Tripartism, Regulation & Zeitgeist

Thanks so much for the opportunity to participate in this forum. I’m privileged to be blogging with a group of such wonderfully compelling, incisive, and original scholars. This promises to be an especially interesting forum, because Kim Krawiec has framed our topic in the thoughtful terms she has. Where I hope to be able to contribute is in thinking about some of the “underground” aspects of contemporary regulatory design that may have played a role in the lead-up to the financial crisis.

From my perspective, the actual structure of the dominant regulatory design approach today, which I call “flexible regulation”, played a significant and underappreciated role in the development of the recent financial crisis. Of course, other hugely important factors were at play: transnational regulatory competition and arbitrage, the potential capture of domestic regulators and legislators, yawning structural gaps in regulation (intentional and otherwise), a failure to identify growing levels of systemic risk, and the overall deregulatory zeitgeist of the past decade.  The reason why the role of flexible regulation needs to be addressed is because its influence is more subtle, but persistent and difficult to respond to.

I have argued elsewhere (before and after the financial crisis) that some elements of financial regulation, such as Basel II capital adequacy requirements and principles-based securities regulation, are forms of flexible regulation. I say this while recognizing the very serious, and instructive, ways in which their real-life versions departed from theory and best intentions. Flexible regulation moves away from the prescriptive, command-and-control strategies that (common wisdom tells us) characterized most regulation for most of the twentieth century. It embraces more flexible, context-sensitive, decentralized, and collaborative strategies designed to leverage private sector knowledge and to foster innovation.  (For more on flexible regulation in the financial sector, see Sharon Gilad’s work, and Julia Black's. The comments below are based on this paper of mine.)

One of my concerns about flexible financial regulation is that relative to command-and-control regulation, flexible regulation is more susceptible to influence from outside the realm of pure regulatory design. Flexible regulation is porous to both “macro level” and “micro level” forces to a degree that command-and-control regulation is not. Overt influence and political pressure operate at the “macro level”, but so does subtler influence at the regulatory agenda-setting stage. I think Kim Krawiec’s new paper  supports a version of this argument, in that gap-filling opportunities around the implementation of the Volcker Rule were substantially taken up by industry representatives, not others.

At the “macro level”, the regulatory agenda in financial regulation was very much a product of consultation with industry, and pre-crisis was substantially framed around three related claims: first, that modern financial markets were too fast-moving and complex to be regulated in a command-and-control way; second, that the innovative potential of the financial sector was hugely socially beneficial and needed to be preserved and respected; and third, that the regulatory burden on the financial sector was too great.  The problem is not that these assumptions are false.  At least the first two are sort of true.  The problem is that the degree to which these assumptions circumscribed regulators’ thinking about their role. Because the agenda was framed around the need for regulators to keep up with the inevitable speed and complexity in global financial markets, the concerns about speed and complexity– the reasons for it, the concerns it might raise, the broader regulatory reorientation it might demand – never came up.  Because the agenda was framed around regulators’ obligation not to stifle innovation, there was no room for a more nuanced examination of varieties of innovation, incentives for innovation, and effects of innovation. This effectively made it impossible for regulators to act on concerns – even to have concerns – about, e.g., the proliferation of the derivatives market. 

At the “micro level”, as well, unglamorous implementational problems undermined the robust, sophisticated, self-interrogating model that flexible regulation was supposed to represent. Regulators were under-resourced, under-informed, and less assured in their role than they might have been in a less industry-driven model. They often failed to be focused enough or systematic enough about pinning down the precise meaning of terms used by industry. This was substantially the product of complexity, including industry-driven complexity designed to get around regulatory requirements.  A significant complicating factor, which Erik Gerding has written convincingly about, was the impact of automation of risk processes by industry actors.

In my view, these “macro level” and “micro level” influences amounted to a form of Bourdieu-style cognitive capture. I’m not making the familiar revolving-doors capture claim, though there may have been some of that. This is more about the imaginative possibilities that were available to many regulators during this time period. Flexible regulation would surely have operated differently in a different historical moment (regulatory design generally was clearly influenced by deregulation-oriented economic policy and neoconservative politics), but I’d suggest that questions about the appropriate regulatory mix of strategies can’t take place in isolation from these considerations.

My question for some of my fellow bloggers, then, would be whether there are limits to the idea of tripartism as a response to regulatory capture. The classic triparism formulation, from Ian Ayres and John Braithwaite’s 1992 book, Responsive Regulation: Transcending the Deregulation Debate, envisions private sector actors playing that role. My worry is that there were not adequate contrary-minded voices within earshot of regulators, and moreover that regulators dispositionally wouldn’t have been inclined to listen to them, during this time. I am not sure that private sector tripartism was even a realistic possibility in the era leading up to the financial crisis. The absence of a broad-based network of private sector actors, something that Daniel Schwarcz identifies as salient, is a second order problem.

Would public sector tripartism have fared better in this era? The proposals that Saule Omarova and Daniel Schwarcz put forward here envision or describe statutorily mandated public sector third parties. This would help ensure that someone in the conversation at least had a mandate to look after, e.g., investor or consumer interests. But I’m not completely confident these third parties would have been able to resist the pull of the zeitgeist in the pre-financial crisis era either. Might they have been equally susceptible to the “macro level” and “micro level” influences above, and to a kind of subtle, cognitive capture?  If not, might they have found themselves too out-of-step with majority opinion to be taken seriously by others? How might we respond to these problems?

Comments

[Erik Gerding]

To play devi'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, Christie?

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