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One of the major challenges for banks is managing not just the creditworthiness of their customers but also the
But in times when macroeconomic volatility and unforeseen tail risk events may roil bank balance sheets, the traditional regulatory impulse to penalize losses may be counterproductive. It is time to rethink how we treat financial institutions that face losses not from fraud or mismanagement but from thoughtful bank risk-taking that is essential to support a dynamic economy. A more constructive, supportive regulatory posture could help preserve stability, encourage responsible innovation and protect the broader economy from unnecessary fallout.
How loans and balance sheets perform is heavily influenced by these exogenous factors, which are often hard to model and predict. Most financial institutions and their regulators, to a great degree, focus on the center of the risk curve. However, given the considerable economic changes the current presidential administration aims to accomplish, the next several years are likely to be unusually uncertain, making modeling of tail risk scenarios more important than is normally the case. In this era, the real risks are even less likely to be found at the center of the curve.
Having said that, banks can’t fulfill their crucial credit function and build the economy if regulations or regulators force them to be overly paranoid about conceivable but unlikely tail risk scenarios. The notion that banks will be punished for losses when harsh tail risk events cause severe losses, even where there has been prudent risk-taking, creates a dynamic that causes banks and the economy to perform in a suboptimal fashion. Both innovation and prudently venturing out on the risk curve — in terms of lending and investment — support the possibility of achieving the American dream for many individuals and advancing entrepreneurial efforts for businesses and enterprising individuals.
It’s in the interest of both the government and the private sector for banks to take risks and be innovative. Particularly at a time when the government is cutting back on many of the programs it has been funding, many important private-sector and semi-private projects will only happen if banks can effectively go out on the risk curve and innovate. For example, while structured finance and “investment” might be bad words in some circles, fulfilling the maturity transformation process often depends upon them.
There is a big difference between regulatory laxity and allowing, even encouraging, sensible innovation. At the same time, to the extent that regulators allow or even encourage such innovation, there will inevitably be more volatility and some losses.
To my mind, regulators should shift their focus to supporting, rather than punishing, financial institutions that have taken prudent risks and engaged in thoughtful innovative efforts. As one well-respected financial executive told me years ago, the worst regulators are those who “show up after the battle has been fought and shoot the wounded.” This is particularly unattractive when a well-regulated, well-capitalized institution has been given a clean bill of health by the regulators then suffers losses due to changes in the external financial environment, as appeared to happen in the mini financial crisis of 2023.
Ultimately, we should move to a more supportive regulatory environment, where regulators look for ways to bolster — in a timely fashion — institutions that take sensible risks and innovate but stumble due to changes in the external economic environment. A failure to support these institutions can, and too often does, cause significant losses for innocent shareholders, employees, the general public and the economy as a whole.
Imagine if in 2007 and 2023 our government had worked with the impacted banks, rather than pushing them to collapse and near collapse. The government itself could have saved tens of billions of dollars, and society as a whole could have saved hundreds of billions.
Enforcement is certainly appropriate, particularly where there has been any kind of fraud, intentional failure to follow regulatory prescriptions in a material way or serious compliance violations that clearly take advantage of the public. But where this is not the case, regulators should give financial institutions time to resolve their challenges — and those of their customers — by allowing capital to serve as a cushion for ongoing operations, not just for winding down. That would be a step in the right direction. Another step would be a modernized and much more flexible discount window that could act forcefully and quickly.
Even in cases where there have been some violations of the law, it is unclear whether punishing the institution, as opposed to the perpetrators of the specific violation, is always the right step. Instead of punishing the shareholders of a large public company and innocent employees, regulators should focus enforcement on the actual wrongdoers, not the institution and its innocent stakeholders.
To emphasize, enforcement shouldn’t be the first thing regulators think of when an institution’s problems are part of a financial storm unrelated to its own intentional missteps. And enforcement is hardly warranted when the institution has been examined, given a clean bill of health and the examiners have not been misled.
Some might argue this approach advocates for forbearance, which could breed serious moral hazard. I’m not convinced moral hazard increases when employees who are guilty of actual wrongdoing are punished. Furthermore, when punishing a broadly held public company, how can a shareholder truly exert any real pressure on a banking institution? I wonder whether in a public-company-large-banking environment, moral hazard has not been an excuse to avoid a more thoughtful regulatory response to crises. Shareholders don’t have access to supervisory information, nor can they, given historic bank practice. What more can a board do when regulators, with dozens of examiners, have given an institution a clean bill of health or when the institution faces an unforeseen tail risk event?
In sum, it is past time for us to rethink how we treat banking organizations in trouble. It is time we work to support institutions in trouble wherever possible, rather than simply punishing the institutions and the public.