Financial Regulations Need to Go Against Market Cycles


William Mills Agency
recently covered the Federal Reserve Bank of Chicago’s 49th Annual Conference on Bank Structure and Competition. Here is a recap of major discussions at the conference. This is the 3rd part of a three part series.

Financial Regulations: Federal Reserve Bank Conference: Part 3

Banking regulation tends to be pro-cyclical, pushing financial institutions into business practices that accelerate both the good times and the bad times, said William M. Isaac, chairman of Fifth Third Bancorp and former FDIC chairman at the annual conference in Chicago.

He said one has to look no further than the last 10 years as pro-lending policies led to the boom of the early 2000s and the bust at the end of the decade. During the boom times, regulators further eased credit policies, while during the bust times, it restricted credit even further.

The regulatory policies are built on models that are always backward-looking and do not account for changes in economic directions, which is why they are pro-cyclical, according to Isaac.

Basel III is similarly pro-cyclical and should be rejected, Isaac added.

Rather than being pro-cyclical, regulation should be counter-cyclical, Isaac said. “It should always go against the prevailing winds. When the industry is struggling, [regulation] should be encouraging banks to lend rather than requiring more capital and adding additional regulations.”

Similarly, tightening should occur during boom times, Isaac added.

One of the biggest mistakes the industry has made, one that many regulators opposed, was mark-to-market accounting for assets, Isaac added. The practice destroyed $500 billion in capital and $4 trillion in lending power just when the industry and the economy needed them most.

According to Isaac, mark-to-market doesn’t account for temporary dips in valuations, which are commonplace, and should only be used for assets that financial institutions have in trading accounts.

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