In a famous scene in the classic film Casablanca the police inspector Renault - when challenged that illegal gambling was occurring right under his “inspecting” eyes - replies with some self-mocking irony, pretending he was clueless about the mischief: “"I am shocked, shocked to find that gambling is going on in here!"

Similarly today a slew of banking regulators and supervisor expressed shock, shock, surprise and dismay - as they put it only today when summoned to a Congressional hearing - that abusive lending, fraud and predatory lending was taking place on a serious scale under their regulatory and inspecting eyes. Indeed, Bloomberg titled a story today with “Abusive Lending, Fraud Fueled Subprime Loan Crisis, U.S. Comptroller Says”. The Comptroller of the Currency is now talking about “abusive lending” and “fraud”.
 

Similarly, a host of other regulators, who testified at a Congressional hearing, made a similar mea culpa. For example, under the headline “Fed Says It Could Have Acted Sooner to Stem Subprime Mortgage-Loan Turmoil”Bloomberg reported that “The Federal Reserve could have acted faster to prevent a meltdown in the subprime-mortgage market by curbing the lax lending standards that contributed to the crisis, the Fed's chief bank supervisor said. ``Given what we know now, yes, we could have done more sooner,'' Roger Cole, the Fed's director of banking supervision and regulation, told the Senate Banking Committee in Washington today, as regulators testified for the first time before Congress on the market rout.
 

How did this failure of supervision and regulation occur? The Wall Street Journal, in its lead article this morning, has a long and excellent analysis on how a web of overlapping – and some times contradictory - regulatory authorities (half a dozen ones at the federal level, and a few dozens at the state level) failed to properly perform their jobs. Part of the problem was that many of the new sub-prime lenders were not under the regulatory jurisdiction of the Fed or the FDIC but rather of state level regulators. But, as the WSJ puts it, federal level regulators cannot just blame the state-level regulators as the climate of the last six years was one of pushing a systematic federal agenda against meaningful regulation and supervision of the financial system. As the WSJ aptly put it:

Federal regulators over the past decade issued rules to tighten standards for making loans to borrowers with blemished credit or low incomes. Yet standards still declined and the volume of loans surged in the past two years. One reason: Changes in the lending business and financial markets have moved large swaths of subprime lending from traditional banks to companies outside the jurisdiction of federal banking regulators…Yet even where federal regulators have jurisdiction, they sometimes have been slow to grapple with the explosive growth in especially risky practices and quick to shield federally regulated banks from states and private litigants. The underlying belief, shared by the Bush Administration, is that too much regulation would stifle credit for low-income families, and that capital markets and well-educated consumers are the best way to curb unscrupulous lending.[bold added]
 

So, indeed a high level federal attitude that stressed self-regulating market rather than sensible and appropriate regulation and supervision of the financial system is at the core of this regulatory failure.
 

Let us consider this latter issue in more detail: