Mark T. Williams

The weak link in bank reform

By Mark T. Williams
July 8, 2010

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THE FINANCIAL reform bill that will likely become law calls for the largest banks and hedge funds to pony up $20 billion in fees to pay for additional oversight. But the law will be ineffectual if the regulators don’t move quickly to upgrade the training and standards of their rank-and-file examiners on the ground.

A litany of new financial reform provisions will need to be interpreted and enforced. Regulators will decide what is acceptable and what is risky bank behavior. How regulators and bank examiners carry out this task will determine if the next financial crisis is detected earlier and averted.

But if bank examiner performance over the last decade is any indicator, regulatory oversight may prove grossly inadequate. Excessive risk-taking behavior by banks can be dampened only by regulators that exert a firm and steady hand. Canada is a case-in-point of strong regulatory prudence.

During the Great Credit Crisis of 2008 not a single Canadian bank went bust. Of the G-7 countries, Canada was the only one that did not have to orchestrate a taxpayer funded bailout because regulators regulated in a consistent matter and did not let banks engage in excessive risk taking.

But will the Fed adopt the Canadian style of bank oversight and aggressively apply this new reform law or will they remain status quo? Remember, the new law would also place a consumer financial protection bureau at the Federal Reserve — yet the Fed failed to stem predatory lending practices that contributed to the last financial crisis.

Complicating this challenge is the sophistication gap that remains between regulators and Wall Street banks. Adequate training, systems, and resources have not kept pace. Examiner salaries are significantly less than the risk-taking bankers they are charged with regulating. It is not uncommon for the wage gap to be five times or more. Without competitive compensation plans, how can government ensure field examiners represent the cream of the crop?

Further, bank examiners in government regulatory agencies are viewed as second-class citizens. This is particularly true at the Fed where those making monetary policy are valued more highly than those conducting safety and soundness examination. The recent financial crisis is proof that field examiners are the eyes and ears of early detection. When they fail in their duty, banks quickly can overdose on risk.

A major flaw in the bill is that it does not hold regulators to a higher standard of accountability. There are no penalties for poor performance. The role of congressional committees must be to act as an important control point to ensure that regulators are held to a higher standard and that they extract clear punishment for weak performance.The sophistication (and potential danger) of products traded by Wall Street banks will continue to expand and that of our regulators need to keep pace. The elevated regulatory role warrants an aggressive human-resources push to identify, attract, and hire talent with the skill set needed to police bank risk-taking activities. To ensure that top talent is retained and not easily poached by Wall Street firms, strong retention programs need to be put in place.

Heading into the G-20 meeting last week, President Obama used the pending new law as evidence that the U.S. is a global leader in financial reform. The determination whether this claim is true will be decided by the actions of our regulators in their ability to carry out their expanded oversight role.

It will be a tall order to fill. More resources must be allocated to increase the chances of success. Our entire financial system is dependent on strengthening regulator oversight and closing this sophistication gap.

Mark T. Williams, a former Federal Reserve Bank examiner who teaches finance at Boston University’s School of Management, is author of “Uncontrolled Risk’’ about the fall of Lehman Brothers.

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