As an industry, we remain in high dudgeon over the inanity of much of Dodd-Frank, the ideological and often unhinged regulatory instincts of our various governments and the vast amount of effort, time and money it takes to comply with the mind-numbing complexity of rules and regulations that seem to be largely untethered from the goal of solving actual problems. We winge. We boviate. We testify, write white papers, fund PACs and pursue “engagements” with the regulatory apparatchiki in the pursuit of sensible relief. But do we still really care?
Are we witnessing a process of reconciliation? Could it be that the capital markets have found a way to thrive inside the current regulatory state’s bear hug?
That suspicion rang a bell from my undergraduate economics classes and I went searching for what I remembered as the Doonesbury Rule. Since the economist in question was actually James Duesenberry, chasing the Doonesbury Rule was not really productive, but I did get to see a bunch of vintage Doonesbury cartoons (I had forgotten how truly funny Spiro Agnew really was). Professor Duesenberry, has been apparently long forgotten, but my search came up with something called the Consumption Function Theory, which is worth our consideration.
Stick with me here. The Consumption Function Theory relates savings and consumption behavior to account income levels. To hash it up a bit and without reference to any of the mathematics, the underlying notion is that as income decreases, consumption remains stable at pre-existing levels. As income moves down, savings gets suppressed. Applying that to a business context, and as the good Professor might have said: as operating costs go up (so that net income is suppressed), output remains higher than the level of current period net income would justify. Putting it another way, the industry is now bigger than its current profit profile would suggest.
I promised that if you stuck with me, I would get there and here’s the punchline! After the dissidence of absorbing the hits of new, more complicated and more expensive-to-comply-with regulations and more liability, which we all predicted would suppress capital formation, it doesn’t seem to have done that to the extent anticipated. We are just living with it.
Maybe this is a long way around the barn, but look at risk retention for a moment. Risk retention appeared to be a disaster (okay, maybe it still will be). Sponsors wouldn’t be able to hold risk retention and no fund vehicles out there would be able to meet the liquidity and tenor obligations of a third party purchaser, at least on the scale needed to run the biz. What’s happened? There’s enough money, the market is working. And what’s more, folks are getting invested in the current structure. Investment grade buyers sort of like risk retention (even though I’m pretty sure that none of them would pay for it, given a choice) and a number of fund sponsors have raised oodles of money to buy risk retention securities (and that doesn’t even mention the number of hours your trusty attorneys have spent becoming experts in this new branch of arcana). While leaping to Y2K may be a tad premature, the industry has accommodated itself to this new set of rules and found a way to succeed.
Enormous new burdens have been put on the banking system; more compliance, more data capture and reporting, more capital required per units of output and, of course, more liabilities. Do the global banks really hate it? Really? They have built compliance departments that have the resources to actually meet the new regulatory burdens giving them a competitive advantage over smaller banks which have neither the resources nor all the competencies to meet these burdens. They have raised truly impressive amounts of new capital. So, while compliance costs have gone up, and while some regulated institutions have had to exit certain businesses, the business of lending continues to thrive. We’re banging right along!
But wait, if our dear Professor is right, as the regulatory burden increases, something has got to give, right? If your operating costs go up and you keep partying like it’s 1999, profits have to go down. It is a zero sum game.
So wassup? Maybe he’s just wrong. Let’s face it – that is not an uncommon state of affairs for economists. But in this case, I don’t think so. What’s going on is that the pain of all this intellectually untethered macroprudential regulation is being masked by the monetary goodies having been larded into the monetary system by the FOMC and the other central banks around the globe. The opiate of liquidity is masking the pain. When the Great Reversal of liquidity begins in earnest, when the tide begins to go out, we are likely to discover that the enhanced burden of regulation will be way more painful than it appears right now. We will find out that the cost of all this regulation is a real diminution in economic activity as the business’ net profitability no longer supports its current scale. When it happens, it will take us all by surprise, it will be painful, and once again stick us with a long and slow recovery.
So, this is not an apologia for equanimity in the face of regulatory overreach. The regulatory output spawned by the Great Recession has had real and painful negative externalities currently veiled by a sea of liquidity.
There is much that should be done to roll back Dodd-Frank, the Basel rules and the rest of the excesses of the regulatory state. There is much that can be done to rationalize existing rules and acknowledge and fix problems which have in some cases overwhelmed the positive benefit of prudential rulemaking that could do the country and our economy a world of good. The industry should struggle to continue to make it a better and more efficient engine of capital formation for the broader economy. If we don’t get some of this fixed, when the liquidity tide goes out, a very real price will be paid for our political classes’ embrace of this politically popular but largely intellectually flawed regulatory regime.