Cleaning Up the Mess: New Rules for Financial Regulation

An Interview with Ellen Seidman

Ellen Seidman is a senior fellow at the New America Foundation, a Washington, D.C.-based public policy institute. From 1997 to 2001, she was director of the U.S Treasury Department’s Office of Thrift Supervision.

Multinational Monitor: What is a thumbnail sketch of the allocation of regulatory responsibilities for the financial sector in the United States?

Ellen Seidman: As many of us have said over the years, if you were going to create this thing from scratch you would certainly not do it this way.

Regulatory responsibilities in the financial sector are divided by functions, so for example investment banks, to the extent they continue to exist, are regulated by different agencies than banks. And banks are regulated by different agencies than insurance companies. Even within those silos, you have a multiplicity of regulators in many of the fields. There are four federal bank regulators and a credit union regulator. In addition, there are 50 state regulators, almost all of whom regulate both banks and credit unions (and sometimes have even broader jurisdiction), but there are still one or two states where even banks and savings and loans are regulated by different regulators. And there are 50 state insurance regulators. Similarly, there are 50 different state securities regulators in addition to the SEC.

MM: Does that multiplicity of regulators and overlapping jurisdiction hurt or help?

Seidman: In general, it hurts. It hurts in part because so many of the corporate entities that are the most systemically relevant cross lines and have subsidiaries or affiliates involved in many of the different functions. To the extent that the various pieces are being regulated by different regulators, and regulation of holding [parent] companies is either nonexistent or very light, it is extremely difficult for the regulatory system to get a handle on what is going on. It also reduces the incentive for the people inside the corporations to actually understand fully what is going on.

On the other hand, in certain circumstances, the states have in fact been effective in being ahead of the federal government, primarily with respect to consumer protection. Sometimes, they move faster. Sometimes, the issues are geographically concentrated, so they are clearer in individual states. And because there are 50 states, you have a better chance of having a Joe Smith in North Carolina who really will take the ball and run with it. But you also have state regulators who are not willing to rise even to the level of federal regulation.

MM: Against that backdrop, there are proposals for a single financial regulator, with many supporting the idea that that single regulator be the Fed. How do you respond to those ideas?

Seidman: I think vesting all jurisdiction in any single entity is likely to be troublesome, if not a grand mistake. It is an enormous job; it's an enormous job where everything is changing very quickly, all the time. I think that a single entity will have even more trouble than multiple entities keeping a hand on all the pieces.

Having said that, I think there is a need for the United States to be able to negotiate internationally with something closer to one voice. I think that there is a need for some regulatory agency to be paying coordinated attention to the risks that are posed by the largest and most interconnected entities.

If there were a single regulator, the Fed seems like the obvious entity. If it's not the Fed, you would probably have to create something new. But the advantages to the Fed are also its problems. Of all the regulators, it is the most politically independent in its governance structures. While the President appoints members of the Board of Governors, those members have extremely long terms, which reduces political influence over them. They also act in concert with the Federal Open Markets Committee, which includes the presidents of the Federal Reserve Banks [seven, spread around the country]. The presidents of the Federal Reserve Banks are elected by their boards of directors, which are mostly made up of bankers. That, of course, raises some important questions about conflicts of interest with the banking industry. It also raises questions with respect to the pieces of the financial services industry that aren't represented at all.

And then you have the fact that the supervisory portion of the Fed is not in Washington. The Fed in Washington writes the regulations, and adopts and implements monetary policy. But the supervisory part of the Fed - the part which reviews individual bank practices and finances - is located in the individual Federal Reserve banks, where the commercial banks have such large influence.

MM: Congress is very likely to adopt a new financial regulatory framework in 2009. What should be the key, overarching principles, both for safety and soundness, and for consumer protection?

Seidman: I think there are seven key principles. One is ensuring capital adequacy, which has several components. The regulator must understand what the risks of the entity are. Then, the regulator must have some way to measure the amount of capital that the entity ought to hold against those risks, with a cushion - because don't forget that the objective is to protect against unexpected risks. We also need to reconsider the place where our capital adequacy rules and accounting systems intersect, so that we can make the holding of capital more counter-cyclical rather than pro-cyclical. Right now, in good years the institutions do not build up capital. They may build up loss reserves, but even there the accounting rules make it very difficult to do that. They don't build up capital when they could, so that in the bad years when you want them to be lending, they don't have a sufficient cushion.

The second principle is consistency of regulation. Unless the same kinds of activities are regulated in the same way, no matter what kind of business entity does them, the business practices will run downhill to the most lightly regulated sector.

The third is effective enforcement. With respect to consumer issues, having rules that are not effectively enforced is worse than having no rules at all. And if you have capital adequacy rules without effective enforcement you get overleveraging - I think that's what happened with the SIVs [Special Investment Vehicles - off-balance sheet entities where many banks placed their mortgage-backed securities investments] in this latest debacle.

I think that the regulators themselves are very important in all of this, but they can't be everywhere, all the time. We can't rely on regulators alone to make the system work well; we need to get incentives aligned.

So, a fourth principle that I would espouse is the notion of everybody having a financial stake in activities that have a long tail. If someone is making a financial investment or arrangement that will unfold over time, then they need to have a continuing stake in it. That needs to happen on the compensation side so that, for example, mortgage brokers or stock traders are compensated not just for making a loan or for this year's investment profits, but on how the loan or investment does over an extended period. It also needs to happen on the instrument side so that all liability can't be assigned. If a bank issues a mortgage, for example, it should have to maintain some stake in that loan, not just sell the entirety on the secondary market.

This leads to another principle, which is transparency. There has to be a good deal more transparency with respect to financial instruments and with respect to counter parties. Some of this is indeed proprietary, but a whole lot less than we tend to think. An increase in simplicity with respect to instruments would help, but I'm under no illusions that we're going to be able to sustain that.

With respect to a lot of consumer issues, also, it is important to extend the amount of public information about what various entities are doing, who they're lending to and under what terms. Data disclosed pursuant to the Home Mortgage Disclosure Act has been incredibly important in enforcing fair lending and enabling us to understand which institutions are serving which communities.

Sixth, strong and effective product regulation (e.g., regulation of lending terms) is a really important part of financial services regulation. It is even more difficult than strong and effective product regulation in the consumer products area, because financial instruments can be changed very, very quickly, small changes make a big difference, and changes are often hard to see. For example, just adding a prepayment penalty to a loan may change it from a fair bargain to a predatory arrangement.

Finally, I think it is time for an affirmative mandate on financial institutions to fairly and equitably serve all consumers in all communities. This would be an extension of the Community Reinvestment Act. Such a mandate will undoubtedly lead to a fair amount of litigation to decide what it means. But the government has always supported the banking sector by setting the regulatory framework - and is now providing direct financial support - and consumers in this country deserve something in return. Of course it's not just banks that are getting the benefit of government support. Investment banks, insurance companies and others are too.

MM: What is the Community Reinvestment Act, and what is it that you want affirmatively imposed upon the banks that go beyond CRA standards?

Seidman: The Community Reinvestment Act (CRA) is a statute that was passed in 1977. It applies to banks and thrifts [savings and loans], and it says that these institutions must serve all of the communities, including in particular low- and moderate-income neighborhoods, in the areas they are chartered to serve. It imposes an affirmative mandate.

The statute also explicitly directs that banks and thrifts are to meet this mandate in a manner that is consistent with safe and sound operations.

The CRA has served well over the course of 30 years in extending the interest and willingness of banks and thrifts to serve all communities by providing the financing for affordable housing, schools and health clinics, and for a lot of economic development, in addition to lending and providing other banking services to individuals and businesses.

But try as hard as the regulators have, CRA has not kept up with a changing financial landscape. In particular, banks and thrifts are the only financial institutions with this kind of affirmative mandate. Credit unions have a similar, but lesser obligation. Today, in many communities, banks and thrifts are not the primary providers of financial services. I think that it's important that other parts of the sector have similar positive obligations.

Having said that, one of the things we learned in the subprime crisis is that just saying you have to serve these communities is not necessarily the right answer. In general, banks that were subject to CRA served the low-to-moderate-income communities and consumers in their assessment areas quite well. But other entities operating in those areas served less well. And outside of the specific areas where bank performance "counted" for CRA credit, some banks did not behave as well either. We need to understand that what matters is not only service provision, but the quality of service. That may be more difficult to measure and require litigation to establish clear standards, but without quality standards, it's a little like the problem of compensating lenders for loan volume with no concern for performance.

There are elements of this concept in other statutory regimes. In the securities industry, you have the suitability standard where somebody selling a financial product is required to figure out whether that product is suitable for the consumer. That doesn't exist in the banking industry, and probably ought to be imported into the banking industry. Part of suitability is consistent with a question that any banker needs to ask with any lending product: Can the consumer pay? But part of it goes beyond that question and tries to match consumer needs with appropriate products.

In the insurance industry you have prior approval of most consumer lines. That has probably kept that industry out of the kind of consumer-product-related problems currently overwhelming the banking sector. There are benefits and problems with prior approval systems, particularly when they include rates as well as product terms, but there are probably things to learn from the insurance context.

MM: How effective is disclosure of terms, conditions and risks as a consumer protection strategy?

Seidman: It's incredibly important that we don't regard disclosure as the whole strategy - and that's in many ways the direction we've headed over the course of the last 30 years. It's not a good direction with respect to consumer financial products. These are not just poor customers we're talking about. Frankly, my guess is that we've discovered that a whole lot of people that we've regarded as sophisticated investors didn't understand a whole lot of what was disclosed to them.

Having said that, there are circumstances under which disclosure can be extremely valuable. First, effective disclosure must be clear and simple. To some extent, that requires that the products also be clear and simple. If you have clear and simple products, disclosing the terms would be a lot more useful.

Second, the disclosures need to be at the appropriate time. Sometimes, this can be during the transaction. I am actually very much in favor of cell phone or debit card alerts where, for example, you try to get money out of an ATM machine, and the ATM machine comes back and says, "If you do this you will overdraft and it will cost $35, and do you really want to do that?" That's a form of disclosure that would be very effective.

On the other hand, in the mortgage area, disclosures on rates and terms need to come much earlier in the process, because you need to be able to shop around.

The third issue with disclosure is that it requires a population that is both more financially literate and has a trusted group that they can ask to obtain financial information. At the New America Foundation, we have worked on the concept of a Financial Services Corps. In addition to generalized financial education, we would build a group of people that consumers could turn to when they need help, and who would be obligated to assist the consumer in a manner that puts the consumer's needs first.

MM: Some consumer advocates are supporting proposals for a Financial Products Safety Commission. What is your perspective on this idea?

Seidman: I think a Financial Products Safety Commission could have some value, but I think we have to be very careful about thinking of it as a panacea also. I think it can have value as an agency whose responsibility is to understand what consumer financial products are on the market, to evaluate those products in terms of their utility, and their transparency and their risk to the consumers, and then to potentially regulate what products can be sold under what terms.

But such a regulatory role would be difficult because of the highly variable and easy-to-modify nature of financial products. It's difficult too because of the different needs of consumers in the realm of financial products, and because of the incredible proliferation of consumer financial products that we have had.

I would not give such an agency sole enforcement authority. I'm not entirely sure I would give it any enforcement authority. But for banking, it is important that bank regulators doing ongoing supervision to have responsibility not just for safety and soundness but also for consumer protection. One of the things that we've seen in the current debacle is that, in general, those entities that did quality lending to consumers have managed much better than those whose lending was bad for consumers. That's an important lesson.

MM: What are credit unions and community development banks, and how has their performance compared to the commercial banking sector in the last decade?

Seidman: In the United States, Community Development Financial Institutions are certified by the Treasury Department as having a primary mission of serving low-income communities or populations that are disadvantaged in respect to getting credit. There are about 60 banks and bank holding companies, about 150 credit unions, maybe 10 or 12 venture capital funds and several hundred nonprofit loan funds designated as Community Development Financial Institutions. In general, these institutions have performed very well for the community and the people in them, and have done OK financially. But the nonprofit loan funds need some subsidy to do what they're doing, in part because they're small, and in part because they're asked to do the innovation in providing new services and products. The banks, thrifts and credit unions in the sector have been solid, in general, although there have been some failures, but they are definitely not great performers. They turn a profit, but they are double bottom line or triple bottom line entities - meaning they measure and value social, and sometimes environmental, achievements as well as financial success.

Community banks are another sector. In general, these are small, local banks that serve a limited number of communities. We used to say that they were under a billion dollars in asset size; that's probably a little low now. Community banks serve their locations, are not big capital market players, and rely heavily on the combination of local deposits and Federal Home Loan Bank advances for funding. This group has, in general, done quite well through this crisis. These are not the high flyers; although there are some with relatively high returns, most are moderate performing institutions. Many are privately held.

The community banks have been severely pressured competitively. Big institutions have taken many of the business clients of the community banks. The insurance companies and the pension funds have gone into real estate, impinging on another line of business of the community banks. Then, on the consumer side, the mortgage brokers and general loan lenders took business away.

Nevertheless, despite all of this, they have done better than large banks. During 2008, the failure rate for banks over a billion dollars was more than seven times the failure rate of banks under a billion dollars. Where these institutions are in communities that are having trouble, the banks are having trouble too, but generally they are doing OK.

Credit unions are a different category. While there are some very big credit unions - the Navy Federal Credit Union, which serves members of the navy, their dependents and former members of the navy, is a $26 billion institution. But most of the credit unions are much smaller. They have both the benefits and the burdens of the community banks in terms of performance, but they are also subject to an additional burden that by their corporate structure can't raise capital. They tend to be pretty conservative lenders, which has helped them.

As a collectivity, they have been more forward-looking than the community bankers in serving the lower income and underserved community. Some of the best work, for example, on alternatives to payday lending is being done by credit unions.

MM: Would the United States be better off if that was the entire landscape for banking and there were no giant institutions?

Seidman: We need a secondary market. To the extent that the bigger institutions are serving as connective tissue in the correspondent role [between the Federal Reserve and other banks] and similarly in the capital markets [between Wall Street investors and other banks], I think they are important.

Also, those small institutions do have limited ability to fund. As businesses get larger, they need bigger institutions. They need easy access to larger amounts of funding. For larger corporations, even those not yet ready for the public equity markets, the big banks do play an important role. We ought, however, to be working very hard to sustain the existence and the health of a community banking and credit union sector.