Why Regulators Never Learn (Fool On the Hill) October 13, 1999

An Investment Opinion

Why Regulators Never Learn

By Bill Mann (TMF Otter)
October 13, 1999

A very interesting thing happened this week, something that was covered by Marketplace (a truly fantastic, mostly Foolish radio program, by the way), but not, to my knowledge, anywhere else.

Alan Greenspan, the chairman of the Federal Reserve, was giving a speech before the annual meeting of the American Bankers Association in Phoenix, and he was discussing the need for specific regulation to respond to the nature of the banking mega-mergers.

In the past three years the country has seen a spate of banking mergers: Citibank and Travelers Group combine to become Citigroup (NYSE: C), NationsBank and Bank of America (NYSE: BAC), First Chicago and BankOne (NYSE: ONE), and CoreStates/ First Union (NYSE: FTU). These and other, smaller mergers concentrate power into only a few companies, a situation increasingly troubling to government officials.

Not since the late 1800s -- when New York was the center of the universe (a situation most New Yawkers think is still the case), J. Pierpont Morgan was getting stock tips from shoeshine boys, and Salmon P. Chase was lighting cigars with banknotes with his picture on them -- has so much banking power been consolidated into so few companies.

Each of these mergers has passed muster with the regulatory authorities at the time, but now Greenspan has a more global concern. To his thinking, since so much of the banking and monetary power of the United States is concentrated in so few companies, the public good is directly threatened by the risk of a significant financial failure by one or more of them.

As a result, Greenspan argued that the Federal Reserve, the Comptroller of the United States, and the Treasury Department need to go back and tailor regulations to each of the largest banks. To this end, U.S. officials are currently working with international banking authorities to study oversight of the largest private banking institutions.

Which begs a few questions. So the U.S. Government has allowed these massive mergers, only very recently, to go through, but is now saying that it needs to be able to respond to a threat should one of them fail. So why on earth were these issues not studied before the mergers were ever approved? For God's sake, did it suddenly come as a surprise that we had some pretty big, powerful, private banks out there?

So now the government wants to take a set of regulations previously universally applied to all banks and financial institutions and customize them to the specific situation of each individual bank. Further, the purpose of these regulations is the overall protection of the American public and the financial system upon which we depend. Are they so deficient as to insufficiently respond to the danger of an oligopoly? (If there really is such a threat, which I do not believe to be the case.)

Why don't we just hand these companies the keys to the candy shop? It's regulatory boondoggle on the level of the head-in-the-sand approach that set up the massive savings and loan collapse in the 1980s. You see, there was a certain level of external factors that made the assets the S&Ls used to secure their loans depreciate, but the reality is that the S&Ls were provided a regulatory framework by which they knew that the government would step in if they failed. That meant that they could take credit risks and fairly aggressive reinvestment tactics, because ALL THEY COULD DO WAS WIN.

The next time I go in to make a deposit, I may just tell my bank to just go ahead and put the money in their own account, because a customized regulatory regime is something that is ripe for abuse. Think about it -- sure, it's pretty admirable to try to set up rules to keep banks solvent, but what's to keep the banks from abusing these very rules, knowing for a fact that the federal government will not let them fail, no matter what? I'm just as positive about the inherent good of man as the next guy, but after all, the Keating Five and the BCCI scandal happened in the past decade. Is our institutional memory that short?

For those who don't recall, or for those to whom our media and government did a pathetic job of informing, here are the gory details. BCCI was a Pakistan-based bank with operations in 70 countries, and big-money banking by such people as the Al-Zayed family, the rulers of Abu Dhabi. BCCI used existing banking laws in the U.S. and other countries to steal and transfer billions of dollars through a spiderweb of holding companies and blind trusts, including First American Bank, a well-respected local institution in Washington, D.C. The scam worked because BCCI was able to use the regulations protecting consumer deposits, while at the same time bribing regulatory officials to ignore irregularities. Larry Gurwin, who discovered the link between First American and BCCI, said famously about the affair:

"The BCCI story is important not just because a lot of people stole billions of dollars but because they got away with it right under the noses of the authorities and none of these watchdogs barked.... This is a story of the breakdown of our institutions."

This is a lot of background, but I'm including it to illustrate a point: Those who seek to exploit the regulations will always remain a step ahead of those enacting and enforcing them. So I ask, what would the government be trying to achieve by customizing regulations to each individual bank? I am certain that there were a group of people right there in the ballroom at the ABA just salivating as Greenspan was making his modest proposal.

What we require is better regulation, not more regulation. The government allows all of these huge mergers, but then, immediately afterward, wants to change the rules? No good. These private companies have already been given the green light to consolidate, and as such have jumped through all of the "common good" hoops that were set up at the time. You want to protect me? Fine, enforce the depository regulations you have on the books and let the executives of these banks suffer the civil and criminal consequences of their actions should they fail to provide adequate fiduciary responsibility for our funds.

But customizing? That's just something they should have thought of BEFORE the mergers, because now the structure is in place. I don't believe for a second that the regulators ever play the chess game well enough to fully understand the consequences of their actions. Sometimes it's better to leave things as they are and prosecute the fire out of someone when they break the social contract banks should have with their depositors.

Fool on!

- Bill Mann, October 13, 1999

Related Links:
FDIC Information on the Savings and Loan Scandal
Senate Foreign Relations Committee Report on the BCCI Affair, December 1992