Lesson from Regulation History: Patchwork Fixes Won't Help the Financial Sector

by: The Baseline Scenario

By Peter Fox-Penner

Improving the regulation of the financial sector is a prime topic of conversation amongst financial economists, and appropriately so. Most agree that massive failures of financial regulation were one, if not perhaps the largest, cause of the 2008 meltdown.

When the conversation turns to the specifics of what needs to be regulated, how regulation should work, and what agencies should be involved, the range of views is tremendous. There is agreement that some kind of prudent regulation is needed, as is investor and consumer protection, but that’s about it. Fueled by billions of dollars of lobbying and purchased research, everyone has their own idea. One super-regulator? Council of regulators? Control bankers compensation schemes? Exchange-trade them? The cacophony is deafening.

As an industrial organization economist, I think this discussion would benefit greatly from a consensus on the role and goals of financial regulation. Paul Joskow, a dean in the IO economics community, recently noted that:

“. . .The one thing that we can be sure of is that we have no shortage of regulatory agencies with overlapping responsibilities for investor protection, financial market behavior and performance, and systemic risk mitigation (prudential regulation) that collectively were supposed to work to keep this kind of financial market mess, as well as scams that were allegedly employed by Madoff and others, from occurring. These regulatory agencies have overlapping jurisdiction, opaque goals, arbitrarily limited authorities, and histories that can often be traced back to Great Depression era financial markets and economic conditions. These regulatory institutions have evolved over the last seventy-five years in a haphazard fashion that has not responded effectively to the evolution of financial institutions, products, and market but more as a series of fingers in the dike to try to keep new leaks from damaging the integrity of the entire dam. Regulatory changes, such as the 1999 repeal of the provision of the Glass-Steagall Act of 1933 that prohibited bank holding companies from other types of financial service companies, the SEC’s decision to end the uptick rule for short sales, and decision to allow “sophisticated investor” to fend for themselves, have been idiosyncratic… and increasingly driven more by ideology as financial markets began to change quickly than by the find of comprehensive framework for regulatory reform that has now become widely accepted by microeconomists in other industry contexts.” (http://econ-www.mit.edu/files/3875)

In short, patchwork fixes don’t work. You have to reform all of the institutions and markets that are sufficiently linked to the imperfections and externalities you need to fix. As Joskow notes, it wasn’t that there weren’t any financial regulatory agencies – “the list of these agencies is as long as my left arm” — it is that there were too many of them, too many cracks between them, and no comprehensive analysis of what kind of processes, tools, and agencies modern financial markets need. [As Exhibit A, see this list of agencies regulating consumer financial products from USA Today].

I agree with Joskow that a comprehensive assessment is lacking from the financial regulatory debate. There is fairly broad agreement that some kind of regulation is needed for banking and other credit institutions (prudent regulation), regulation of securities and commodity markets, regulation of insurance markets, and [more acrimoniously] regulation of other consumer financial products. I search in vain, however, for serious analyses of whether the same regulator, using the same enabling statutes and the same regulatory instruments, is right for each of these jobs.

It doesn’t appear likely. The history of regulation shows that effective regulators should not have conflicting, complex, or multiple missions. An agency should not have conflicting incentives, such as those posited by Raghuram Rajan, between the Federal Reserve’s role as inflation fighter and its role promoting bank stability via regulation. Similarly, it seems obvious that the objectives of a bank regulator to promote well-capitalized and solvent banks conflicts directly with the objectives of consumer financial product regulation.

Regulatory agencies also should not have many non-regulatory tasks that interfere with their focus and compete for this leader's attention. It is hard enough for a public agency to get good at regulating one kind of market or instrument. Stand-alone agencies also have a better chance of getting the resources they need to do a good job, avoiding government budget processes and their attendant limits and delays. This is not an argument for duplication, but rather for separating agencies that might have conflicting objectives.

Another lesson from regulation’s history is to keep the mechanics of regulation as simple and as transparent as possible. Yes, regulation always creates incentives for the regulated firm to exploit information asymmetries, and regulators have imperfect incentives as well. But experience suggests that regulatory mechanisms have to be fairly simple to work – often a lot simpler than most economists would prefer.

One essential corollary of keeping it simple is that one has to sacrifice some product variety and customized trading for a more constrained set of regulated products that can be understood, measured, and watched. Effective regulation always constrains product choices and trading options. Intended or not, that’s what it does. It is one way of making sure nothing falls through the cracks. Nonetheless, today’s airwaves are filled with arguments that regulatory reform will stifle financial product innovation and attending benefits.

In addition to limiting product variety within firms, successful regulation often has to limit the complexity of firms’ financial organization and size. The history of utility regulation and liberalization suggests that there is a limit to the complexity of the firms that can be regulated effectively by regulators with limited time and resources. I expand on this “too big to regulate” idea in a second post following.

Finally, it is widely accepted that regulatory agencies must strike the right balance between independence and accountability. The agency should not subject to immediate political pressure from industry or politicians, but through a process of checks and balances, such as staggered regulator terms, bipartisan appointments, post-employment restrictions, and a high requirement for expertise, the probability of capture should be minimized. This is another reason to separate regulatory from non-regulatory organizations. Similarly, stand-alone regulators are more likely to be free of burdensome government budget processes and are more likely have the freedom to hire and pay for the expertise needed to understand complex, fast-changing markets.

In the 1930s, Congress responded to the financial crisis with three extensive studies, the Pecora Commission, the Federal Trade Commission’s seven-year, 101-volume study of utility financial practices, and a similar two-year study by the House Commerce Committee. I sincerely hope that Congress’ financial reform commission or some alternate forum fills this need. An earlier Baseline post reports that the initial signs were that the Commission will not delve as deeply as is needed. Since then, the commission has been largely silent in public. I hope this is an indication that the commission is working hard, away from prying political and media eyes, to do a thorough, objective, and compelling look at the full scope of reforms that are needed.

The rolling discussion of financial regulation in this and many other blogs is a fantastic innovation in academic and policy discourse. Perhaps it is the 21st century version of the Pecora Commission and its multi-year, multi-volume reports. Perhaps, it seems hard to imagine, a political consensus for comprehensive change will emanate from a blogosphere dialog amongst us policy wonks alone.

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