John Cochrane On Problems With Regulations

See Rule of Law in the Regulatory State. Excerpt:

"Banks

Start with finance. Finance is, of course, where the money is.

The Dodd-Frank act is 2,300 pages of legislation, in which “systemic” is never defined, making a “systemic” designation nearly impossible to fight. The act has given rise to tens of thousands of pages of subsidiary regulation, much still to be written. The Volker rule alone — do not fund proprietary trading with insured deposits — runs now to nearly 1,000 pages. To call this Talmudic is to insult the clarity and concision of the Talmud. (Recent critiques here and here.)

The result is immense discretion, both by accident and by design. There is no way one can just read the regulations and know which activities are allowed. Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their ok on every major decision of the banks.

The “stress tests” are a good case in point. Seeing, I suspect, the futility of much Dodd-Frank regulation, and with the apparent success of the Spring 2009 stress tests in the rear view mirror, such tests have become a cornerstone of the Federal Reserve’s regulatory efforts. But what worked once does not necessarily work again if carved in stone.

In “stress tests,” Federal Reserve staff make up various scenarios, and apply their own computer models and the banks’ computer models to see how the banks fare. However, the Fed does not announce a set scenario ahead of time. They Fed staffers make up new scenarios each time. They understand that if banks know ahead of time what the scenario is and the standards are, then the clever MBAs at the banks will make sure the banks all pass. And billions of dollars hang on the results of this game.

Now, the Fed staffers playing this game, at least those that I have talked to, are honest and a-political. For now. But how long can that last? How long can the Fed resist the temptation to punish banks who have stepped out of line with a stress test designed to exploit their weakness? Is it any wonder that few big banks are speaking out against the whole regime? They understand that being an “enemy” is not the way to win approvals.

And the stress-test staff are getting handsome offers already to come work for the banks, to help the banks to pass the Fed’s stress tests. Ben Bernanke himself is now working for Citadel.

If this sounds like the cozy world of “capture,” however, remember the litany of criminal prosecutions and multibillion-dollar settlements. These are instigated by the Attorney General and Department of Justice, with much closer ties to the Administration, but they revolve around violations of securities regulations. Is it a coincidence that S&P, who embarrassed the Administration by downgrading U.S. debt, faced a $1.4 billion dollar settlement for ratings shenanigans, while Moody’s, which gave the same ratings, did not? Pay up, shut up, and stay out of trouble is the order of the day.

The Wall Street Journal nicely characterized today’s Wall Street, quoting John J. Mack, Morgan Stanley's ex-chairman “Your No.1 client is the government,” which embeds “About 50 full-time government regulators.”"