How effective are post-financial crisis bank regulations?

Bankers and regulatory experts don’t always agree about the efficacy of the regulations banks are required to follow, so when they do, it is worth taking note. Now, a new survey [PDF] highlights some areas of agreement — notably that capital requirements and stress tests are effective, and that the Consumer Financial Protection Bureau is not. 

In the wake of the 2008 financial crisis, many new regulations were passed to improve risk management practices at financial institutions. The Dodd-Frank Act alone propagated hundreds of new regulations. But analysts are just starting to look at how those new regulations are playing out.

The MIT Golub Center for Finance and Policy, in collaboration with consulting firm Grant Thornton LLP, set out to find answers. They conducted a survey of U.S. banks to find out three things: How did banks respond to the regulations, how effective were they at preventing risk, and what were the costs?

By surveying risk management staff from financial institutions and also regulatory experts — such as scholars and think tank employees — they found that banks primarily had invested in enhanced risk management practices because they were required to do so. Banks and regulatory experts also agreed on several points regarding the effectiveness and cost of the regulations, though regulators generally viewed regulations as more effective than did bankers.

“This report is an important starting point for having a constructive conversation about where we should be going in the regulatory process,” said Deborah Lucas, director of the Golub Center and MIT Sloan professor.

It is also a good time to be looking back on these regulations, according to Doug Criscitello, executive director of the Golub Center and MIT Sloan senior lecturer, since politicians, bankers, and regulators are starting to question their necessity. “We saw the pendulum swinging in a big way towards increased regulations and supervision in the immediate aftermath of the financial crisis,” he said. “We now see it coming back in the other direction, at least in the U.S., hastened by the recent election.”

The results.
Lucas and Criscitello, who co-authored the report with Kyle Shohfi and Rajkamal Iyer, along with Jose Molina and Frank Saavedra-Lim at Grant Thornton, agree that perhaps the most significant finding from the report involves the reasons why banks implemented risk management practices after the financial crisis. “A large portion of it is driven by being responsive to regulations,” Lucas said. “A notable exception is cybersecurity. That was an area where banks were greatly concerned and interested in making more investments to beef up risk management than what regulators were requiring.”

However, many of those risk management practices have begun “to morph into business as usual practices,” Criscitello said, likening the situation to parents forcing their children to eat more healthfully, only to have the children eventually realize that healthy food is not only good for them, but also good tasting. “These practices could drive the risk management function of the future — even if the current regulatory environment becomes more relaxed.”

The report also revealed where banks and regulatory experts agreed and disagreed in terms of the efficacy and cost of the regulations. Whereas banks and regulatory experts disagreed about things like the costliness of living wills, they agreed on several important regulations. Notably, both banks and regulatory experts thought that capital requirements and stress tests were effective, but costly. They also both thought that the Consumer Financial Protection Bureau was costly and ineffective.

This is important, Lucas said, because if both banks and regulatory experts agree that something is ineffective, there should be changes.

Perhaps most importantly, “this gives us a place to build from,” Lucas said. “These areas of agreement and disagreement are important for having a constructive conversation about where we should go on the regulatory front.”

Going forward.
Finally, the researchers asked what bankers thought could be done to reduce the financial burden of the regulations. They noted things like consolidating redundant regulations and reducing the number of regulators they deal with. Lucas thinks that not only could those suggestions be implemented, they probably should be. She also thinks that one of the most likely changes to happen is reducing the number of regulations for small banks.

Both Lucas and Criscitello agree that their findings should be used as a jumping off point for further discussion about financial regulations and risk management practices. As to what will happen in the future, though, Criscitello said, “Stay tuned. The pendulum continues to swing.”