Arnold Kling  

Financial Regulation and Public Choice Theory

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An outstanding guest post by "bond girl" at Baseline Scenario.

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?

Her suggested remedy:

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.

Sounds like rating agencies. Aware of this, she writes,

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

it is easy to poke holes in an idea like this, particularly since it is only sketched out in a couple of paragraphs. But keep in mind that we do not have a competing regulatory solution that is foolproof. So I would like to see something like this introduced into the policy debates as an option.

I think that the challenge is to come up with a reward system for the regulator/entrepreneurs. It isn't just fraud that you are trying to find. What you want is a set of incentives that in 2004 and 2005 would have rewarded the social entrepreneur for identifying and measuring the exposure of key financial firms to stress in the housing market and to the misbehavior in the mortgage market. It's even tougher than that, because there are two types of errors the regulator/entrepreneur can make. One is to fail to spot a dangerous situation. The other is to incorrectly characterize a benign situation as dangerous. Too much incentive to avoid one type of error will increase the errors of the other type.

Note: She has a link to a speech by Ben Bernanke in June of 2006, which illustrates the extent to which what Danny Kaufmann calls "cognitive capture" affected the regulators.

To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization.

In other words, all the stuff that we now think of as the cause of problems was, at the time, regarded as the solution.

Comments and Sharing

COMMENTS (5 to date)
david writes:

I would be astonished if said social entrepreneurs did not also find a way to offer slightly less stressful tests in exchange for some kind of return. Doubtless the regulators of this entrepreneurship will also be self-interested and may themselves take a cut, no?

As they say, the market finds a way. Policy inflexibility is perhaps the best option here.

Less snarkily, I'm wondering whether individuals are now supposed to be 1) self-interested or 2) subject to cognitive capture. These are fairly obviously not the same.

Les writes:

I agree with David that the market will find a way. So, rather than appointing regulators, let the market work.

Note how well the market does work: Consumer Reports rates a multitude of goods and services. There are many other independent rating agencies that rate health care organizations, electric appliances, corporate stocks, mutual funds, insurance companies, universities, etc. And there are blogs, journalists and others who offer opinions - for example the user comments on

Not every rating organization is objective, and not every rating organization is perfect. But competition tends to weed out some of them. In addition, "caveat emptor" is a wise policy.

Sharper writes:

Encourage bankruptcy insurance.

Compete to insure stock and leinholders against bankruptcy in the companies their assets are tied up in. Rates will be set competitively with the insurers having tons of incentive to actually understand the risks of a particular company.

The change in rates over time should be a great measure for how risky a company is.

Shawn Smith writes:

America is already set up to do this...the federal government should set the standards that the states should follow but leave the "how" to regulate to achieve those standards to the states. The state regulators who produce a regulatory scheme that provides financial stability will be sought after by the other states to improve. We already see some competition among the states on taxes, education, etc.

Mike Rulle writes:

Sometimes we forget how regulations are created. Regulations are created with the help/lobbying of those who are regulated. I am not sure we can or should do anything about this. As Arnold has pointed out repeatedly, there were regulatory arbitrages available to financial insitutions. These were not accidents. These were created, in part at least, with the belief that the less aggressive regulations (those which permitted more leverage) were, in fact, more appropriate. So what happened when AIG/Lehman failed? Wall Street was bailed out (AIG plus TARP).

Moral hazard is a continuous story. But let's assume that this past October we chose not to bail out anyone---letting the market fend for itself. What would have happened? I have no idea, but it is not the slightest bit obvious as to whether the result would have been worse or better. This does not mean the Fed and Treasury could not have met with banks and provided leadership (say, like Greenspan did with LTCM--I don't recall any commitment of Fed or taxpayer dollars then, other than increased liquidity to banks by the Fed---but no purchases of securities that were underwater).

We might have found out that things were not as bad as we thought, in which case perhaps the "more leveraged" regulatory policies could have withstood this crisis. Or, we might have discovered it could not. If the latter, then the banks would have learned something regarding regulations and probably would have acted accordingly already regarding new rules.

Instead, we have had this interminable distraction caused by the Government in the overall management of banks. The whole system seems forced and artificial right now. Merely outsourcing this whole issue to yet another 3rd party seems exactly the wrong thing to do.

If we no longer "permit" moral hazard, the next generation of managers are likely to be more careful. If moral hazard, on the other hand, is viewed just as a nice thing in theory but unrealistic in practice, no 3rd party regulator with incentives (chosen how?) will contain the ability of smart people to find "loopholes".

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