It's time to break up banks' top regulator

(breakingviews.com) -- U.S. financial regulators have spent the last several years in a race to impotence. The clear winner of this chase to the bottom is the Office of Thrift Supervision (OTS), the agency that served as chief financial regulator to a motley crew of credit crunch losers, including Countrywide, Washington Mutual, IndyMac and American International Group. Shuttering OTS would be a good first prize.

Other regulators haven't exactly covered themselves with glory. In sheer numbers, more small state-chartered banks regulated by the Federal Deposit Insurance Corporation have failed. In size, only the government's determination that Citigroup (C, Fortune 500) was too big to fail and must be bailed out prevented the Comptroller of the Currency from winning the gold medal for incompetent regulation.

But the OTS exhibited the worst symptoms of regulatory capture - that's to say taking the side of the industry it regulates instead of the public. Some signs are trivial but telling. It called institutions under its oversight "customers." Others are extraordinary. It allowed multiple thrifts, among them failed IndyMac, to backdate capital infusions so that earlier quarterly financial statements looked healthier than they would have done.

Without this action, IndyMac probably would have closed its doors sooner, possibly reducing associated losses to FDIC and depositors - the bleeding usually increases as undercapitalized financial institutions stagger on. Scott Polakoff was replaced as acting head of OTS and put on leave at the end of March while the backdating matter is being investigated.

The reasons for this regulatory version of Stockholm Syndrome are multiple. The minimal number of bank failures in the middle of the decade bred widespread complacency among all financial regulators. The Bush administration tended to sympathize with the idea that markets regulate better than federal agencies. And the growth of unregulated mortgage brokers and other non-bank financial companies made even OTS oversight look stringent by comparison.

But OTS funding also probably played a key role in its failures. The agency's budget comes almost entirely from fees levied on the thrifts it regulates. Fees are based upon asset size. This structure gives OTS, or indeed any regulator, a potential incentive to first try and lure financial institutions into becoming thrifts and then look the other way if they enlarge their asset base through questionable lending.

These conflicts of interest were worsened by financial consolidation. A handful of institutions accounted for much of OTS's budget - Washington Mutual, for example, provided about 12% of the agency's operating funds, according to Patricia McCoy, a professor at the University of Connecticut School of Law who has testified to the U.S. Senate on the matter.

OTS rejects the notion that it encouraged or even temporarily benefited from regulatory arbitrage. But this is hard to square with history. Countrywide switched to the OTS in early 2007, a move that did consolidate the company's oversight but was also widely attributed to the attractions of the agency's perceived lighter touch.

That switch meant four of the five biggest issuers of option ARMs - a particularly virulent form of mortgage loan that former OTS head John Reich had praised in speeches - were under OTS supervision. The fallout from the housing downturn forced Countrywide into Bank of America's (BAC, Fortune 500) arms. The other three - IndyMac, Downey Financial and Washington Mutual - all failed.

So what can be done to prevent this happening again? Funding regulatory agencies at least partly through Congressional appropriations rather than user fees might help cut the ties between industry and regulators. It's no panacea, though. The predecessor to OTS was abolished precisely because lawmakers leaned on regulators - and threatened to cut their budgets - to stop an investigation into Lincoln Savings and Loan, the thrift controlled by Charles Keating which subsequently went bankrupt. But at least the distance between regulator and regulated is greater when funds come from Congress.

A better idea is regulatory consolidation on the federal level, with broad new statutes that apply to surviving regulators. For example, underwriting should be based on consumers' ability to repay. Common lending standards on sensible principles would limit the wiggle room in which toxic lending products thrive. And reducing the number of agencies should reduce regulatory arbitrage.

After all, Washington bureaucrats gain prestige and influence by winning turf wars, not unlike the private sector companies they oversee. Minimize the soil that can be fought over, and financial institutions have less ability to play one official off against another.