Some Further Thoughts on Financial Regulation

As some of my previous posts have suggested, the ideal structure of financial institution and market regulation is maddeningly elusive. The U.S. structure was never well thought out and planned; it was created piecemeal in reaction to various historical financial developments, problems, and crises – most notably in the 1930s, 1970s, and more recently. Because of the way politics works and laws are enacted in the U.S., it is difficult to reform financial regulation absent a crisis, and even then reforms may fail to address some fundamental problems.

In the UK, by contrast, the government has been able to change the regulatory structure with less political difficulty given the nature of the political system (though, as the recent election there attests, the UK political system appears to be evolving in fundamental ways). For example, in 2000, the Labour Government headed by Tony Blair consolidated most financial regulation in the Financial Services Authority ("FSA"). In the aftermath of the financial crisis of 2008, the Conservative Government headed by David Cameron deemed the FSA to be a failure and in 2013 split the FSA into two entities, one for business conduct regulation and the other for prudential regulation and gave more authority to the Bank of England.

Sometimes, there is something to be gained by rearranging and consolidating or splitting (as the case may be) regulatory boxes. In the U.S., there is a good case to be made for merging the SEC and the CFTC and for having fewer bank regulators. The case for the former rests on the similarity of many of the market instruments the two agencies regulate; the case for the latter rests on forum shopping by banks. One could go further and pose the question whether insurance companies (life, casualty, and health) should be primarily regulated by the states given the important role these entities play in financial markets and also ask whether the regulation of pension funds is adequate.

One thing is clear. When Alan Greenspan was the Federal Reserve chairman, he liked to argue that multiple regulators would foster competition among regulators and that this would result in better regulation. Of course, that is an application of faith in the free market and competition in an area where it makes no sense. Greenspan’s not terribly well hidden agenda was that competition among regulators for entities to regulate would result in regulatory laxity, which he thought was desirable. Given the financial crisis of 2008, that is no longer a widely shared view.

The main problem with financial regulation is regulatory capture. While restructuring the agencies responsible for regulation may help, it does not solve this problem. When there are multiple regulators, there is a tendency for each agency to be an advocate for the entities it regulates and to fight any encroachment by other regulators. This can even extend to matters that are not strictly in the regulators’ jurisdiction. For example, some years ago there was a political fight over whether derivatives should be marked to market for accounting purposes, as the Financial Accounting Standards Board ("FASB") had proposed. (This simplifies FASB’s complex proposal but gets to what the dispute was about.) The bank regulators supported the banks in fighting the proposal, while the SEC supported it. The issues revolved around capital requirements and the stability of reported income. For broker-dealers regulated by the SEC this was not an issue, since SEC capital rules key off assets for which there is a market and are valued at market (or "fair value") prices. For banks, this had the potential to increase capital requirements if there were a decline in the value of certain of their derivatives holdings. Of course, the regulators could come up with a regulatory capital measurement that went contrary to FASB rules, but the regulators did not want to do that.

In the end, a version of the FASB rule was finalized. As for Treasury, the staff was divided. Those who worked on bank regulation argued against FASB; those who worked on securities regulation, which included me because of Treasury’s government securities market rule-making authority, sided with the SEC and FASB. Ultimately, Treasury political appointees sided with FASB. A provision was included that effectively stated that inflation-indexed bonds structured in the manner of Treasury’s inflation-indexed bonds did not have an embedded derivative that needed to be split out and marked to market. Whatever one thinks of the merits of that particular provision, it obviously was in Treasury’s interest for FASB to conclude this as the Treasury was trying to develop a market for the new security.

As for the SEC, the staff there seemed to be heavily influenced by the largest broker-dealers and held out Goldman Sachs as having excellent compliance programs. In some areas, Goldman no doubt has good compliance programs. But one wonders if the deference SEC staff paid to firms like Goldman led them to miss some of the practices that exacerbated the bursting of the housing bubble and the 2008 financial crisis.

Despite the foregoing, consolidating regulators does not necessarily solve the regulatory capture problem. It probably limits the types of entities that can do the capturing to the largest firms and exchanges, but these entities will find a way to both charm and pressure a regulator with broader responsibilities than the current one. After all, as the Carmen Segarra tapes suggest, the Federal Reserve Bank of New York ("FRBNY") will sometimes handle large and influential firms with a light touch (in this instance, Goldman Sachs), even though the FRBNY would seem to be powerful enough to be immune from influence and pressure.

There is no obvious answer on how to reform the regulatory system. Dodd-Frank made some improvements, but the ability to resist regulatory capture requires leadership and a change in the culture of the regulatory agencies. As regards leadership, it is not sufficient to have a gung-ho regulator who heads an agency for only a few years. The leadership must be sustained from administration to administration. Also, a gung-ho regulator may not always be for the best. It is not always the case that writing lots of regulations solves problems, especially if they are not well designed to solve identified problems. Moreover, regulators need to show good judgment, which was absent in the lead-up to the 2008 financial crisis. After all, the regulators had authority that they did not use, which might have at least lessened the severity of the crisis. Particularly egregious was Greenspan’s refusal to use the Fed’s authority to curtail what was happening with subprime mortgages.

Given the current state of our political system, it is hard to be optimistic about making significant improvements in regulation. Any administration which wants to improve regulatory oversight and appoints people to the agencies who share that view will get pushback from certain factions in Congress. The large financial entities know how to play the Washington game, including how to influence Congress and exploit rivalries and tensions among various government agencies. Currently, probably the best discipline on the financial sector is the memory of the 2008 crisis. However, as time passes, memories of that will fade and a new crop of ambitious people will be working at the firms with no personal memories of 2008 at all.

This does not mean that we should quit trying to improve financial regulation. While there will certainly be serious problems in financial markets – there always are – perhaps we can be able to mitigate them. The regulations we have and their application and enforcement are not worthless; they do a lot of good. They could, though, be better.