Regulating banks: maybe bureaucrats aren’t so bad after all

A more robust Canadian supervisory ethos may be gaining ground

Among the trickier stories to follow in the aftermath of the 2008 financial markets meltdown has been the debate over banking regulation. Clearly, something went catastrophically wrong, especially in the U.S., but exactly what?

Proponents of a largely unbridled market have argued—not persuasively, to my mind—that the core problem wasn’t lax regulation and permissive oversight, but rather perverse signals from government. They blame, for instance, U.S. government policies aimed at promoting home ownership for having skewed the mortgage market.

But it’s hard to see how Washington’s interventions, clumsy though they might have been, invented mortgage-backed securities and credit-default swaps, or prodded banks to speculate wildly on them. No, at its root, the 2008 credit crisis and the resulting recession cannot be blamed on too much government rather than too little.

So the question is, what sort of beefed-up regulation is needed? Here the story takes on what must be by now for many readers a familiar Canadian twist. Canada’s banks held up nicely, thanks mainly to solid federal policy. The easy observation is that since the mid-1990s Ottawa has required banks to maintain better capital reserves and more conservative leverage ratios than their U.S. and British rivals.

Beyond those rules, however, there’s the matter of Canada’s assertive, intrusive, judgmental model for regulatory supervision. As I’ve written before, the key in not the rulebook, but the leeway given for the federal financial supervisor to get in the faces of bankers and tell them to fix emerging problems with their lending long before they get out of hand.

I revisit this topic mainly to note an interesting passage on the need for diligent enforcement—not just smart rules—in a New York Times story this morning about Paul Volcker, the former U.S. Federal Reserve Board chairman and Obama advisor, and avowed fan of the Canadian regulatory system.

Volcker has pushed for a rule in the new American banking legislation, already passed by the U.S. House and up for a vote in the Senate this week,  that would limit risky investments by banks in hedge funds or private equity. Here’s what he’s quoted as saying in the Times:

“The success of this approach is going to be heavily depending on how aggressively and intelligently it is implemented…  It is not just a question of defining what needs to be done, but carrying it out in practice, day by day, bank by bank.”

He is echoing what John Palmer, the former top Canadian financial regulator, and his current successor, Julie Dickson, have been arguing for months in the often arcane process of hammering out the coordinated international adoption of better banking rules and oversight.

Of course, Palmer and Dickson are the sort of supervisors who believe in their job. Ideology can and has prevented other public servants, especially in the U.S., from using their powers. Under Alan Greenspan, whose reputation hasn’t held up quite so well as Volcker’s, the Fed wasn’t inclined to intervene. “Rules are not enough,” wrote Jeff Madrik in a New York Review of Books essay on what went wrong. “Greenspan had been given the authority to examine the quality of mortgage lending by Congress in the 1990s, but simply did not use it, pleading free-market principles.”

There are hints that the more robust Canadian supervisory ethos is gaining ground over Greenspan’s discredited brand of reticence. The final communiqué after the G20’s recent Toronto summit declared that “stronger rules must be complemented with more effective oversight and supervision” and that supervisors should have “specific powers… to proactively indentify and address risks, including early intervention.”

This is an interesting development not only because it might ultimately prevent or at least lessen the damage done by a major banking crisis. We’ve come through a long era in which any suggestion that mere bureaucrats should be empowered to meddle in the affairs of business was to invite derision.

A more balanced perspective, closer to John Kenneth Galbraith’s idea of “countervailing powers,” seems to be taking hold again, at least when it comes to keeping a critical eye on the banks.

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