Enforce the regulations that we already have

Republicans and Democrats are arguing over how many regulations we should add—or remove—from the financial services industry.  Before we think about altering the regulations, we should think about enforcing the ones we currently have.

Ever since the sub-prime meltdown erupted during 2008, politicians on both sides of the aisle have taken aim at the rules and regulations under which the financial system operates.

Democrats argue that the crisis resulted from the under-regulation of the financial system.  In response, the Democrats enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.  Dodd-Frank constituted the most extensive expansion of financial regulation since the reforms enacted in the aftermath of the Great Depression.

Republicans counter that the financial crisis was largely the result of too much government involvement in the financial system.  They blame the crisis on government sponsored entities like Fannie Mae and Freddie Mac, as well as, in the words of Republican presidential candidate Mitt Romney, “Washington mis- and over-regulation.”

During his State of the Union address last month, President Obama took up a slightly different theme, arguing that during the run-up to the crisis, “Regulators had looked the other way, or didn’t have the authority to stop the bad behavior.”

Evidence published last week by the New York Times suggests that, in fact, regulators did look the other way.

The Times story focused on the Securities and Exchange Commission (S.E.C.), which has jurisdiction over securities markets, including the authority to file fraud cases against financial firms.  In addition to monetary fines, firms that are found guilty of, or settle fraud charges are liable to be denied preferential treatment by the S.E.C.  This restriction is costly for firms that are so penalized, making it more expensive for them to raise money and, theoretically, harder to commit the same violations again.

The Times found that the S.E.C. routinely waived the non-monetary penalties for Wall Street firms, issuing at least 344 waivers during the last decade.

This not the first time that S.E.C. permissiveness has led to trouble.  In 2004, the five member commission voted unanimously to allow the largest Wall Street firms to judge for themselves how much capital to hold.  Since it is cheaper to borrow than to raise capital, the debt levels of these firms skyrocketed. When the subprime market collapsed, these heavily indebted giants either collapsed or required a government bailout.

Nor is the S.E.C. the only culprit.  During the savings and loan (S&L) debacle of the 1980s, the crisis was made more severe because deposit insurance authorities routinely granted regulatory forbearance—that is, allowed S&Ls to remain open long after their balance sheets revealed them to be lost causes.  Instead of giving troubled institutions  time to work their way out of trouble, regulatory forbearance gave these S&Ls more time to rack up larger losses that would eventually be borne by the taxpayer.

The debate between Republicans and Democrats over how much regulation is necessary will—and should–continue.  Before we worry too much about what regulations to enact, however, we should make sure that regulators enforce the regulations that we have.