Remarks by
Eugene A. Ludwig
Founder and Chief Executive Officer,
Promontory Financial Group
Delivered to the
Boston University Center for
Finance, Law, and Policy
February 2013, Boston, MA
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Remarks by Eugene A. Ludwig
Founder and Chief Executive Officer, Promontory Financial Group
February 2013
Thank you for inviting me to speak; it’s truly an honor to
be here, at a center that is so distinctly at the forefront
of the study of finance. Professor Cornelius Hurley has
done a tremendous job building this center into a hub
for research on the role finance can play in “the good
society.” The free movement of capital, guided by prudent oversight, can be a powerful tool for the common
good. We should not lose sight of this in the wake of the
crisis — when finance’s failings are on display, we must
remind ourselves of its capacity for good.
I particularly want to commend the Center for its focus
on financial inclusion. Credit can be a powerful tool in
the fight against poverty. But the political landscape
around financial access has become more and more
complicated. The Center is working to show how microcredit and remittances can help low-income people
around the world, and building a road-map for those
who want to help.
Today, I plan to speak about another tool for a fairer,
stronger, more inclusive financial system: supervision. It
is a key to sound and stable finance that has been too
often neglected in the last five years of reform.
Like so many major catastrophes, the recent financial
crisis erupted from a confluence of circumstances. It is
trite to say, but it was indeed a perfect storm — of lax
housing underwriting, of a bubble in the housing and
bond markets, of financial tools that were not built to
withstand a major storm, of too much liquidity and of
too much greed.
Each of these elements has been much scrutinized, but
one element of the crisis that is still poorly understood is
the role of regulation and supervision. Some would say
that we lacked sufficiently prescriptive financial rules,
and that supervision was lax. And in many cases, like
the derivatives space, this account is in fact true. Too
often, false comfort was taken in the netted position,
and too little respect was accorded the notional. Tail-risk
modeling and stress testing were remarkably weak.
However, for me, this is not simply a story of too little
regulation and too much laxity. Rather, it is about the
rise and fall an ideological viewpoint — indeed, an experiment — in a particular type of regulation and supervision. The experiment was market-based oversight,
relying on financial actors to be their own regulator and
supervisor, with a limited place for the government.
Many in the 2000s believed that market participants
would be prudent and cautious because it was in their
own interest, and that self-interest would be more effective and efficient than government rules and supervisory
admonition. The roots of this worldview are decades old,
of course — Hayek’s theory that the state is the enemy
of efficiency on the “road to serfdom.” And of course,
there was an audience for self-regulation even before
the 2000s. The difference was that, in the “aughts,”
market-based supervision was reified through administrative policy, not just law. Agencies were given smaller
staffs, their activities were scaled back, and the tone at
the top was pointed towards a hands-off approach.
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So, it was not so much that the regulatory watchdogs
were asleep or did not have sharp enough teeth. It was
that they were caged.
This approach to regulation and supervision, this experiment, simply did not work. One of its strongest supporters, and the most distinguished economic figure
of his time, Alan Greenspan, recognized this fact and
was forthright enough to tell Congress as much in 2008:
“Those of us who have looked to the self-interest of
lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
To this day, there is a failure to fully appreciate the role
of this “market-based supervision” concept and its application through administrative fiat in the financial crisis.
But also, there has been a profound misunderstanding
of the relationship between regulation and supervision
themselves. In policy and in popular discourse, we have
failed to appreciate their differences, their strengths, and
their relative weaknesses.
Regulation is the act of rulemaking to implement law. It
has a very particular history in America, and is sometimes dated to the Interstate Commerce Commission,
which was founded as part of the Interstate Commerce
Act of 1887 to set rates and national standards for the
railroads. (The Comptroller’s office came earlier, as I
will address a bit later in my talk.) The regulatory model came into its own during the New Deal, with figures
like Louis Brandeis and James Landis. But the ICC’s
experience showed why regulation rarely works without
effective supervision.
The ICA was written in response to enormous public
pressure, especially in rural communities, where railroad
operators had gained a monopoly and state commissions were powerless to fight it. It was a good idea — a
national solution to a national problem. But the ICC had
few ways to make sure the railroads were complying
with the rules. Their remit was slim, and their staff was
too small to chase down many leads. They relied on the
train operators to police themselves.
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Lots of people stop here and use the ICC as a story
of regulatory capture. A former U.S. Attorney General,
William H.H. Miller, said in 1889 that it “satisfies the
popular clamor for a government supervision of the railroads, while at the same time that supervision is almost
entirely nominal.”
But the story continues. Congress amended its work
— with the Railroad Safety Appliance Act in 1893,
the Elkins Act in 1903, and the Hepburn Act in 1906,
which gave ICC enforcement actions the force and effect of law. After this, with a new and bigger staff, the
ICC did its best work. It had the tools to examine what
was actually going on and the responsibility to enforce
common standards among the railroads. Finally, it had
enough on-the-ground understanding and the power to
demand changes and it did.
That power — the power to actually be on the ground,
to understand what is actually taking place, tied to enforcement potential — is what makes supervision both
so necessary and so critical. In fact, it is at the heart of
what supervision is: A close, candid look at the affairs
of a vital industry, which finds and fixes shortcomings
before disaster arrives. It is how governments obtain the
information they need to make sure institutions live up
to the letter and the spirit of the law. Supervision is also
how government keeps up with industries that change
more quickly than laws do. It avoids the pitfalls of overzealous rulemaking, which, in an attempt to solve every
problem, can often create new ones. It can give rise to
important changes, without the panic that excoriating
headlines can cause.
Supervision and regulation work together; you can’t
have one without the other. They’re ham and eggs;
they’re Fred Astaire and Ginger Rogers. But our response to the 2008 crisis doesn’t reflect that fact.
We have a vast array of new regulations and an eroded faith in supervision. Dodd-Frank alone is over 2,000
pages, with what will amount to tens of thousands of
new pages of rules, guidance, examination procedures,
and so on. Basel III adds even more to the mountain of
new regulations.
operating honestly was to physically go on-site and —
yes — “count the cash.”
Supervision has not been cut back, but neither has it
been upgraded or reformed. We continue in the United
States to have a cacophony of supervisors, which include state bank, insurance and securities regulators;
three national bank regulators, two national securities
regulators, and one new consumer regulator. For some
institutions, this means dozens of supervisory bodies
with different rules and different approaches. It also
means hundreds of on-site supervisors, sometimes
at the same institution. And alas, it is still possible for
the bad apples to engage in a search for supervisory
arbitrage.
This level of onsite examination and supervision improved bank safety and stability, but it was not perfect.
It did not avoid economic and financial market volatility.
And occasionally, supervisors were fooled. A charming
story worth reading in this regard is a story by the famous author O. Henry entitled “Friends in San Rosario.“
It recounts how even a diligent examiner can have the
wool pulled over his eyes (perhaps, at times, in a less
charming and positive way than O. Henry describes).
A situation like this leads one to ask whether the game is
worth the candle — whether in the modern age, stress
testing, resolution and recovery rules, systemic risk
management, and strong enforcement make handson supervision obsolete. Put another way, I have asked
impertinently in recent years to spur discussion: Why
should banks need nannies, when plenty of other important institutions don’t get the same degree of constant oversight? What makes banks and other financial
institutions so special?
A bit of history might help with the answer.
In modern finance, supervision grew out of Abraham
Lincoln’s National Banking Act and National Currency
Act, both of 1863. They predate the ICC and are rooted
in what has been called the “count-the-cash” method
of oversight. The Comptroller’s first job, in a time of war
and economic tumult, was responding to the concern
that dishonest bankers could steal cash, fiddle with the
books, and put depositors and communities at risk. This
was different than public concern with the railroads,
which were thought to engage in price gouging, not
outright fraud. Financial statements, the thinking went,
could be easily doctored. The only way to keep banks
These early roots clarify a bit why banks needed (and, I
believe, still need) supervision. Like railroads, banks are
vital resources — but unlike railroads, they are opaque.
You may see the safe, but the money might not be inside. Value can walk out the door quickly and, in the
absence of hands-on supervisors, in ways that are hard
to detect. But there are other reasons why supervision
makes sense in a modern world. Let me suggest a few.
First, complexity. No set of rules, however comprehensive, can address every single instrument or activity a financial institution uses or does. Those that do are bound
to fall short or otherwise be too complex to enforce.
Second, dynamism. Financial institutions search far and
wide for new businesses, and new ways to do old businesses, and they can change strategies more quickly
than Congress can change the law. In this context, written rules are like the Maginot Line. To effectively control
risk, you need flexibility and knowledge of “facts on the
ground.” Supervisors have both.
Third, diversity. Banks and other financial intermediaries come in all shapes and sizes, with different strategies, products and approaches. Supervisors can tailor
the rules to individual circumstances and let banking be
both innovative and safe.
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Nonetheless, modern supervision has its flaws. I have
already briefly mentioned the problems of arbitrage, duplication, and burden inherent in America’s multiple-supervisor construct. But in addition, great supervision is
still a bit of a “black art,” with less science and less consistent rigor than is desirable. Supervisory education is
still largely done through apprenticeship. Colleges and
universities do not offer courses or degrees in this important area. We at Promontory are trying to do something about this, establishing one of the first degree programs in regulation and supervision in the world.
Another flaw is just as applicable to regulation as supervision. These critically important disciplines lack a true
body of research. There really is very little study around
what works, what works best, and what works over
time. What study there is, largely revolves around opinions and commentary, not quantification and rigorous
comparative analysis. In part, this kind of important academic rigor is frustrated by the “supervisory privilege”
doctrine, which cloaks most supervisory information in
secrecy. So the government, not the academic community, is the repository of information, and that repository
remains — to the extent it has not been discarded —
“locked in the safe.”
Supervision also has its limitations. Like much of regulation, it is meant to pinpoint and prevent moderate-to-serious economic shocks. It is not designed to deal with
massive earthquakes. Better design of supervision
may well improve this situation, but it will not resolve
it. Systemic regulation is still an important part of the
puzzle.
So where does that leave us? Supervision is as necessary as it is neglected. We can and should improve
it. We need more science, more education, and more
good policy work on the subject. Practiced properly, supervision is a vital part of a larger system. Dismissing it,
or using it as a scapegoat for systemic errors, takes us
further from the goal of safe and sound finance.
About Gene Ludwig
As CEO of a premier strategy, risk management, regulatory, and compliance consulting firm, Gene Ludwig is a trusted adviser to the world’s
leading financial companies. He is recognized as a farsighted thinker on the most pressing issues confronting financial services. Before
founding Promontory, Gene served under President Clinton as Comptroller of the Currency, head of the agency responsible for supervising
the preponderance of U.S. banking assets. He later became Vice Chairman and Senior Control Officer of Bankers Trust/Deutsche Bank. A
former partner in the law firm Covington & Burling, Gene earned degrees from Haverford College, Oxford University, and Yale Law School.
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Promontory is a leading strategy, risk management, and regulatory compliance consulting firm for the financial services industry. Promontory’s professionals have
deep and varied expertise gained through decades of experience as senior leaders of regulatory bodies and financial institutions. Promontory assists clients in
meeting regulatory requirements and in enhancing governance, risk management, strategic plans, and compliance programs.
Promontory Financial Group, LLC
801 17th Street, NW, Suite 1100, Washington, DC 20006 Telephone +1 202 384 1200 Fax +1 202 783 2924 promontory.com
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