Bank regulators should avoid ‘broken windows’ approach

The “broken windows” theory about policing — introduced in New York in the 1990s — posited that fixing or preventing broken windows led to discouragement of larger and more serious crime. Wall Street regulators after the financial crisis adopted some characteristics of the broken windows theory in their approach to regulation and enforcement.

As it pertains to law enforcement, what was once thought to be success related to some aspects of the broken-windows approach has been largely debunked by research, including a 2006 paper by Bernard Harcourt and Jens Ludwig. Such research showed that secular trends in crime nationwide exaggerated the apparently strong impact of broken-windows policing in New York, while the attention to small potatoes may have diverted focus away from the most pressing issues related to curbing crime. One wonders if Wall Street regulators have endured similar disappointment.

Regulators at the Federal Reserve have kept the pressure on banks all aspects of the business in their reviews and examination since the crisis. In response, banks have significantly increased the ranks of employees in risk and compliance. The Code of Federal Regulations published by the Government Printing Office now needs three volumes to cover the securities-related regulations, up from two volumes in years past.

“Broken-windows” policing policy was seen as a way of discouraging more serious crime, but its success has been questioned. Post-crisis regulation has similarly focused on granular details to the detriment of the big picture.

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But more regulations do not necessarily result in better outcomes. Requiring banks to prioritize every rule may lead to them prioritizing none. The heavy focus on granular details of compliance communicated by regulators might mean supervisors and bankers could miss the big picture. In other words, a “broken windows” approach to regulations may not achieve the desired…

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