Bank Regulators Have Conflicting Goals

Last month, POLITICO published an article that detailed a new mortgage rule that the Federal Reserve is proposing. Specifically, the Fed is looking to disincentivize banks from offering low down payment loans to consumers by making them more expensive, with the aim of avoiding a repeat of the 2008 financial crisis.

Civil rights and housing groups have joined forces with banks to push back against the proposal, arguing that it would put homeownership out of reach for many low-income Black and Brown Americans. I understand their concerns, but as a former banking executive, I would like to offer some more background about the situation and conflicts that regulators face that might assuage their feelings.

In the United States, for various reasons we have divided bank regulation between several organizations (The Fed, The Comptroller of the Currency, the FDIC, as well as state agencies and other parts of the federal government). I am going to refer to them collectively as “the regulators.”

The regulators have, broadly speaking, several goals which come into conflict.

Goal 1: Stability

Foremost, regulators want to prevent a banking crisis where banks fail to operate and the American people suffer a major disruption in their lives.

Banks fail because they lose money. The best way to prevent a bank from losing money is to make the bank do things that make money, not lose money. The problem is that the bank officers have an incentive to take high risk bets, because if they fail, the bank officers can (at the worst) lose their jobs, but the FDIC will rescue the depositors. If they win, then the officers can get a huge windfall. For that reason, the regulators have imposed all kinds of regulations to prevent banks from doing certain risky things. For example, the bankers are not allowed to take all of the money to a casino and bet on red — even though that might work out wonderfully.

Of course the rules are much more complicated and nuanced. But overall, the rules are designed to help banks avoid losing money: Only lend money to people who have the ability to pay it back. Only lend on collateral (houses or cars) that are worth significantly more than the amount of the loan. If you lend money to someone, and they can’t pay it back, take action quickly, e.g. repossess the car, foreclose on the mortgage. Waiting usually just makes it worse.

Goal 2: Consumers

The regulators, as representatives of “We the People,” also want banks to treat people fairly and avoid throwing people out of their homes, especially if they are sweet grandmothers who fought in the Vietnam war, just because they can’t pay their mortgage. Generally speaking, we want bright, young, ambitious people to be able to buy houses, even if they don’t meet some bureaucratic rules about being able to pay for them.

This is the fundamental origin of the tension regulators experience. When lending money for mortgages, banks are generally supposed to secure collateral that is worth more than the amount of money they lend. The normal guideline for residential mortgages is that a bank might lend 80% of the value of the house. That is considered prudent for two basic reasons:

  • Since the homeowner saved up 20% of the cost of the home, he or she has a vested interest in keeping the home, and will probably do whatever it takes to avoid losing it to a foreclosure (which the lender would also prefer not to happen).
  • If the lender does need to foreclose, they will likely be able to sell the house for enough to cover most of the balance of the loan. The lender usually has a small loss on a foreclosure because (a) if the house could be sold for enough to cover the loan, the homeowner probably would have done so (b) it often takes months to foreclose, during which the interest on the loan is still being charged (c) there are expenses to maintain and repair the house (people being evicted are sometimes not particularly careful to avoid damaging the house).

The way banking works is that the bank has money from the people who own the bank – let’s, say 10%. It also has money from depositors – the other 90%. Regulators calculate the percentages based on what kinds of things the bank does with the money. Keeping it in cash in a vault is very low risk, so the bank can have a lower percentage from the owners and a higher percentage from depositors. On the other hand, investing in higher risk stuff, e.g. buying buildings and leasing them to small businesses, would require a higher percentage from the owners and a lower percentage from depositors.

Basically, the Fed’s proposal is to increase the regulators’ assessment of risk for home mortgages with lower down payments.

And that is the conflict. If you want to avoid the possibility of banks losing money – and therefore closing – then making the banks have a higher percentage of money from the owners and a lower percentage from the depositors (which is backed up by the FDIC) is a good thing. If you want to encourage more homeownership by people who do not have as much capital, then it is a bad thing.

I would argue that the regulators mentioned in the POLITICO piece are not being capricious.  They are trying to do their jobs. And the best way to prevent someone from defaulting on their mortgage is … to not give them a mortgage in the first place.

The problem is that the regulators have decided that they need to have a hard and fast rule that does not involve either the bank managers or the regulators having any discretion. We need regulators who have legal authority, and the gravitas and the willingness to use that authority, to use judgment in the course of their regulation and supervision. And we need those regulators to insist on the banks employing managers who will act in the spirit of the rules, not managers who see their entire jobs as finding loopholes in the regulations and exploiting them.

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