relating to mortgage lending. During the negotiations, he voiced opposition to a provision that would give banks immunity from further prosecution on related charges. It doesn't seem to end there, either. A report issued months later identified JPMorgan Chase, Bank of America, and Citigroup (among others) as having allegedly violated the settlement, and Schneiderman wasted no time in taking action. He sued Bank of America and Wells Fargo for breaching the terms of the National Mortgage Settlement.

Mary Jo White, SEC chairwoman
Appointed by President Barack Obama this year, White is a veteran lawyer who spent the better of her career prosecuting "complex securities and financial institution fraud" for the state of New York.

Under her leadership, the agency is undergoing a dramatic transformation. Just recently, the SEC struck a settlement with JPMorgan for $200 million over securities violations. This may not sound like an aberration from the usual slap on the wrists given by regulators, except the SEC finally extracted an admission of wrongdoing. It is one of the first of its kind that any American regulator has gotten, and it's already opened the floodgates to more aggressive settlements.

Janet Yellen, Federal Reserve chair nominee
After a bizarre vetting process in which Larry Summers had to withdraw his name from consideration of the Fed chairmanship, Obama finally nominated Janet Yellen. She is the current vice chairwoman of the central bank and would be the first woman to hold the top job, assuming she is confirmed by the Senate.

While bank regulation has not been part of Yellen's portfolio as governor, her involvement as Fed head would not be unwelcome to bankers. In a speech to the International Monetary Conference, she voiced her opinion on separating investment banks from commercial banks: "I am not persuaded that such blunt approaches would be the most efficient ways to address the too-big-to-fail problem."     

If confirmed, it's clear Yellen would govern the central bank as a consensus-building moderate. Her management style has reaped huge benefits as an economist, but it may be less effective as a regulator. After reviewing financial forecasts by 14 key players at the Fed, The Wall Street Journal reported that Yellen came out on top in terms of accuracy. That's fantastic, but being inclusive can also result in trust-based LIBOR-style regulation.

It can encourage lobbyists to weigh in and water down proposed changes, or Fed officials looking to score a big-paying private-sector job can attempt to soften up a pending rules change. It's not that lobbyists for the financial industry are evil or ill-intentioned, but their incentives are higher bonuses vis-a-vis higher profits, not a safer banking system. 

Conclusion
That said, it's clear that regulators are toughening up. They believe the sector is stable enough to withstand the kind of enforcement actions that would have been debilitating in the immediate aftermath of the crisis. This week the spotlight has been on JPMorgan's legal troubles, but does anyone really believe that those possible transgressions are unique to just one bank? The financial sector is incredibly competitive, and a wise investor should add a heavy risk premium to the outlook on any of the big banks.

Finding the strongest bank
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  • Report this Comment On October 24, 2013, at 10:47 AM, Polarbear87 wrote:

    While a certain amount of financial regulation is good in a free market, the idea that financial companies should face financial penalties just because they can (as stated in this article) seems to be what is wrong with the current system of regulation. Financial regulators attempt to get in front of some issues, but most often, they regulate with 20-20 hindsight, which makes the financial businesses fraught with unknown and in many cases, unknowable risks. I'm not talking about cases where there is outright fraudulent intent, but cases where simple risk taking is now thought be criminal, just because of the perceived consequences of the risk taking. The idea that JP Morgan somehow should have understood the consequences of bailing out a competitor for the good of the financial system and the world economy as a whole is intellectually suspect, and likely more motivated by political intent than any sense of right or wrong. In fact, this seems to be the administration's way of breaking up the "too-big-to-fail" banks - by prosecutorial fiat. So while the author may argue that business sometimes runs amok, so can regulation, and we need to be just as vigilant about regulatory and prosecutory limitations for the good of us all.

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