This week the administration begins a serious behind-the-scenes charm offensive on its regulatory reform plans. The argument seems to be: we are where we are on banks' solvency/recapitalization, so let's not argue about that; it's time to strengthen financial regulation in line with our G20 commitments. 

But there is a serious dilemma lurking behind the foreshadowing, the rhetoric, and the talking points. (Aside to Treasury: please find somone other than big financial players to endorse your next 100 days report; many taxpayers will find p.5 of your first report particularly annoying--if you don't understand this point, you are too close to the big banks.) 

Here's the problem.

At this point in most financial crises, you would have a big recapitalization program underway--with or without the trappings of a formal insolvency process. Bank executives would be out, and new teams would be well on their way to figuring out how risk control systems broke down so completely and deciding how much of the business can be sold off vs. restructured vs. closed. Obviously, we are somewhere quite different--in our brave new post-stress test world, the insiders who run these banks feel like they just won the lottery (or perhaps that's the right to run all future lotteries, with most of the winning tickets reserved for themselves and with the government footing the bill for any potential losses?)

The political pressure to regulate tightly in this environment is obvious and, with every further public relations gaffe by the industry and inspector general investigation into its friends, the legislative agenda will get tougher on banks.

There is an obvious economic case for tightening regulation--after all, even the people who ran the Great Deregulation from Treasury during the 1990s now say, "when the facts change, we change our minds." But the lack of sensible upfront recapitalization for the banks means that they will be tempted to go even further in terms of regulatory tightening. After all, the incentives for executives running banks are now all messed up--irrespective of whether they were really Too Big To Fail in the past, they're all convinced they are Way Too Important To Fail today. 

If your bank fails at the same time as all other banks fail or hit serious trouble, there will be a bailout. The implication is that bank executives should copy the behavior of others, as much as possible; above all else, don't do anything different--idiosyncratic risk is the real danger. Chuck Prince (former head of Citi) nailed this, as well as a good portion of your retirement savings:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. (July 2007)

The dilemma, of course, is that you don't really want to overtighten regulations on banks during a recession--this will further discourage lending. This was an important rationale for doing an upfront recapitalization and forcing a change of control in big banks. When we missed that opportunity, we essentially set ourselves up for "procyclical regulation."

And if you think we can punt on regulation and come back to the issue when the economy looks stronger, you need to spend more time on Capitol Hill. The banks are already bouncing back in terms of political clout, and they have a simple regulatory answer: nothing meaningful. So if you support the end of deregulation, you need to push for it now.

By the way, is Chuck Prince still rich?

[Cross-posted at The Baseline Scenario.]

--Simon Johnson