Financial Regulation: Disincentivized Investigators Won't Improve Anything

In his very gracious introduction to my inaugural post at O&M, Peter Klein noted that my research is at the border of finance and industrial organization. Quite true (and indeed, “borderer” is a good description of me overall.)

That border is very, very busy today. Indeed, so much is happening there that it is difficult to keep up. In the aftermath of the financial crisis, Congress and regulators are beavering away on laws and regulations that will completely reshape the organization and regulation of financial markets, and especially of the area of particular interest to me–derivatives.

I anticipate that many of my O&M blog posts will explore these issues, but I’ll start with something very topical. Senator Chris Dodd on Tuesday heaved up a 1136 page proposed financial regulation bill, and one proposal that is attracting considerable attention is his plan to consolidate banking regulators. Dodd is not alone in thinking along these lines. Even before the financial crisis, there were myriad proposals to consolidate various regulators, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission. These have only gained in popularity in light of the crisis.

In the modern financial markets, firms are big and complex, and operate in many markets (defined geographically, or by product). It is difficult to fit a big financial firm into any box. A firm like Goldman Sachs (GS) deals in the securities markets and the derivatives markets. So it doesn’t fit comfortably in a securities box, or a derivatives box, so in the current system for regulatory purposes the firm is split into pieces, some of which are put into the securities box and others into the derivatives box (and there are many other boxes too for a big firm like Goldman).

This leads to potential for conflicting regulations, jurisdictional disputes, regulatory arbitrage, and other problems. So, the Dodd proposal–and most of the other consolidation proposals–advocate creating really big boxes, and in the extreme, one big box that regulates everything a financial firm does.

The problems of the seen are well known (though arguably exaggerated). What concerns me are the largely unexamined problems of the as yet unseen big box alternative.

Economic theory can shed some light on these problems. Specifically, any government agency multitasks. The CFTC, for instance, regulates the financial health of futures brokerages and polices market manipulation. The more expansive the agency, the more tasks it will perform. Thus, regulatory consolidation exacerbates multi-tasking problems.

Moreover, any agency has multiple principals, including Congress and the White House. Moreover, even within Congress there are multiple different constituencies that view themselves as principals. The more expansive the regulatory agency, the more principals it will have; more Congressmen will perceive an interest in the activities of the agency because it will regulate a larger array of firms operating in more districts.

Agency theory tells us that multi-tasking agents working for multiple principals face serious incentive problems, and that given this, it is the interest of the principal(s) to subject the agent to very low powered incentives. Indeed, assigning the agents more tasks and subordinating the agent to more principals generally requires (in a second best arrangement) a reduction in incentive power. Weaker incentives, in fact, than those that regulators currently face.

Thus, Congress will find it in its interest to subject an uberagency that regulates everything that breathes (financially speaking) to very low powered incentives. This translates into an agency that is highly bureaucratic, sluggish, unresponsive, (fill in additional pejoratives here).

Regulators hardly covered themselves with glory in the lead up to the crisis. Does anyone really believe that a single, even less incentivized super regulator is likely to do any better? Has anyone who matters even asked the question?

Comments

[Monty Pelerin:]

Most people cannot conceive of a world without regulations. I can’t either. But I can conceive of a world that most would think ridiculously defunct of oversight.

We tend to view the world in terms of what exists now, instead of what could or should exist. A good economist never ignores the institutional framework, because it provides the incentives to which economic actors respond. A great economist, however, goes beyond the existing. He examines the institutional framework from a normative perspective. Why did the existing framework evolve? What political and business interests produced it? Can patches to the system improve it? Do we need a completely different approach to regulation?

A particularly incisive post on this comes from Cafe Hayek:

"Thomas Sowell has said that economics helps you understand that there are no solutions, only tradeoffs. In that spirit, I want to recommend Arnold Kling’s study of the financial crisis, Not What They Had in Mind. My favorite quote from the essay is a variant on Sowell’s:"

"The lesson is that financial regulation is not like a math problem, where once you solve it the problem stays solved. Instead, a regulatory regime elicits responses from firms in the private sector. As financial institutions adapt to regulations, they seek to maximize returns within the regulatory constraints. This takes the institutions in the direction of constantly seeking to reduce the regulatory “tax” by pushing to amend rules and by coming up with practices that are within the letter of the rules but contrary to their spirit. This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime’s ability to prevent crises degrades."

The “Wisdom of Crowds” provides some insight as to why this occurs. Typically, a larger group of people is wiser than a smaller group. When the larger group (the industry being regulated) has financial incentives and the smaller group (the bureaucrats) have no financial interests (or limited in the sense of bribes, perquisites, future employment, etc), there is little hope for regulation succeeding. Either the regulatory body becomes “captured” or outsmarted.

Our regulatory focus is punitive. It is designed to build boxes based on “Thou shall nots.” Such an approach is always behind. It is always dealing with the last horse to escape from the barn. Such a strategy will always fail because of the innovation of business. Only a change in regulatory philosophy that is based on the free market as the policeman has any chance of working. The State mindset is unwilling or unable to recognize this. Hence we will move from one regulatory failure to the next.
Monty Pelerin economicnoise.com

Nov 12 12:01 PM

[Tom Armistead:]

I agree with the reasoning about the incentives that would result from this proposed master bureancracy. There would be suffocating pressure to see no evil, hear no evil, and speak no evil, an excruciatingly slow game of three monkies. Much like the SEC, their front line investigators soon came to understand that they should not ruffle the feathers of any major players on Wall St.

In Dodd's legislation is buried the concept that FDIC would double check the work of the bank examiners, since they would be the agency paying for the consequences of the bad examinations.

Spreading the functions among a variety of regulators and giving them the power and the incentive to check up on each other might improve things.

Nov 15 04:53 PM