“This NYT article about Minsky is a joke, right? “Let’s keep these bankers off balance by not telling them all the rules and not telling them when we change the rules!” That’s ”stepping over dollar bills to pick up pennies.” Who creates most of the artificial stability/straight line growth, that leads to imprudent lending and mal-investment? Our government and their central bank, The Fed!!! Why? They are afraid of the political repercussions…

…of a normal business cycle (with temporarily lower economic activity and higher unemployment), yet the business cycle must occur for prudent lending and investment to occur. This is at the root of the massive 2008 financial crisis, yet virtually no one in government is addressing it, because its solution is painful to implement. (It’s the same principle as not allowing smaller natural forest fires to burn, when the rare one actually does occur, it can’t be easily brought under control and it becomes massive and unnecessarily damaging.)”, Mike Perry, former Chairman and CEO, IndyMac Bank

“Mr. Minsky pithily observed that stability gives rise to instability. As the economy grows steadily, banks and companies start to overreach. Banks lend too much, and companies and consumers overborrow, which ultimately makes the system fragile. And while financial regulation was necessary to limit excessive behavior during those stable times, Mr. Minsky observed that bankers eventually found ways around the rules.”, Peter Eavis, “How Regulators Mess With Bankers’ Minds, and Why That’s Good”, The New York Times, April 15, 2016

Rules, Rules

How Regulators Mess With Bankers’ Minds, and Why That’s Good

Peter Eavis

Bank regulators on Wednesday sent a message that big banks are still too big and too complex. They rejected special plans, called living wills, that the banks have to submit to show they can go through an orderly bankruptcy.

The thinking behind the regulators’ call for living wills is that if a large bank crash is orderly, there will be no need to save it and no need for taxpayer bailouts.

Pretty straightforward, right? Not for the banks. The regulators deliberately did not communicate the exact things the banks needed to do for their plans to pass muster. In this way, they kept them on their toes — and treating powerful banks this way may end up playing a surprisingly important role in keeping the financial regulation effective over time.

Over the decades leading up to the financial crisis of 2008, banks learned how to sidestep and water down the relatively tough regulations introduced after the crash of 1929. This ability of the banks to get their way was spotted by Hyman Minsky, a maverick economist who died 20 years ago. He was prophetic, too. He identified and warned about the sort of trends in the financial system and the wider economy that helped cause the last financial crisis. That is why when everything started falling apart in 2008, some commentators said a “Minsky moment” had arrived.

Mr. Minsky pithily observed that stability gives rise to instability. As the economy grows steadily, banks and companies start to overreach. Banks lend too much, and companies and consumers overborrow, which ultimately makes the system fragile. And while financial regulation was necessary to limit excessive behavior during those stable times, Mr. Minsky observed that bankers eventually found ways around the rules.

This part of Mr. Minsky’s thinking was on my mind this week at the annual Minsky conference at theLevy Economics Institute of Bard College. The focus of the gathering was the Dodd-Frank Act, the sweeping overhaul of the financial system that Congress passed in 2010. Many of the speakers, being acolytes of Mr. Minsky, said they expected the bankers to find ways to dodge Dodd-Frank in the coming years.

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Hyman Minsky, an economist who died almost 20 years ago, was prescient about the trends in the financial system and wider economy that contributed to the financial crisis of 2008. Credit Levy Economics Institute of Bard College

But Dodd-Frank might have built-in self-protections. It seems to take into account Mr. Minsky’s warnings, with provisions that allow the law to be refreshed and changed as the financial system evolves. Regulators have already used those features to seize the initiative over bankers.

They have done so with so-called living wills. The regulators get to determine what needs to be in the living wills. One senior agency official told me on Wednesday that they try not to make the exercise so clear that the banks treat it just like any other compliance exercise.

Perhaps even more important are the annual regulatory stress tests that assess how large banks would bear up under theoretical crashes in the markets and global economy. Undertaken by the Federal Reserve, these tests have caused significant headaches for the banks, and some banks have failed them, mostly because their plans for handling the hypothetical stress were judged inadequate. This has caused unease among the banks’ senior managers. If the banks flunk the stress tests, they don’t get to distribute money to shareholders or buy back shares. The banks are kept on their toes because conditions assumed in the tests, and the things regulators look for, can change.

Dodd-Frank also set up something called the Financial Stability Oversight Council, a special regulatory body that sits above other regulators. One of its main jobs is to scour the financial system looking for new risks. If it can resist the influence of bank lawyers and lobbyists, the council could use this power to limit the growth of new financial products that are devised to avoid regulation.

The council also seeks to identify which large financial firms that are not banks — think, big insurance companies — should be subject to stricter regulation. It’s a duty that was devised in response to the huge buildup of risks at the American International Group, which received one of the biggest bailouts.

True, the financial industry has already won a substantial victory to limit regulation. A Federal District Court recently ruled that the council could not subject MetLife, a large insurance company, to stricter regulation. Still, many lawyers believe that the court’s ruling is shaky and will be overturned on appeal.

Mr. Minsky would be wary, however. These features of Dodd-Frank that allow regulators to stay ahead of the banks require independent-minded regulators to use them. The economy is strengthening, and banks are getting healthier. This is the period of stability that Mr. Minsky warns about, when the regulators start to believe that most risks have been constrained, causing them to miss new dangers. And the financial industry is likely to win important victories in Congress that roll back regulation, as it did at the end of 2014, when an important part of Dodd-Frank was gutted.

But for now at least, banking regulators seem willing to use their freedom to mess with the banks.

A version of this article appears in print on April 15, 2016, on page B1 of the New York edition with the headline: Messing With Minds of Bankers Is Good.

Posted on April 15, 2016, in Postings. Bookmark the permalink. Leave a comment.

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