Smoothing the Financial Regulation Cycle

I would like to focus on what we can do to help smooth the procyclical patterns of the financial regulatory cycle, and in particular whether some features of the Dodd-Frank Act might help.  What is the procyclical problem in regulation?  During economic and credit expansions, financial regulators are subject to strong capture pressure—the starting point for all of us in this forum.  Worsening the problem, regulators are subject to the same psychological and social biases that affect market actors during a boom.  They forget the problems that can occur when things go bad, and assume that the market does not need much regulation.  As a result of both, rules get weakened, enforcement is lax, and regulators fail to anticipate growing new risks and take measures to contain them.  Yet, during the boom, when private actors are building up too much risk, is precisely when we want regulation to strengthen.

 When a crisis hits, both factors change.  For a brief moment, financial regulation becomes politically visible.  Ordinary people want politicians and regulators to do something.  The political calculus of capture changes.  Moreover, the regulators and politicians themselves become aware of the risks of unregulated financial markets.  As a result, significant new legislation and regulation to address financial risk become possible.

 But these new rules can go wrong in at least two important ways.  If they have real bite, then implementing tough rules during a crisis may inhibit the extensions of credit that are needed to get out of the crisis.  Precisely when we want rules to become looser, they have gotten tighter.  It’s even worse if the strict new rules turn out to be ill-considered in major ways, as they often will be.  Or instead, it may be that politicians pass vague or complex legislation which sounds tough, knowing that when regulators get around to implementing it they will go light on the industry.  The ignorant public is fooled (and they no longer care when the legislation is gutted later on), and the financial market players/big political contributors aren’t too upset, because they understand the game.  This is basically the point of Kim’s great study, and there’s a lot to it.

 Is there any way to avoid these problems?  I strongly doubt we can eliminate them completely—they are too built in to the core incentive structure of our political and economic system.  But maybe there are some things we can do to lessen the problems.  Essentially, we want to find a way to take the political will that appears only during crisis, and translate that into serious, sensible regulation, but regulation that will take effect only after the crisis is over and if anything become stronger as periods of stability and prosperity become longer and more successful.

 I think there are some elements in Dodd-Frank that may help accomplish this smoothing of the political cycle.  I have written about some of them in my Don’t Panic! piece and in a piece with Dan Schwarcz on Regulatory Contrarians.  A few notable examples:

--The requirement that regulators institute procyclical capital rules.  The great advantage is that by limiting regulator discretion it may help bypass the capture pressure and over-optimism that plague the system.  The question marks are whether there are adequate measures with which to trigger tougher capital requirements, and whether regulators can really commit to allowing the rules to work.  Also, market participants may find ways to get around set rules.

--The Office of Financial Research.  This could become a good example of what Dan and I call a regulatory contrarian.  As an independent office that draws upon academics and does not itself make rules, it may be less subject to capture and more independent in its thinking.  Its mandate requires it to constantly ask questions about emerging systemic risks, so that the incentives for researchers within it may be to identify risks, not ignore them.  Whether the office will really be active, and even if it is, whether it can succeed in convincing regulators to follow its warnings, are of course major questions.

--Various consumer or investor offices and representatives created within the Act.  The biggest is of course the Consumer Financial Protection Bureau, but there are a variety of others.

--The Financial Stability Oversight Council brings together the major financial regulators periodically and requires them to at least talk about emerging risks.  Whether that talk will lead to serious thought, much less action, is of course as yet quite unclear.

--The many required reports to Congress.  These at least force regulators to regularly publicly explain themselves on a variety of points, and give members of Congress a chance to shine light on some problems.

--The many required studies.  These at least require regulators to think about some problems.

 There’s more (read our paper), but this gives a sense.  Congress seems to have been aware that in giving so much discretion to regulators who fell asleep the last time around, it needed to try to build in mechanisms to prod the regulators to stay awake.

 Will this all work?  It can’t work completely.  The problems are too intractable.  But when Dodd-Frank was passed and I began to go through it and notice these various mechanisms, I had some guarded hope that they could do some good.

 How’s it going so far?  Kinda rocky.  Given all the new rules required, it is hard for one person to stay up on what is happening, especially for someone like me for whom this is a secondary area of research.  As I discussed in a recent forum at the Conglomerate, the rules so far seem to be a mixed bag.   Some look good, some look lame, and many are late.  The lateness raises one important criticism of the Act: perhaps it took on too much.  That may be right, although most of the Act (not all, but most) aims at real problems the crisis brought out.  Even if so, perhaps the Act should have staggered the schedule for implementation over a longer period.  That would have allowed regulators to focus attention on fewer rules at a time, and also would have helped smooth out the political cycle. 

 What has most surprised me is how quickly the opposition to regulation has gained in force.  Industry opposition was inevitable, but most of the Republican party now seems committed to eliminating most or all of Dodd-Frank.  I would have thought it was still too early to so blatantly pander to the bankers who got us into this mess and caused so much anger when they got bailed out.  I was wrong.

 So I’m less optimistic now than I was when Dodd-Frank passed, and I was never all that optimistic to start.  But still, I hope the various mechanisms I have discussed here may yet do some good.

Comments

[Erik Gerding]

Three questions, Brett:

1. What motivates your regulatory contrarians?

2. How do you make sure they don't interfere too much with the effective functioning of an agency?

3. Doesn't the various administrative mechanisms in the Dodd-Frank strike you as the administrative engineering equivalent of the financial engineering that precipitated the crisis? Is there something to be said for the fact that financial reform tends to be patterned not only after the dominant ideology of the time (ours might be the "Age of Engineering") but also after the industry it is designed to regulate?

[Brett McDonnell]

Those are hard questions.

1. Our regulatory contrarians are of course 100% motivated to pursue the public good.

OK then, a more real answer. It probably varies depending upon whether one is considering persons drawn from pro-consumer organizations or academics, but for both, I would think their personal vision of optimal policy plus a desire for the prestige that could come from visible advocacy within the federal government are likely to be the main drivers. It's hard to under-estimate the importance of status as a motivator. The main difference from professional regulators or private industry actors is the contrarians have different reference groups from whom they derive their status.

2. We deliberately want to give our contrarians little power, so they won't be tempted by it. They can suggest ideas, pester, take up time, and so forth, but in the end there's not much they can do if they can't convince the agency they are right. That is of course why they may often be ineffective.

3. Nice point. I was especially struck by that with Subtitle F of Title IX, various controls on the SEC. For instance, sect. 961 requires the Directors of the various divisions of the SEC to annualy certify as to the adequacy of internal supervisory controls. I can just imagine corporate lobbyists upset with the Sarbanes-Oxley internal controls certification requirement chortling at that one.