A response to Erik Gerding on making capture work

Erik Gerding made the following comment to my last post, and I thought I might try to respond in the form of a post:

To play devil's advocate: what if, instead of fighting regulatory capture, we try to make it work. What if we admit that big banks are naturally going to be cozy with regulators? Under certain circumstances, this gives regulators better information and additional tools -- like moral suasion -- to influence big banks.

Some commentators attribute the concentration of banks in Canada to the success of Canadian regulators in heading off subprime investments by banks. Is there any validity to this, Cristie?

I've always wanted to ask you the big question: "Just how did you Canadians avoid the crisis?" Is there something about the regulatory environment or process in Canada that gave it an advantage?

 Erik, thanks for the question. Before talking about how Canadians avoided the financial crisis, I should point out that Canada had its own asset-backed commercial paper (ABCP) crisis in 2007, which in many ways was a harbinger for the broader financial crisis. A lot of risk was poured through that sector, which as short term commercial debt had the benefit of a partial exemption from the normal securities regulation disclosure rules.

Thinking of the broader crisis, certainly some would say in happy retrospect that Canadian banks had a more conservative (“prudent”) culture vis-à-vis leverage. It does seem true that Canadian banks overall had fairly robust risk management policies and processes in place. Just as important, mortgage lending is less aggressive here, and Canadian banks held onto their mortgages rather than securitizing them. (This is partly because mortgage interest is not tax deductible, so the buyer side and the nature of the investment are different.) Having not picked that low hanging fruit, maybe banks didn’t then find themselves compelled to securitize consumer credit card debt, etc. The counterfactual to the prudence story would be those several events I attended in 2005-2007 at which some members of the banking community bewailed what they perceived as the restrictive capital requirements imposed on them by Canadian regulators. At least some Canadian banks were most eager to do what their American neighbors were doing. These folks might have been lucky, by being late. Let’s not forget, either, that practically all the banks were very deep into ABCP. I think that to the extent it fits at all, the “prudence” story fits better overall with regulators than with industry actors.

But your question, Erik, goes to the relationship between regulators and industry.  It was significant that all banks in Canada and all their subsidiaries were regulated by one regulator, the Office of the Superintendent of Financial Institutions (OSFI). It’s also significant that OSFI, along with some of the large securities regulators in Canada, operated in a more compliance-oriented culture and a less enforcement-oriented one. (See e.g., Eilis Ferran and Jack Coffee.)  A compliance-oriented culture would be one characterized by more ex ante dialogue with industry, and a Braithwaite-style ratcheting enforcement pyramid within which ex post enforcement is the last resort. Based on my limited experience cross-border, it is my impression that Canadian financial regulators do tend to function in a relatively more compliance-oriented way, so there were opportunities for ongoing communication. It’s also relevant that Canadian banks are indisputably oligopolistic, and make very nice profits from their retail clients alone on things like customer bank fees and merchant credit card fees. But my own view is that the claim that a tightly regulated oligopoly will work better over the long term than a competitive banking market assumes altogether too much about the wisdom and objectivity of regulators in that kind of environment.

The provocative question for me is whether there’s a necessary correlation between compliance-oriented, dialogue-heavy regulation and either (1) a relatively small, manageable community of industry actors and/or (2) a fairly enmeshed regulator/industry relationship characterized by extensive social ties, etc. There are hints of this coming out of comparisons of UK and US takeover regulation, and Don Langevoort’s assessment of “light touch” securities regulation in the UK.  The first isn’t easily scalable. At its worst, the second shades into “club government”. I personally am not alright with club government, which makes me leery about proposals to “make capture work.” It might work to prevent crises that jeopardize those parties’ interests, but I don’t think it would work to prevent the abuse of ordinary, unconnected people.

As someone who has spent considerable time talking about the need for an “interpretive community” in securities regulation in particular, I’m unwilling to accept that there might be some irreducible relationship between cronyism and compliance-oriented (or principles-based) regulation, or between openness and a costly, highly imperfect ex ante enforcement-oriented approach. Where I land (and I’m very interested in everyone’s thoughts on this) is in favor of a compliance-oriented approach that structurally forces transparency and broader participation in a way that cozy club government on its own will not. This might include something like FSA-style consumer panels, explicit participation requirements on regulators (woefully bearing in mind  caveats arising from Kim’s paper), or something like Ontario’s Investor Advisory Panel.

Comments

[Erik Gerding]

Thank you for this response, Cristie. I am struck in reading this thoughtful post and your insightful and nuanced writings over the years how different you (and many other law professors) approach regulator incentives and problems like capture than do many economists. As one point of comparison, consider the work of George Kaufman on regulatory forbearance that lead to "prompt corrective action." It is not just different ways of defining the problem, but also very different models of what makes regulators tick.

As I noted in a later post, many economists have a similar attitude to Kaufman's earlier work about the failings of regulators in the current crisis and what is needed to address those failings. The need to make regulations more automatic has gained much traction in the economic community.