Bank Regulatory Arbitrage and Deregulation: the Number of Bank Regulators Matters

One of the key points of debate over financial institution regulation reform is how many different bank regulators there should be and the extent of their respective bailiwicks.  Some argue that the number of regulators is a secondary issue.  It's not.  It's a first tier concern.  A critical flaw of our banking regulation system is the ability of financial institutions to engage in regulatory arbitrage, which has a corrosive effect on the quality of bank regulation.  As long as there are multiple federal banking regulators supervising essentially equivalent financial institutions there will be regulatory arbitrage, which will inevitably undermine whatever statutory framework Congress sets forth for financial institution regulation.

Currently there are four key federal banking regulators:  Office of Comptroller of the Currency (national banks), Office of Thrift Supervision (federal savings banks), Federal Reserve Board (all bank holding companies and also state-chartered Federal Reserve member banks), Federal Deposit Insurance Corporation (state-chartered insured banks that are not Federal Reserve members).  There's also the National Credit Union Administration (federal credit unions).  There are some further twists to this mess, enough so that a good chunk of a banking regulation class is spent just on figuring out who regulates what entity within a bank holding company structure.  This piecemeal structure is a regulatory system that developed out of peculiar historic circumstances; increasingly there is less and less difference in the types of financial intermediation offered by different types of financial institutions. 

It is relatively easy for financial institutions to switch regulators; it basically involves changing the type of  charter they have.  And because the type of bank charter now has only a limited impact on the type of activities in which a financial institution can engage, the main factor for financial institutions to consider when deciding what sort of charter to have is what sort of constraints different regulators will place on them.  To some degree this is a matter of formal regulations, but a lot of it is a question of what sort of tacit supervisory guidance and allowance will be granted.  A lot of banking regulation is not in the formal statutes, but in their regulatory application.  The way a regulator chooses to apply the statutory scheme is often as important as the statutory content.  

Financial institutions have a strong incentive to seek out the most permissive regulator; there is no bonding benefit from a particular regulator, as the differences between regulators are largely invisible to the public and the market.  Moreover, federal banking regulators, or at least OCC and OTS, have an incentive to play to financial institutions.  These agencies are funded not from the federal budget, but from assessments on the financial institutions they regulate.  They way for these agencies to generate regulatory business (which, not coincidentally, affects post-government employment opportunities) is to offer laxer regulation.  

Thus we have financial institutions looking to find the most permissive regulator and regulators competing for regulatory business by offering the laxest regulation.  This means that as long as there are multiple bank regulators supervising essentially equivalent institutions, there will be adverse regulatory selection, and this will slowly erode the quality of banking regulation.  While the negative effects of this regulatory race to the bottom can be diminished by having outstanding individual banking regulators, there is an inevitable tectonic movement here. 

Not surprisingly, the real deregulation of banking that presaged the current financial crisis were not from big flashy legislative moves, but from agency actions.  Gramm-Leach-Bliley largely cemented what had already happened on agency watch, while the Carter-Reagan deregulatory actions (DIDMCA and Garn-St. Germain) are just too far removed to be proximate causes of the current crisis, even if they started the ball in motion.  

Sadly, the deregulatory story that has been told has focused on legislation, but the real deregulatory story is one of agency action:  either preemption of state consumer protection laws or agency opinion letters that eroded Glass-Steagal (Saule Omarova has a wonderful forthcoming paper on the latter phenomenon).  Beyond these formal, documentable steps, there is also a world of informal supervisory action and inaction that loosened banking regulation.  This type of informal action is difficult to document, but the truly scurrilous case of the Office of Thrift Supervision and Countrywide and IndyMac is instructive.  This history of agencies leading the deregulatory charge should make us inherently suspicious of continued agency attempts at deregulation, such as the OCC's claim (now before the Supreme Court) that it has sole authority to enforce state consumer protection laws against national banks.  

Politically it might be hard to smash through the various bank regulatory bailiwicks.  But for the long-term health of our bank regulation system, it would be very worthwhile.