This was written after reading about the reported $13 billion dollar settlement for JP Morgan Chase for fraudulent mortgage securities activities.
Well, without trying to sound pornographic about it, size per se doesn't matter. The reality is that given the amount of damage that was inflicted on millions of American families, JP Morgan (or any bank) couldn't begin to pay a fine that genuinely approaches the magnitude of the harm done.
Participants in the financial system have been viewed as sophisticated individuals who are the best able to understand what they are doing, and so are the most able to promote their long-term economic well-being. By extension, these people also believe that the government has no expertise in banking and finance and so should not impose any restriction on what people can do with their money. This belief is all the stronger when the economy has been performing well for a long time.
This philosophy may recognize that financial crises and instability are possible but argue that they are rare events that are unpredictable and random. The best that can be done is to protect against those random shocks through appropriate buffers like capital and liquidity ratios. At the same time, however, having too much capital and liquidity is costly and so the point becomes to find the optimal level of both.
The move toward risk management is the ultimate expression of this belief. It uses complex mathematical algorithms to determine what the appropriate level of buffer is given existing risks on- and off-balance sheet. The goal has been to refine the measure of the different risks as well as the methods used to calculate the appropriate buffer. The government has a limited role in determining those appropriate buffers, especially for "sophisticated" financial institutions.
Top regulators and supervisors appointed by Congress have been screened through hearings to make sure that they shared this philosophy. Then they set the tone in their respective agencies regardless of the eagerness of lower-level staff members to enforce regulations and to promote effective supervision. This made it very difficult for in-field supervisors to issue cease and desist orders, to bring criminal charges rather than civil charges, and to close unsustainable businesses without strong resistance from policymakers and top regulators.
Black (2005) provides a very detailed insider's account of this state of affairs in the 1980s. The most effective staff members were passed over for promotion, legal barriers were put on staff to prevent them from closing down profitable but unsound businesses, and regulators were highly influenced by businesses and voted to remove themselves from the power to supervise.
In addition, federal regulators competed among each other to regulate and supervise existing financial institutions. This allowed financial institutions to shop for the most lenient regulator and to switch regulators when they considered their current regulator too intrusive (Black in 2005, Financial Crisis Inquiry Commission in 2011).
As a consequence, even though the amount of regulation in place is high, rules were not applied or they were applied leniently in order to promote the needs of businesses and to promote market mechanisms.
Instead of hiding losses and supporting bad management, the government should promote an orderly liquidation of banks which would require honest and transparent accounting of the genuine size of the losses on their respective balance sheets.
In addition, a better road toward recovery would be to deal with the source of the lingering problem, which is the fact that borrowers cannot pay their mortgages. While some borrowers will not be able to repay under any condition because they were never able to afford the house in the first place, millions would benefit from mortgages with permanently lower interest rate and lower principal outstanding.
In addition, the government could help to sustain households' income by promoting full employment through a national jobs program. By lowering debt services and sustaining income, the delinquency rate on mortgages would decline which would sustain loans and securities. However, bankers do not currently see an economic interest in going that route and find foreclosure more immediately profitable, even when they face multi-billion dollar penalties for wrongdoing.