The Danger of Discretion

By James Kwak

Justin Fox says that financial regulation should be simpler and should give less discretion to regulators.

The argument goes like this: the biggest flaw in current financial regulation is not that there is too little of it or too much, but that it relies on regulators knowing best. We regulate because financial systems are fragile, prone to booms and busts that can have harmful effects on the real economy. But regulators aren’t immune to the boom-bust cycle. They have an understandable habit of easing up when times are good and cracking down when they’re not.

As I’ve said before, the Obama Administration’s plan is likely to give us more sophisticated regulation, but if it doesn’t give us more powerful regulators with more incentive to stand up to the industry, all the sophistication in the world won’t matter. Regulators didn’t use the tools they had – the Fed could have policed risky mortgages (and raised interest rates), the bank regulators could have insisted on higher capital requirements, etc. – because they lacked the motivation to use them in the face of overwhelming opposition from the banking industry and, probably, the power to resist Congress and the administration, whichever party controlled them.

As Ezra Klein puts it: “When evaluating a particular financial regulation proposal, ask yourself this question: Would these regulations have worked if Alan Greenspan hadn’t wanted to implement them?” That’s a good question, although it’s a bit unfair: if you posit a regulator who doesn’t believe in regulation, then virtually any regulatory scheme is bound to fail. This is why Fox and Klein argue for ironclad rules that don’t leave room for discretion. In addition, though, I think we also need to think about how to make sure we get regulators who are not cheerleaders for or captives of the financial services industry.

Comments

[John Lounsbury:]

It looks like the foxes guarding the hen house to me. The fox has full discretion as to when he'll have dinner.

Jun 30 12:04 PM

[dcb:]

If you read much of what Nassim Taleb suggests as an industry structure it doesn't not appear to require much regulation. A kind of DUMB, SIMPLE, ROBUST system. it is the systemic use of leverage that creates a systemic problem. The problem is that leverage is what drives the compensation structure of the industry, and without it they would not get the false "alpha" returns generated from it. so it kills their pay.

Small. dumb. structures without leverage pose no systemic risk.

Jul 01 08:34 AM

[dcb:]

Dear James,
You and Simon are pundits in this debate where the people are being left out of the decision process and their best interests ignored. It is one thing to tak about it and another to do it. Why not use your position and the web site ipetitions.com to allow people to express their displeasure at what is going on and then you can forward the data to the relevant officials. I'm tired of watching the man I voted for ignore the wishes of almost everyone who voted for him. What's the point of this whole "grass roots" stuff if you candidate ignores his own voters!!!

Jul 01 08:38 AM