Discretion and financial regulation

An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.

It's easy to explain why. In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be "tough" in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A "conservative" bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank. Moreover, the examiner will be "proven wrong", again and again, until she loses her job. Her fuddyduddy theories about cash flow and credit analysis will not withstand empirical scrutiny, as crappy credits continually perform while asset prices rise. Valuations can remain irrational much longer than a regulator can remain employed.