The Road Not Taken

12170_sarahbloomraskin The Road Not Taken WORD ON THE STREET: We've all faced business decisions that offer the opportunity to choose between taking the high road and the low road. In the banking industry, the high road offers a way to do business and to succeed over the long term by building enduring relationships; structuring profitable, win-win arrangements; and treating customers and communities as meaningful stakeholders in the bank's work.

But sometimes, choosing this high road just doesn't seem to take us where we want to go fast enough. Suddenly, the low road can seem attractive and tantalizing, and it may offer short-term rewards that can be hard to resist. Taking the low road can be an exhilarating and profitable ride for a while, but it almost always leads to disaster and wreckage, and when banks are the vehicle, taking the low road can cause significant economic and financial problems. As we've experienced over the last several years, when your car is wrecked, it's a long walk home.

At the Federal Reserve, we are working with our fellow regulators to realign the restraints and incentives – the guardrails and HOV lanes, if you will – of the regulatory system to promote use of the high road and warn bankers off of the low roads where the rocks are falling, the curves are sharp, and many calamitous accidents happen.

But this is not a task that the regulators can accomplish alone – any more than police officers can stop cell-phone use on the roads without the active participation of motorists, parents, telephone companies, the media, and so on. New laws and regulations may lay the groundwork for change, but necessary, sustainable results are realized only when the regulated – be they drivers or banks – get on board.

If drivers are key players in ending texting-while-driving, then the banks themselves are essential actors in our economic comeback, and community banks play a central role. Community banks were not major culprits in the subprime mortgage crisis, but they definitely suffered from it and took some hard hits because of it.

The best community banks exemplify the high-road virtues that we seek to revive as standard operating practices throughout the banking system, generally. I am referring to close customer service, long-term vision and sustained relationships, investment that benefits the bank and the community, commitment to sound underwriting, and consistently legal and ethical practices and transparent governance.

Large-scale economic and financial events provide an opportunity to re-think basic assumptions – that is, once we get through the period of crisis management. But it takes a while to get there, and reactions to financial crises consist, first, of strategic containment and then, of developing techniques of prevention. In terms of our recent financial crisis, the Federal Reserve attempted to provide the containment through the use of both traditional and innovative macroeconomic tools. Congress, in turn, attempted to supply the subsequent preventative tools. In that regard, the Dodd-Frank Act, which embodied Congress' strategy for preventing another crisis, was passed in July 2010.

But in addition to containment and prevention, there is a third component to a meaningful response that we ignore at the public's peril. And that is a significant probing of the more fundamental aspects of how well our financial system is serving us and at what cost. In fact, I have spent a lot of time, post-crisis, thinking about the role that banks and other financial market entities play in the U.S. economy and in local communities, how well they play that role, and how much it costs us as a society to encourage or enforce that role through regulation.

To date, much of the public discussion of the recent financial crisis has focused on the specific symptoms of this particular episode of financial malfunction. Most people are aware that the staggering loss of jobs, income, and wealth we experienced were associated with what went wrong in the financial sphere. But we cannot forget the need to relate these results to the role that banks and other financial market entities should play in the first place. We need to ask how well banks and financial market entities are performing that role and how to assess the public and private sector costs associated with assuring that they play this role.

In many ways, the choice of which road to take is a function of the particular business model that the financial institution chooses for itself. Community bankers have embraced a business model that is based almost exclusively on pure financial intermediation between borrowers who want to engage in economically productive activities and depositors who have funds to advance for such activities.

This high-road business model means that these financial institutions easily understand the impact of your actions on local homeowners, businesses, and communities. As a state financial regulator, I saw the individual impact that financial institutions had on the local and overall economies of the state; at the Federal Reserve Board, I see the collective impact that these activities have on the economy as a whole.

But there are also flawed business models that create misaligned incentives that lead to what I believe are low-road outcomes. Such outcomes stem from a banking model that blithely ignores the core function of banks as financial intermediaries between those who have credit and those who need it.

The low-road banking model leads to a series of business choices emanating from a business plan and culture focused largely on quick profits with little consideration of longer-term risks and costs, not only to individual firms, but also to the financial system more broadly. The model implies indifference to the consequences of poor risk management, executive compensation schemes that encourage unmitigated and unmonitored risk-taking, and reliance on public dollars to save financial institutions from their own folly and the injuries that their folly creates for the people of our country.

Some may argue that we have learned our lessons and have left the low road behind us in the wake of the financial crisis. That may be true. Yet we know that low-road business models exist and persist: for example, when we hear about billions of dollars of losses resulting from what were supposed to be conservative hedging strategies, or about the manipulation of key market interest rates.

News like this causes the public to question the banking sector's commitment to the public welfare and its willingness to help the nation get back on its feet. And while I believe that most consumers understand that community banks did not, by and large, engage in the most egregious practices, institutions that continue to take the low road tar the image of the entire banking sector.

The role of regulation

New regulation may not always be popular – but, when crafted appropriately, it can effectively alter the actions of those financial institutions that follow low-road business models. Given that the recent crisis in the financial system contributed to a sharp downturn in the economy that had broad effects, including the loss of millions of jobs, we have seen how all Americans are on the hook for financial institutions' decisions. The relationship between financial markets and the public compels decision makers to correct the adverse incentives and moral hazards created by low-road business models.

In my view, though, the regulation of low-road banking models is not without cost. Indeed, some banking models are so complicated that they cannot be regulated without the expenditure of significant public or private dollars. When these business models have such a distant connection to meaningful financial intermediation, I believe that we as a society may very well want to rethink whether we want to support these business models at all. The costs of supporting them, simply put, may be prohibitive.

Indeed, there may not be worthwhile regulatory approaches to all problems, even where the benefits of an activity outweigh the costs to regulate it. For example, when considering the ‘cost-to-regulate’ perspective, some regulatory structures consist of rules that are based solely on metrics. While such rules may have the advantage of being less costly and easier to implement than a more subjective rule, as a regulator, I have to ask whether a metric-based rule will foster the development of internal controls, processes, and cultures that are capable of correcting the problems embedded in a low-road business model.

Metrics-based oversight regimes do not work well in correcting misaligned incentives if the metrics in the regime can be manipulated. It is the potential of metrics manipulation that leads me to favor, in certain instances, clear restrictions on the scope of particularly unproductive activities.

The path that we collectively travel is influenced by the fact that we live in a society populated by institutions with radically different business models; the low-road models can be incredibly large and complex or they can be small and predatory. Because there are costs associated with financial regulation, I am advocating that we understand the public benefits that the financial activity dictated by the model is intended to deliver.

Sarah Bloom Raskin is a governor of the Federal Reserve System. This article was adapted and edited from a speech delivered at the Graduate School of Banking at Colorado. The original text is available online.


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