The big bad banks are in trouble with the Fed again, The Wall Street Journal reports:
Two large European banks, Deutsche Bank AG and Banco Santander SA, are expected to fail the Federal Reserve’s stress test over shortcomings in how they measure and predict potential losses and risks, according to people familiar with the matter.A rebuke would mark the second year large foreign banks, which were drawn into the Fed’s stress tests in 2014, failed to meet the U.S. regulator’s expectations for risk management. As banks have bulked up capital cushions to ensure they can withstand losses in periods of turmoil, the Fed has focused on more qualitative issues, including whether banks accurately measure potential losses in credit portfolios and correctly collect risk-exposure data. The Fed also seeks to determine whether they have strong internal controls.Failing the stress tests would likely subject the U.S. units of Deutsche Bank and Banco Santander to restrictions on paying dividends to their European parent companies or other shareholders.
Everybody who remembers the financial crisis of 2008 to 2009 or has studied the history of finance will be glad to read about the Fed’s aggressive program to make sure banks are well-prepared for various risks. And if that effort means that banks have to trim the dividends they pay to their shareholders, that’s certainly better than a huge taxpayer bailout.But there’s a catch. Note in this story that one bank estimates the cost of compliance at over $50 million for one year. It takes a very large bank to be able to afford that kind of payment. This is how all regulations work: they are often adopted in a punitive spirit by politicians or bureaucrats who think banks (or whoever else is being regulated on any given day) have been making too much money, getting away with murder, bilking their customers, and on and on. Often they are right, human nature being what it is. And so the regulations are adopted with a goal, among others, to limit the power of these big firms and bad actors.However, more often than not, the regulations end up reinforcing the power of the big, bad actors. After all, small upstart competitors can’t afford $50 million compliance programs. Only very large and powerful firms have the resources to compete in highly regulated markets. The result: less competition for the big boys, and long-term pressure that both shrinks the number of firms in a regulated marketplace and that increases their average size. The banks you were trying to punish and limit have grown stronger as a result of your actions.Worse, they will use that strength to change the regulations. Very large and rich firms, the kind who can pay the costs of compliance and still make profits, have huge amounts of social power. They can donate money to politicians. They can offer jobs to retiring civil servants at ten times the pay the bureaucrats used to make. They can hire very smart lawyers. They can pay lobbyists. They can support research programs at think tanks and universities. They can burnish their images with large charitable donations. And they can do all these things day after day, month after month, year after year.The result, and it gets worse over time, is regulatory capture. The inmates control the asylum: some guards they bribe, others they befriend until the rules work better and better to limit competition and are less and less effective at curbing the power or limiting the profits of those who, more and more, control the writing and interpretation of the rules.This is one of the ways that countries that invest more and more resources in tighter regulations end up with incredibly powerful and well-entrenched corporate sectors. And it accounts for the reality that the American regulatory system, the great white hope of the blue social model, becomes less and less able over time to deliver the kinds of results people want.Over time, regulatory systems degrade: they become more corrupt, less effective at dealing with real risks, and increasingly suppress innovation and competition rather than promoting them.Zealots are sure there’s a right way to deal with this. Radical libertarians never met a regulation they liked, and radical technocrats never saw a problem that couldn’t be regulated away. In fact, we are always choosing between imperfect alternatives.In finance right now, things are particularly tricky. The rapid progress of IT, where computers allow participants to develop extremely complex securities and other products as well as to execute very complex and quick trading strategies, means that financial markets are in a process of rapid change. The size, shape, and speed of financial markets continues to evolve very quickly. At the same time, the nature of the international financial system and the underlying nature of the world economy are both changing as well.Paradoxically, that makes smart and effective regulation more necessary than usual (as market participants may be failing to measure and offset risks that they don’t fully understand) but also more difficult than usual as the regulators themselves have a hard time figuring out what is going on. Add to this the effects of regulatory capture and the turbulent and chaotic nature of political systems, and it is easy to see that we don’t, as a nation or even as a species, have this problem under control.That has several implications. The most important is that we are in a kind of post-technocratic era when it comes to financial markets. It’s unlikely that regulation can or will give us the smooth ride we all want. The world economy is going to look a bit more like it did in the 19th century, when booms and busts rocked governments and economies in a time of rapid change. Financial market firestorms are likely to be with us for some time. That financial instability is going to have political and social consequences and figuring out how they will play out across continents and economies will be one of the activities that keep pundits and risk analysts in business.So Deutsche Bank and Santandar are ponying up to keep the Fed happy, and Fed regulators are looking more deeply than before into the inner workings of the powerhouses of our financial system. That’s probably a good thing, given where we were in 2008 and 2009, but financial regulation isn’t a magic wand that will tame the power of large corporations or make booms and busts go away.