Baseline Scenerio -- Now This is Good

for the wonkish on financial regulation!



The Baseline Scenario
Filling the Financial Regulatory Void
Posted: 08 Aug 2009 05:15 AM PDT
This guest post was contributed by Bond Girl, a frequent commenter on this site and author of The Bond Tangent, a very good blog on the esoteric but important world of municipal bonds. I invited her to write it after reading her comments on the topic of financial regulation on this post.
In June, the Obama administration released a report outlining various financial regulatory reforms. The proposed reforms are intended to meet five objectives, essentially: (1) to eliminate regulators’ tunnel vision; (2) to regulate certain financial products and market participants that have so far evaded supervision; (3) to protect consumers from unfair and deceptive sales practices; (4) to provide a framework for responding to financial crises and the failure of major financial institutions; and (5) to promote these efforts globally. Much of the subsequent policy debate has been focused on whether or not the reforms detailed in the report address these objectives. This is a political triumph for the administration because it distracts from the report’s one glaring omission – how to address a culture of sustained affinity between the supervisors and the supervised.
The administration’s proposal appears to portray the financial crisis as nothing more than an accident of reasoning. Because financial regulation in our country evolved in a fragmented manner, regulators’ perceptions of risk were determined by their respective niches when a holistic understanding of risk was required to predict a market failure of this magnitude. It logically follows then that the administration’s preference would be to create a meta-regulator (in this case, by extending the powers of the Federal Reserve and establishing an advisory council) to oversee the supervisory project as a whole and seek out system-wide threats.
While I am sure no one would dispute that a holistic understanding of risk is required to assess financial stability, an even more basic condition of effective regulation is that regulators are motivated to provide honest information about the institutions they supervise. I am not inclined toward conspiracy theories and I obviously do not buy into the caricature of industry players sold by the mainstream media. That said, it is clear that there is a large degree of regulatory capture going on in the financial sector, either directly though professional incest or indirectly through shared intellectual sympathies, which some players have been able to exploit to such an extent that it has reduced standards for the entire industry. It is also clear that this is hardly a novel development.
Financial institutions did not amass trillions of dollars of toxic assets and tangle themselves up in a destructive web of credit derivatives by accident. Financial institutions did not produce and maintain technology allowing them to take advantage of traditional investors by accident. A thief was not able to operate a multi-billion-dollar Ponzi scheme for decades by accident. We are not talking about the occasional rogue trader here who has bribed his compliance officer. Even within the existing regulatory architecture, these activities required a considerable amount of complacency (to be polite) by financial regulators across agencies, over the course of many years, and through many cycles of political appointees from both parties.
I would argue that the fundamental flaw in financial regulation is that it is based on the assumption that regulators are not self-interested individuals like the rest of us. We think about regulation only in terms of how to engineer the incentives of the regulated and ignore the fact that regulators themselves rarely have a stake in doing their job well, which in any other occupation would limit the motivation and types of individuals a position attracts. We all know how the performance of a consistently good trader is rewarded. How is the behavior of a consistently good regulator rewarded?
On the other hand, it is not difficult to see what incentives regulators have to adopt a collaborative posture with the industry (again, to be polite), especially within the organization in which the administration wants to concentrate regulatory responsibilities. The presidents of the Federal Reserve Bank of New York generally come from or end up at investment banks. So many Goldman Sachs employees have held positions in the Treasury and Fed banks in their careers it is a cliché.
Even beyond this, there is probably some value transferred just through the association or intellectual sympathy with industry-types (what Jon Hanson would refer to as “deep capture”) that results in regulators having a bias they do not recognize. If one revisits what Fed officials were saying about financial innovation leading up to the crisis, it is not difficult to see that (1) they thought they were thinking holistically about the risks financial innovation posed, and (2) they were not being intellectually honest in the information they presented about the industry. Even the more prescient regulators figured innovation was a good thing at the time. As a rule, supervisors were disposed to explain away risk by market discipline because they believed themselves to belong to a club of people with special, sophisticated knowledge of the markets, and this is something they value. From the perspective of some in the financial industry, it is something that can be traded.
Sheila Bair’s argument in the regulatory turf war spectacle that is underway would be that these examples illustrate the risk of concentrating supervisory responsibilities in one entity. But it is not a matter of luck whether we get a regulator that is more or less swayable by the industry. By virtue of regulators’ incentives, the financial industry is basically self-regulated.
It is unlikely that consumers will ever hold much influence over the realities of the financial regulatory process because they are not organized in comparison to the financial industry, which concentrates significant resources in the creation of inefficient regulators. By and large, consumers are not well-informed about what they have at stake in the regulatory process and, even if they were, that would not be the sole determinant of how they define themselves politically.
Adding another layer of guards to guard the existing guards ultimately results in an infinite regress. I do not think it is cynical to suggest that, absent an actual paradigm shift with respect to accountability in the financial industry, we are just going to have more of the rent-seeking that has gone on to date and the economic calamities that ensue. For my part, I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the holdings of financial institutions independently and audit their records.
These contracts can be funded by fees charged to the industry that pass through the federal budget and are subject to public scrutiny. Although the fee income that supports these entrepreneurs would derive from industry operations, the social entrepreneurs will not have the power to establish the fees themselves, which should reduce the “shopping” behavior that already exists in financial regulation and with the rating agencies. Some degree of slack will develop as with any form of delegation, but that may be reduced to some extent by adding performance-based metrics to the terms of contracts or by giving the companies a portion of recoveries when they identify instances of fraudulent behavior (similar to what the Internal Revenue Service does with its whistleblower program). Even if social entrepreneurs pull their employees from the same pool of talent as the financial institutions they inspect, the opportunity to profit should make them less sympathetic to industry interests and encourage them to invest in furthering their expertise.
I would hope this is something most people in the financial industry would support. It would be an opportunity to show the industry still cares about actual capitalism.
By Bond Girl