A new look at standardization: It is not always the best concept.

In the August 12th Wall Street Journal, the top editorial article was about bank regulation.  “S&P and the ‘Regulator’s Dilemma’”  The point of the article is when government begins to over regulate that it makes problems.  Is the goal of the government to protect the banking system or is it to protect every bank.  Right now they are making rules at the individual bank level on how they are run and managed.  What the article points out that if the government truly is able to enforce exact standardization, the all banks are run identically.  That means that all the banks will have exactly the same weak points and the entire system can collapse if one of the weak points occurs.  The example is the bundled mortgage securities, where the banks are told that assets with a AAA rating by the approved rating organizations are required to be held at some percent.  Since the mortgage vehicles were rated AAA (due to some shady practices) the banks jumped on them and collected a lot of that kind of assets.  When they failed (because they were not really AAA level risk investment vehicles) then the entire banking system was at risk.

If the Fed had chosen to regulate the banking systems and let the banks manage their own risks the failure would not have been so pervasive.  This is also a concept the Forrest Breyfogle writes about in his IEE books.  Manage the enterprise system while identifying performance metrics for the diverse functions to manage their part of the business.   Let some level of non-standard practices exist if they are managing the proper performance measures correctly.  A good idea!

Another reason that this WSJ article piqued my interest is that another banking article was published on August 10th about a bank in Texas that was closing “Fed Up: A Texas Bank Is Calling It Quits” by Robin Sidel.  In this article, a 27 year old bank is closing and selling its few branches to avoid the micro management of the FDIC regulators.  The regulators do not like the types of loans that this bank has made.  It says most loans were less than $100,000 to customers with less than $1,000,000 in revenue, which are small businesses.  The bank has 80% of its loans in this small category and the regulators want them to drop it to less than 25%.  It might seem like a good idea, except that the bank has a significantly lower default rate and higher profit rate than other banks in the US.  The regulators are trying to make the bank fit a model that they believe limits the risk of failure, but it evidently works for this bank.  This article describes the case that today’s article discussed, the over standardization of the banking industry.  The regulators demand that all banks to have a similar loan profile, but what if there are other ideas that work well in one region.  It is not allowed.  So this bank is closing and turning its banking charter back to the government and is going to supply the loans that they want to provide as a private equity fund without FDIC protection.

The message in this situation, is to standardize only where it is beneficial.  Standardization is not always beneficial.