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Why Alan Greenspan's Fed lets banks off easy on corporate fraud.

Regardless, the agencies contend that compiling a prohibited-transactions list “is not the most effective approach,” as Nazareth and her fellow regulators said in their letter to the Senate subcommittee. Instead, they wrote, “as we…plan to reiterate in supervisory guidance, it is the responsibility of banks, broker-dealers, and other financial-services companies to develop and maintain policies and procedures to assure that they are in compliance with all applicable laws and regulations.”

In other words, the regulators’ solution is to remind the bankers that they have to obey the law, and to ask the public to take it on faith that regulators will turn over evidence of wrongdoing to prosecutors.

Just Say No?

The regulators’ stance reflects the fact that the Gramm-Leach-Bliley Act embraced financial deregulation. Indeed, bank regulators contend that legal and reputational risk encourages considerable self-restraint on the institutions they oversee. Granted, private litigation against the banks could yield bigger penalties than those imposed by the regulators. But the decision by Judge Melinda Harmon in December 2002 to dismiss investor claims against banks involved in the Enron case would seem to close the door to future such actions.

True, the decision did lead to a settlement between the banks and the government. But Brad S. Karp, an attorney at New York firm Paul, Weiss, Rifkind, Wharton & Garrison LLP, believes that other courts are unlikely to cite Harmon’s ruling as precedent. Karp told the TBMA conference that Harmon ignored important parts of a 1994 Supreme Court ruling that limited banks’ legal liability in such matters, and says she has been “widely criticized for her reasoning and jurisprudence” in the case.

As for reputational risk, some academics question whether this, too, provides much incentive for self-restraint. Richard Portes of the London Business School points to new game-theory research that suggests that the conventional view of this risk overestimates its importance. As Portes puts it, bank customers may not avoid dealing with an institution whose reputation has been besmirched, because they may well believe that they themselves are smart or powerful enough to negotiate fair terms nonetheless.

What’s more, self-regulation will be reinforced by the new international bank regulatory scheme, known as Basel II, scheduled to go into effect late in 2006. The proposed rules focus less on capital-reserve requirements imposed by regulators than on their evaluation of institutions’ ability to manage risk. Citigroup and Chase, in short, will be able to decide for themselves whether their reserves are sufficient for the risks they are taking.

Greenspan himself professes great faith in such an arrangement. In remarks last May at a conference sponsored by the Chicago Fed, he sharply challenged the view that the government is better than the banks themselves at ensuring effective risk management. “Private regulation generally is far better at constraining excessive risk-taking than is government regulation,” he said. “Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties.”

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