The Faculty Lounge

Volcker Rule Draft Leak

As many of you already know, a leaked version of the proposed Volcker rule has been circulating.  Here is the preamble from the confidential staff draft, dated September 30, 2011, posted by the American Banker yesterday.

 

The Rogue Trading KISS

Unfortunately, a busy travel schedule – including a lovely visit to Boulder -- over the last few days has kept me from blogging more about alleged UBS rogue trader Kweku Adoboli.  Hopefully, I’ll have time to correct that this week. 

New information emerged over the weekend that suggests numerous parallels to the 2008 Jérôme Kerviel rogue trading scandal at France’s Société Générale. This is not terribly surprising.  As I detailed in connection with the Kerviel case (see the set of links below), most of these high-profile rogue-trading cases follow a fairly familiar pattern. 

Despite initial speculation that the complexity of Adoboli’s trades inhibited detection by risk management personnel, this is rarely the case.  As I discuss at length here, most of the high profile rogue trading cases initially blamed on the use of complex derivative or other products are actually more the product of basic risk management and compliance failure.  In other words, rogue traders tend to Keep It Simple, Stupid – they enter fake trades or otherwise manipulate risk management systems, forge documents, lie when questioned about their unauthorized trading activity, and follow a number of other tried and true strategies to evade detection.

It looks as if the UBS case will be no different.  UBS has now disclosed that the losses arose from trades in S&P 500, DAX, and EuroStoxx index futures, which Adoboli concealed through fictitious trades.  This is very similar to the Kerviel scandal (which, in turn, bore many similarities to prior scandals.) 

There are two other notable similarities between the Adoboli and Kerviel cases. First, both migrated from the back office, where they gained knowledge that later facilitated their illicit trading and cover up.   Second, both were on the Delta1 desk, which has broader implications for financial reform issues, such as the Volcker rule. 

I will be back later to discuss those implications in more detail.  But, in short, rogues such as Adoboli and Kerviel aptly illustrate the thorny enforcement problems associated with attempts to distinguish prohibited proprietary trading activity from permitted client service and market making activity. These difficulties, according to GAO, impede even the study of proprietary trading at banking entities, which does not bode well, in my view, for Volcker rule implementation and enforcement.

Related Posts:

When $61bn Seemed Like Real Money

Denial: It Ain’t Just A River In Egypt

It’s The Stupid Culture

It’s The Culture, Stupid

Kerviel’s Fake Trades: Genius Or Copy Cat?

Kerviel’s Fake Trades: The Anatomy of A Cover-Up

On Warning Signs II: Follow The Money

On Warning Signs: You Can’t Get There From Here

Rogues Versus Scapegoats

Kerviel Trial Opens to Fanfare

Société Générale: Back In The Saddle Again

Jérôme Kerviel to Société Générale: Stand By Your Man

 

The Rogue Trader Returns (Again)

From the FT:

Kweku Adoboli, a 31-year old trader in UBS’s London-based exchange traded funds business, was arrested on Thursday morning in connection with a $2bn loss due to unauthorised trading at the Swiss group’s investment bank. 

The Swiss group declined to comment, other than saying the loss had been caused by “a trader” and the matter was under investigation. It warned that the discovery could prompt it to report an overall loss for the group when third-quarter figures are revealed in October.

That’s really all the information I see so far, but I’m sure that there will be more.  If you want to get a leg up on the inevitable press comparisons to prior rogues see here:

When $61bn Seemed Like Real Money

Denial: It Ain’t Just A River In Egypt

It’s The Stupid Culture

It’s The Culture, Stupid

Kerviel’s Fake Trades: Genius Or Copy Cat?

Kerviel’s Fake Trades: The Anatomy of A Cover-Up

On Warning Signs II: Follow The Money

On Warning Signs: You Can’t Get There From Here

Rogues Versus Scapegoats

Kerviel Trial Opens to Fanfare

Société Générale: Back In The Saddle Again

Jérôme Kerviel to Société Générale: Stand By Your Man

 

Reforming Financial Reform? The Wrap-Up

Many thanks to our guest bloggers Cristie Ford, Erik Gerding, Brett McDonnell, Saule Omarova, and Dan Schwarcz for what has been a really amazing two day on-line forum.  I’ve greatly benefitted from hearing their views on financial reform, and from the feedback on my own thoughts.

I notice that the original forum title had a question mark at the end – i.e. does financial reform need reforming?  I ‘d say that our guests mostly feel the answer to that is yes.  There was less agreement on exactly the nature of needed reforms.

Erik proposed some institutional redesign, soft countercyclical devices . . . and romance. There was some debate, prompted by Dan, about whether the political economy of financial regulation is fundamentally different from that of other issue areas. Cristie and Erik had some debate on the possibility of “making capture work,” with Cristie rejecting cozy club government in favor of a compliance-oriented approach that structurally forces transparency and broader participation. Saule proposes the statutory creation of a systemic risk PIG to impose structural checks on capture.  And Brett proposed (and argued that Dodd-Frank already contained) a variety of smoothing mechanisms to help address procyclical patterns of financial regulation.

I didn’t propose any solutions, and simply remained content to provide some hard evidence about the activity of relevant actors – including industry, public interest groups, and the general public – with respect to the Volcker rule. I do continue to think that the answer has to begin with Congress.  I complained from the start that some pieces of Dodd-Frank looked a lot to me like legislators seeking cover, with federal courts and agencies as the natural scapegoats if things went wrong down the road.  

A sincere thanks to all of our guest bloggers for this forum! I couldn’t have asked for a better group to have this discussion with.

Cycles and Romance in Financial Law

Thank you to Dan for questioning my argument that the political economy of financial institution regulation is different. I agree whole heartedly that there are other areas of law -- like environmental law -- in which a concentrated industry can externalize cost onto a diffuse public.

But there are still crucial differences between the political economy of environmental law and the political economy of financial institution regulation:

First, the negative externalities in financial institutions are more closely coupled with the very services that the public demands. We want financial institutions to take risks, extend credit, and provide capital. Too much of these good things, however, can put the government safety net into play. In environmental law by contrast, there is a tradeoff between positives (jobs) and negatives (pollution). No one wants dioxin. It is possible that technological advances or Coasean bargains can mean we can have more jobs without more pollution. But if financial markets are even somewhat efficient, it is hard to have more reward without more risk taking.

Second, financial markets are subject to cycles. It is when the political cycle becomes too closely coupled with the financial cycle that we need to be most concerned. Booming financial markets can contribute to disaster myopia among regulators and herd behavior by financial institutions and investors. I looked at the interactions between market cycles and regulatory cycles a few years ago  and am exploring them much more in my book. Perhaps similar cycles and feedback loops exist in other regulatory areas (if readers have thoughts on this, please e-mail me), but financial markets makes the feedback stronger.

Third, let’s talk romance. In environmental law, there is at least a semblance of interest group pluralism because environmental groups are deeply and ideologically committed to defending wildlife, protecting natural spaces, and fighting pollution. Financial regulation doesn’t have that same civil society. Claire Kelly has written very creatively about the possible role of civil society in financial regulation. But where is the motivation for people to participate? Where is the ideology? Where is the romance?

I am not being facetious. Earlier in the summer, we had dinner with environmentalist friends who described how they met and fell in love in the “movement.” Where is the “movement” in our field? (Granted my future wife thought it was cute when I was reading Against the Gods before we were dating, but still…)

Moreover, I think “insurance” regulation differs somewhat from “banking.” When I pressed you a few years ago, you said that (bond insurance and credit derivatives aside) insurance didn’t raise the same systemic risks that banking did. So I think there is less incentive for firms to externalize the cost of their failure on taxpayers (AIG is different, because it involved insuring financial products). That of course doesn’t diminish the possibility that “Joe the Plummer” will get screwed when he purchases his life insurance.

Adaptive Regulation and Channeling Politics

In my first post, I argued that negative externalities from the failures of financial firms and government guarantees and subsidies made the political economy of financial institution regulation different. In my second post, I argued that financial institution regulation was inherently unstable. My co-panelists have explored different facets of the political problems of financial regulation.

If the financial industry has some “natural” political advantages, financial regulation is inherently unstable, and the government safety net is in constant danger of being exploited in subtle ways, what is to be done? Cristie, Saule, Brett, and Dan have all made serious proposals in their scholarship that focus on making financial regulation more adaptive. One refreshing aspect of all of their work is that each of them has not sought refuge in some technocratic fantasy in which politics can be escaped. Rather their ideas seek to use legal institutions to channel political forces.

In that spirit, I set forth in this post some of my own ideas on channeling politics and making financial regulation more adaptive. These ideas come from the concluding chapter of my book-in-progress on “Bubbles, Financial Regulation, and Law.” I underscore the modesty of the objectives of these proposals. The goal is not to eliminate the potential for abuse of the government safety net nor to completely counterbalance the political advantages of large financial institutions vis a vis taxpayers and the greater public. Nor is the objective to smooth out the business cycle or to prevent all asset bubbles and financial crises. Rather, the aim of these proposals is to mitigate the probability of really bad financial crises.

The Incentives of Individual Regulators

One of the things I explore in the book is addressing the incentives of individual regulators. Financial reform tends to focus on regulatory bodies and too seldom looks inside the black box at the incentives and behavior of the individuals at agencies. In my book, I float a few trial balloons that borrow from “pay for performance” movement in the private sector. I ask whether at least a portion of a regulator’s long term compensation should be tied to various performance metrics. For example, should regulator pensions take a (measured) hit if financial institutions in their regulatory “portfolio” fail.

And I Thought I Was a Pessimist

Part of my strategy in my first few articles on financial regulation ("Of Mises and Min(sky)" and the quite misleadingly titled "Don't Panic!") was to try to corner the market on pessimism.  Staying the course looks bleak given where that course has taken us.  Extensive new regulation will fail both because of the capture issues at issue in this forum as well as the sheer complexity and the bounded rationality of regulators.  Laissez-faire led to the Great Depression.

But I have clearly failed at cornering this market.  One of Erik's posts nicely summarizes the failings of most leading approaches.  Kim's attempt to summarize the first set of posts from yesterday has us waiting for Superwoman.  But it turns out that Superwoman cannot get confirmed in the U.S. Senate.

Up to now, I have more or less defended the Dodd-Frank Act as a way to muddle through with modest new rules that address the leading gaps we saw in the crisis.  Extensive delegation to regulators was needed given the obvious inadequacy of Congress (which, remember, is also subject to capture, and which for the most part doesn't have a clue what it's talking about).  Various strategies in the Act, discussed in my first post, try to keep the regulators awake and honest.

But maybe even that is just too much for this country's regulatory capacity.  Our financial markets are a vast mess, we have no tradition of grooming and valuing career regulators, and one of our two political parties is deeply allergic to the whole project.  Maybe a much more slimmed-down response to the crisis would have been better.

What might such a response look like?  I see two or three elements.  One is a resolution authority so the government can step in with failing financial companies, quickly dispose of their assets, and punish those in charge.  This is needed not just for the very biggest too-big-to-fail companies, but for much if not all of the shadow banking world--a series of failures of modest companies can be just as bad as the failure of one big company.  That's how we got into the Great Depression, after all.  A second element is a relatively simple set of capital and maybe liquidity requirements.  These again should apply to most or all shadow banks, though be stricter for the too-big-to fail institutions.  And some of the contrarian roles, especially the Office of Financial Research, would still be useful even within this stripped-down approach.  In sum, I'm suggesting Articles I and II of Dodd-Frank but expanded beyond just the biggest companies, and that's it.  That wouldn't be good enough to stop a future crisis, but then again, neither is what we've done.

So maybe the title for my next article will be something like "Never Mind:  Starting Again with Our (and My) Response to the Financial Crisis."

Is the Political Economy of Financial Regulation Really Fundamentally Different?

A common theme in many of our posts is that there is something different about the political economy of financial regulation -- particularly systemic risk regulation.  Erik argues this is because of the presence of government subsidies in this domain, which place costs on the most diffuse group possible (taxpayers) and are hard to value ex ante.  Saule's thoughts are similarly premised on the notion that there is no natural public interest group for systemic risk regulation.  Kim's work suggests that financial regulation may face distinctive political dynamics because of the  difficulty that ordinary individuals have in meaningfully engaging with the complexities  of the underlying issues.  Brett suggests that part of the problem is that the public only pays attention to systemic risk immediately after a crisis, but by the time that the rules are (or should be) implemented public attention is focused elsewhere, allowing industry to dominate regulatory proceedings.  And Christie worries that the prevalence and logic of flexible regulation in financial regulation makes it susceptible to industry influence.

I think there is much truth and wisdom in these characterizations of the process of financial regulation, and systemic risk regulation in particular.  At the same time, I wonder exactly how distinctive financial regulation is on these fronts.   Erik is clearly right that few industries enjoy government guarantees in the same way as financial firms.  But it seems to me that there are many regulatory domains in which costs are externalized on to a group that is even more diffuse than taxpayers.  The most obvious example is environmental regulation, where those who bear the cost of excessive risk are citizens, non-citizens, taxpayers and non-taxpayers.  And the costs of environmental harms are equally, if not more, indeterminate than then costs of financial guarantees.

Now, it is surely true that there are numerous public interest groups in the environmental domain relative to financial regulation, so this may suggest that the key difference is actually the complexities of financial regulation, relative to environmental regulation.  But the details of environmental regulation are themselves immensely complex: is it any more complex/ boring/ difficult to decide how many parts per a million of some obscure chemical firms should be allowed to release in the atmosphere than it is to decide how much regulatory capital financial firms should maintain?  Perhaps the difference does not involve the complexity of the underlying regulatory issues as much as it involves the salience of the broad regulatory topic.   It's always appealing to donate to environmental public interest groups who want to save pandas and polar bears.  Maybe there is no analogous pitch that can be made to support public interest groups focused on systemic risk regulation?  

This may be.  But it's worth pointing out that one of the core motivations behind the Tea Party movement has been anti-bailout sentiment.  Now the Tea Party is certainly not engaging in the regulatory process in the same way as public interest groups typically do.  But whether this will continue to be so in the future is less clear to me.  In any event, there are clearly numerous regulatory domains in which there are just as few public interest groups as in financial regulation (limited to systemic risk issues): consider regulation with respect to telecommunications or food safety.  

Nor does it seem to me that financial regulation is fundamentally different from other forms of regulation with respect to the prevalence of flexible regulation as a necessary or dominant strategy.  Indeed,  flexible regulation is at the heart of the "new governance" literature.  And only a very small percentage of this writing (with Christie's excellent work being a notable example) is focused on financial regulation.  

Similar responses can be made to the notion that financial regulation is inherently cyclical in the attention it captures from the public.  Mining accidents create immediate demands for enhanced regulation, but the public soon forgets about the issue and it drops out of the news cycle.  This is also true of environmental accidents such as the BP oil spill -- when was the last time any of us saw (much less read) news coverage on regulations governing deep water drilling?  And while it may be true that the worst time to implement stricter regulations is in the immediate aftermath of a crisis (when political will to do so still exists), rule-making is an inherently slow process meaning that there will always be a large gap of time between an event that draws public scrutiny and a permanent, rule-based, regulatory response.

 In the end, I DO think that the political economy of financial regulation is different in many ways.  This results from the combination and particular instantiations of all of the factors that have been identified in this forum.  At the same time, though, each of these individual issues also arises in other regulatory contexts.  As such, I think we have much to learn from work on combatting regulatory failure that is not specific to financial regulation.  Two of my favorite recent entries to this literature are Rachel Barkow's Insulating Agencies: Avoiding Capture Through Institutional Design and Wendy Wagner's Administrative Law, Filter Failure, and Information Capture.   Notably, much of what these articles discuss overlaps with the themes we have been hitting on in the course of this forum.

 

The Volcker Rule and the Limits of "High Politics"

Kim Krawiec’s new empirical work on the degree and nature of “public” input around incorporating the Volcker Rule into the Dodd-Frank Act (which I mentioned in my last post as well) is valuable, eye-opening, and truthfully a bit depressing. It has a lot of resonance with some of the agenda-setting literature that comes out of political science: see, e.g., Anthony Downs, or Frank Baumgartner and Bryan Jones. One of the ideas that comes from this literature is that policy dynamics tend to be characterized by short periods of high public and political attention to issues, surrounded by long periods of “low politics” in which policy fields are left in the hands of semi-closed epistemic communities. During those long periods of “low politics” institutionalized norms and/or taken-for-granted assumptions tend to go unquestioned.

I think Kim and I would agree that over the last twenty or more years, prudential regulation in particular had fallen into a period of "low politics”. I would argue that this was one of the reasons that prudential regulation was insufficiently forward-looking and public-regarding. Notably, other areas of securities regulation – consumer protection in the United Kingdom, for example, or post-Enron legal reform in the United States per Roberta Romano – had spent some time in the realm of “high politics”.  Kim’s paper reinforces the notion that during periods of high politics, it may be relatively uninformed public attention that drives the policy agenda forward. The need to be seen to be “doing something” prompted the inclusion of a version of the Volcker Rule in Dodd-Frank.

But Kim’s paper also complicates the story, suggesting that the stark contrast between the careful written submissions of industry and the from-the-hip nature of many written public responses, plus the vastly better in-person access that industry representatives had to federal agency representatives, may be powerful influences even in a high politics moment. In other words, in times of low politics, industry actors are persuasive because they are embedded in the semi-closed epistemic community that makes the rules. In times of high politics, industry actors are still persuasive because they can be more thoughtful, informed interlocutors and because by virtue of their status and contacts, they are in a position to try to influence regulators when opportunities present themselves to help fill gaps and resolve ambiguities in legislation. Given that legislative gaps and ambiguities will be inevitable, and assuming we’re not prepared to do away with consultation or reason-based decision making, what response can there be for those concerned with undue industry influence over financial regulation and policy making?

Kim’s paper suggests that, at least when the subject matter is technical and gap-filling opportunities exist, the fact that an issue captures a high politics moment does not insulate it from the in-group influences that we worry about in moments of low politics. In other words, around technical issues, we always need to be worried about capture at a microsociological level. One, partial, response would be to shrink legislative gaps and ambiguities to the greatest degree possible, for example by drafting highly detailed, prescriptive legislation. By doing this, we would be saying that preventing undue industry influence is more important than rolling industry expertise, or the expertise of frontline regulators, into the rule-making process. We would also be saying that we are less worried about legislators pandering to public opinion than we are about regulators being captured by industry. At least to me, this feels unsatisfactory. As much as I am concerned about undue industry influence, it feels like throwing out the proverbial baby.

Alternatively, could we re-examine the roles that regulators and members of the public play in this story? If we are not confident about the public’s capacity to engage meaningfully with the subject matter, and Kim’s account suggests that we should not be, then it is not clear what we are trying to do with public input. In spite of directing effective letter-writing campaigns, the public interest groups intervening in the debate about the Volcker Rule seemingly had minimal impact. A sheer volume of letters had nothing to contribute to the technical questions that federal agency actors were addressing. Can we support and amplify a meaningful public voice in this process? Another (not mutually exclusive) solution may be to work toward developing a regulator with greater independent-mindedness, capacity, and the ability to itself engage forcefully and intelligently with industry. Financial regulation would benefit from building in, at a structural level, greater attention to these forms of influence. Brett McDonnell and Daniel Schwarcz’s depiction of the “regulatory contrarian” may be part of this picture, as would regulatory architecture that is better set up to systematically track and justify its own decision-making processes. Nor should we underestimate the contributions made by independent observers with the benefit of good access-to-information laws. Kim Krawiec’s empirical work sheds a lot of sunlight on the process she investigates, and demonstrates what a significant role an engaged scholar can play.

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.

The Inherent, Ineluctable Instability of Financial Institution Regulation

In my last post, I concluded that the presence of government subsidies – particularly guarantees explicit (deposit insurance) and implicit (Too-Big-To-Fail) – makes the political economy of financial institution regulation different from other areas of the regulatory state. In this post, I argue that these government subsidies and moreover, the underlying reason for government subsidies, contributes to the inherent instability of financial institution regulation.

The presence of government guarantees – explicit or implicit – creates strong incentives for financial firms to externalize the cost of their risk taking onto taxpayers. But there is more to government guarantees than moral hazard. Consider the following:

Market distortion: When the government subsidizes some financial firms but not others, it distorts the market. A lower cost of capital allows the subsidized firms to undercut their competition. This can drive competitors either out of business or, if risk is being mispriced because of an asset boom, into riskier market segments (a phenomena I explored in a symposium piece).

Cheaper debt and leverage: Government guarantees also make debt cheaper than equity. This supercharges the incentives of financial firms to increase leverage. Higher leverage of financial institutions, in turn, works to increase the effective supply of money. More money can fuel asset price bubbles and mask the mispricing of risk (phenomena explored by Margaret Blair in this paper, as well as by me in a forthcoming symposium piece in the Berkeley Business Law Journal.)

Cheaper debt and regulatory capital arbitrage: Cheaper debt also supercharges financial firm incentives to game regulatory capital requirements (something I am writing about in the context of the shadow banking system. See also Jones; Acharya & Schnabl; Acharya & Richardson.

Bailouts and correlated risk: Governments face pressure to bail out firms when their risk taking is highly correlated (because multiple firms will fail at the same time). On the flip side, this creates a strong incentive for financial firms to take on correlated risk. (See, e.g., Acharya et al.). Correlated risk taking reinforces the kind of herding that behavioral finance scholars have analyzed in the context of asset price bubbles.

So feedback loops abound. What to do, then, about government subsidies?

“Stop us before we bail out again”

Is There An Elizabeth Warren of Systemic Risk?

And would that be a good thing? 

This is a bit of a tongue-in-cheek way, I suppose, of trying to tie together some of the preceding posts and pose some follow-up questions for our guest bloggers.  Let me start with the first question, does systemic risk regulation need its own version of Elizabeth Warren? 

Now obviously Elizabeth Warren is a controversial figure, with many who worship her and others who seem to think she’s one step away from the devil.  So, I don’t intend this to be a debate about her personal merits.  Instead, what I’m trying to get at (granted, through a title designed to entice and/or inflame readers) are some of the points made by our guests here today. 

For example, in Saule’s very interesting new paper, which she discussed earlier today, she urges the creation of an independent government instrumentality staffed primarily by academics, public figures, and representatives of consumer and other public interest groups.  Similarly, Brett (building on an article with Dan) argues that the Office of Financial Research could become a regulatory contrarian – “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.”

Although both concede that these proposals still leave many open questions, both, it seems to me, rely on the notion that a structural change of this sort can impact the political balance of financial reform.  That could be right, and one of the points I hope I’ve highlighted through my posts on the Volcker rule is the disproportionate investment by the affected industry in influencing regulatory outcomes. Still, though, some potential hurdles and concerns come to mind, some of which have already been thoughtfully raised by Cristie. 

For example, Cristie worries, to oversimplify her nuanced critique a bit, that regulators were not inclined to listen to real contrarians during the lead-up to the financial crisis.  I also notice that in his post Dan says:

empowered public interest groups do not simply provide regulators with additional information and perspective; they marry that information and perspective with the threat of political pressure through the use of media and public outreach.

So, I take it that Dan’s response to Cristie, at least in part, would be that successful contrarians would need to have, not only structural access, but also a type of grass-rootsy political power. Which, I have to say, brings me back to thinking about Elizabeth Warren.

Now, Paul Volcker was clearly an important public figure behind the Volcker rule. And folks like Simon Johnson and Nouriel Roubini were highly engaged in public advocacy and media play on systemic risk issues as well.  But I just haven’t noticed your average Joe or Jane in line at the grocery store talking about Paul Volcker or Simon Johnson in the same way they seem to talk about Elizabeth Warren.  Even the constant attention to Roubini’s sexual exploits hasn’t seemed to make him quite the household name that Warren has become. Does the public just find her more interesting?

Or is it because, once we move away from issues more directly related to consumers – or that seem to especially prompt their ire, such as compensation issues – it’s just not as easy to get the public engaged?  And if that’s so, what does that mean, if anything, for these types of contrarian and tripartism proposals?  Because, in addition to the incentive issues that Erik suggests make financial institution regulation different from other types of regulation, there just seems to me to be a problem with public salience and information levels, that I have to admit, is troublesome on many fronts. 

One of the things that surprised me about the Volcker rule letters was the amount of public anger they evidenced – people are really pissed off out there.  But it’s a rather ill-defined and amorphous sense of anger.  Rarely was there any indication that the writer understood, or cared, what proprietary or fund investment is, much less the ways in which FSOC interpretation of the Volcker rule’s complex and ambiguous provisions might govern such activities.  This suggests, not only the opportunity for principal-agent problems vis-à-vis elected officials, but potentially with any empowered public interest groups as well. 

That’s why, as I mentioned in my first post today, the normative implications to be drawn from this conversation will, I think, be in the eye of the beholder. Those who perceive elected officials as overly responsive to public sentiment will, I suspect, view federal courts or, in this case, agencies, as the gatekeepers against panic-driven regulation.  And the last thing they probably want is an Elizabeth Warren of systemic risk riling up the public about issues it doesn’t understand.  System critics concerned with transparency and accountability, however, will likely be troubled by the disproportionate (and relatively unified when it comes to externalizing costs, to come back to Erik again) influence of regulated financial institutions that we’ve been discussing here today, even when the regulation at issue is of questionable utility. 

Preventing Capture through Consumer Empowerment Programs

Excessive industry influence is a potential problem in many regulatory domains.  This influence can operate through diverse mechanisms, including implicit promises of future employment or political contributions, cultural and behavioral forces, and industry production of excessive amounts of information. In the wake of the global financial crisis, Gulf oil spill, and West Virginia mine disaster, academic interest in understanding and limiting these forms of regulatory capture has skyrocketed.  

One of the most exciting recent projects on this topic is an edited volume, Preventing Capture: Special Interest Influence in Regulation, and How to Limit It, which is forthcoming in 2012.  The diverse backgrounds and preeminence of the editors -- Daniel Carpenter, Steven Croley, and David Moss -- have allowed them to assemble an interdisciplinary group of leading scholars to “definitively revise and recast our understanding of capture and contribute to increasing the accuracy and practical impact of scholarly work on the issue.”

I was fortunate enough to be invited to join this group, largely because of the paucity of academics who study insurance regulation – one of the largest and most important domains of state regulation (and one in which allegations of capture are common).  My chapter examines programs that attempt to offset or temper industry influence by affirmatively promoting the influence of consumer groups or representatives.  These programs come in two basic varieties. First, Texas maintains an independent government entity known as the Office of Public Insurance Counsel (OPIC), which is tasked with representing the public interest in various regulatory matters.  Such “proxy advocacy” is also common in utilities regulation.  Second, California and the National Association of Insurance Commissioners (NAIC) operate programs that amplify the voice of public interest groups who would ordinarily be under-represented in the regulatory fray.  For the last five years, I have served as a consumer representative in the NAIC’s program.  These programs fit the general model of “tripartism,” whereby independent public interest groups are endowed with formal authority to participate in regulatory processes.

Based on these short case studies, the chapter offers guidance about when these types of programs are most likely to be effective, at least in the context of insurance regulation and similar regulatory settings, such as state securities and banking regulation.  First, it suggests that proxy advocates such as OPIC are most effective when there exists a clear consumer position, new information is likely to impact regulatory results, and the involvement of non-industry stakeholders is limited.  The Chapter argues that these conditions are met in a broader set of circumstances than the current deployment of proxy advocacy might suggest.  At least in insurance regulation, there is often a coherent set of “consumer positions” that can be identified based on historical trends.  Although these positions may not always (or perhaps even often) represent optimal regulatory policy, they will tend to be under-represented in regulatory processes that do not substantially involve non-industry stakeholders.  In non-salient, complex, and state-based fields like insurance regulation, non-industry stakeholder engagement in regulation is often quite rare.

At the same time, tripartism enjoys important comparative advantages to proxy advocacy in certain settings.  For instance, unlike proxy advocates, tripartite schemes do not require the existence of a clear-cut consumer perspective.  Perhaps even more importantly, in contrast to proxy advocacy, tripartism may be capable of influencing results even if non-industry stakeholders already present “consumer positions” to regulators.  This is because empowered public interest groups do not simply provide regulators with additional information and perspective; they marry that information and perspective with the threat of political pressure through the use of media and public outreach.   A key shortcoming of tripartism, however, is that it requires a robust network of public interest groups with broad-ranging expertise and interests.  As noted above, such a network does not always exist, resulting in tripartism allowing a single public interest group to gain excessive influence.

Real Reform In Britain? (by Lawrence Baxter)

From my colleague Lawrence Baxter comes this very useful comparative glimpse at the financial reform questions we're addressing here today:

This morning the British Independent Banking Commission (ICB) released its long-awaited Final Report. Given the clear direction signalled by the ICB in its Issues Paper: Call for Evidence released a year ago, the recommendations in the report had already been anticipated for months. The British Government has accepted the report, at least in principle. The Financial Times reports that the Chancellor, George Osborne, Business Secretary, Vince Cable, and the Prime Minster, David Cameron agreed last week that the report’s main recommendations should be enacted.

The Report contains three major sets of recommendations:

1. Retail banking operations should be “ring-fenced.” In other words, they should separated as legal entities from the larger corporate banking group of a “universal bank” (for example, one that provides wholesale and investment banking operations as well), and have their own boards of directors. The retail entity would be restricted to certain activities, and other financial organizations would be prohibited from engaging in these activities. There are numerous related restrictions which, in sum, vaguely resemble the kind of firewall created in 1933 by the US Glass-Steagall Act (now repealed). 

2. Large banks should have higher “loss absorbency” capacity. This is defined through a series of requirements varying according to the size of the risk-weighted asset ratios of these organizations, their leverage ratios, and whether they are global systemically important financial institutions (so called “G-SIFIs).

3. Stricter enforcement of market efficiency and competition rules (the analogy to US antitrust laws), including greater transparency requirements. An interesting element of this recommendation is that the “product ranges” of banks should “include an easily comparable standardised product.” Here let us recall the continuing battle in the US over the Consumer Financial Protection Bureau and its powers.
The Report also welcomes the British government’s commitment to give the recently created Financial Conduct Authority a “new primary duty to promote competition.” A timely cross-Atlantic comparison is the enhanced investigation currently being conducted by the Fed of the proposed acquisition of ING Direct by Capital One–a deal that would have been hastily approved only a few years ago.

These are strong recommendations based to some extent, in my view (here and here), on the very sound principle of subsidiarization, which is designed to inject modularity into the structure of the behemoth universal banks. The recommendations are, however, a little weaker than banks had originally feared, and they would only need to be fully implemented by 2019 (timing designed to coordinate with the Basel III implementation schedule). As a result, the stocks of some British banks actually rose today, notwithstanding the fact that the recommendations will cost the industry approximately $9.5 Billion (£7 billion). A major part of this cost is the result of the higher cost of funding that investment and other non-retail banking will incur if they can no longer use the inexpensive contributions of retail depositors.

Of course the industry and its allies, including the Confederation of British Industry (CBI), are howling their opposition to the recommendations. The head of the CBI, John Cridland, was so moved that he delightfully called the anticipated ICB recommendations “barking mad.” So until the British Parliament actually enacts them into law we cannot be certain of their final form and strength.

But one should salute a sincere, thoughtful and robust effort on the part of the Commission to get at the source of one of our major sources of financial instability, namely the sprawling universal banks that, by virtue of their necessary Too-Big-To-Fail nature, hold all of us hostage to their fortunes.

Can we expect similar fortitude from our non-independent and grotesquely bureaucratic Financial Stability Oversight Council?

x-posted at theParetoCommons

Systemic Risk Regulation as a Political Problem: A (Modified) Model of Tripartism

Reframing systemic risk regulation as a political dilemma inspired me to take a closer look at the possibility of introducing some form of tripartism in this area.  The concept of tripartism as an element of regulatory design comes from Ayres and Braithwaite’s seminal work on responsive regulation.  To put it simply, Ayres and Braithwaite argued that empowering public interest groups (PIGs) provided a potential cure for regulatory capture.  This notion, however, is of limited value in the context of financial systemic risk regulation. The general public lacks specialized expertise necessary to participate in complex and often technical decision-making in the systemic risk regulation area. Even organized PIGs in the financial sector tend to focus on consumer protection rather than systemic risk issues. Therefore, this traditional concept of tripartism is not likely to work in financial sector regulation.

In a recent paper, “Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation,” available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1924546, I attempt to outline, in very broad strokes, a modified tripartite system that might work in this area.  In the absence of “organic” systemic risk PIGs, I propose the statutory creation of a functional equivalent to such a PIG: the Public Interest Council. The Council would have a special status as an independent government instrumentality created by Congress and located outside of the legislative and executive branches. Its explicit charge would be to protect the interests of the U.S. taxpayers in preserving financial stability and minimizing potential systemic risk in the financial markets. It would comprise individuals who are independent from both the industry and regulators and who are competent in issues of financial regulation – primarily academic experts, but also certain public figures (not holding any official post) and representatives of consumer and other public interest groups.  Although the Council would not have any legislative or executive powers, it would have broad statutory authority to collect any information it deems necessary from any government agency or private market participant, and to conduct targeted investigations and reviews of specific issues and trends in financial markets. The Council’s statutory powers would also include the right to request regulatory agencies to report on their activities or to take action in identified areas, to participate in regulatory rule-making, and to petition Congress to take action with respect to specific issues of public concern.

In effect, the Council’s main function would be to impose structural checks on regulatory capture and to diffuse the industry’s power to control the regulatory agenda by putting both financial regulators and financial institutions under constant and intense public scrutiny.  In that sense, the proposed Council may be viewed as a permanent equivalent of a congressional advisory commission whose task is to shine the disinfecting sunlight on the workings of the financial services industry and its official overseers before the disaster strikes.

This proposal is likely to raise some eyebrows. In the article, I discuss some of the main potential criticisms and challenged. More than anything, this is truly a thought experiment. But I do believe it raises a critically important set of issues that need to be addressed more explicitly.

The Sausage Making of Financial Reform, II

In my last post, I was discussing the public comments on the Volcker rule.  As noted, 7316 of those comments are a virtually identical form letter.  I outline the possible implications of that in the paper.  But the remaining 515 comments submitted by private individuals that were not traceable to a form letter also yield a useful comparison to letters from other groups.  

Table 2 breaks down the comments by group and word count.  Figure 2 displays this information graphically, showing the distribution of word count by: private individual not using the PIG form (in red), private individuals using the form (in blue), and all others (in green). (You can click on any image to enlarge).

There are three spikes in the data, at less than 50 words, at 200-249 words, and at 250-299 words (note the larger sizes of the two bins at far right, representing comments with 350-799 words and those with 800 words or more).  The spikes at 200-249 words and 250-299 words represent the PIG form letter and its slight variations (in it’s original form that letter is 244 words.) The spike at comments of less than 50 words represents only letters from private individuals. 

The shortest comment -- only a single word, “regulate” -- was submitted by a private individual.   The longest comment, received from SIFMA (the Securities Industry and Financial Markets Association) measures 19,500 words.   The industry and trade group comments are, as a general rule, lengthy, contain cogent arguments on behalf of a generally narrow interpretation of the Volcker Rule’s scope of prohibited activity, advance detailed legal arguments relying on numerous statutes and cases, reference the Dodd-Frank legislative history, and often contain thorough empirical data. They are meticulously argued and carefully drafted. 

In contrast, comments from the general public tend to be short -- the average word count, excluding the PIG form letters, is only 86, and roughly half of the comments, again excluding those using the PIG form letter, are less than 50 words.  In addition, these public comments by and large lack specific suggestions or recommendations for interpreting and implementing the Volcker Rule, generally urge that the rule be “enforced” or “adopted,” contain many grammatical, punctuation, and typographical errors, and express extreme anger at the banks and, often, at the political system as well.

The meeting logs also give some insight into the work of Dodd-Frank statutory interpretation and implementation that goes on behind closed doors.  I break down those logs in great detail in the paper, but will give a brief overview here. 

Whereas financial industry representatives met with federal agencies on the Volcker Rule a total of 265 times, meetings with entities or groups that might reasonably be expected to act as a counterweight to industry representatives in terms of the information provided and the types of interpretations pressed numbered only 18. This is roughly the same number of times that a single financial institution -- JP Morgan Chase – met with federal agencies on Volcker Rule interpretation and implementation.  As shown by Table 8 and Figure 3, financial institutions, financial industry trade groups, and law firms representing such institutions and trade groups collectively accounted for 93.64% of all federal agency Volcker rule meetings, whereas public interest, labor, research, and advocacy groups and other persons and organizations accounted for only 6.36%.  Moreover, the quality of meetings with financial institution representatives exceeds that of other agency contacts on several measures.

I’ll be back again to talk about some of the implications of this research, and to relate it to the papers and posts of our other forum participants.  

 

How the Political Economy of Financial Institution Regulation is Different & The Rise of Shadow Banking

Thank you to Kim for organizing this forum and inviting me to join a group of scholars whose work I have enjoyed tremendously.

One of the framing questions that Kim asks, is “how is financial reform” different from other areas of reform or law and regulation making?” In one sense it is not. We can use many of the standard tools in the political economy tool box to make predictions about who is likely to win and loses as the sausage gets stuffed into the casing.

Regulatory Fights within the Financial Sector

For some of the vast number of Dodd-Frank rulemakings, there will be more cohesive industry groups on both sides of a fight. Think the Durbin Amendment -- debit card interchange fee issue. In those cases, well-worn theories (going back to interest group pluralism) would suggest that at least there will be a fair (if not evenly matched) fight. The more cohesive the interest group and the more it has at stake, the more likely it is to solve collective action problems and win a Beltway brawl. (If I were making odds on this fight, I would say that the banks and payment industry may have more cohesion, but there are plenty of merchants in every Congressional district who feel the pinch of being charged each time a consumer buys Cheetos with a debit card. In the end, I think the financial side will still win out, but not necessarily because of interest group dynamics. The caps on interchange fees boil down to price controls; even if the controls bite, ultimately the payment industry will find other ways to charge for their oligopoly.)

We can certainly find examples from financial regulatory history in which two financial industry groups squared off over regulation/deregulation. I’ve been doing a fair amount of research on how regulatory arbitrage and deregulation contributed to the “shadow banking system” (what’s that? for now – think of it as “securitization.”) One thing I am looking at in particular, are ways in which bank regulators slowly changed their interpretations to allow banks to participate in securitization (I am following in the footsteps of some great work that Saule has already done on incremental change in bank regulator interpretations). In one series of interpretations, the OCC gradually and creatively re-interpreted the Glass Steagall Act to allow banks to participate in securitization whether through investment, securitizing their own assets, or dealing in asset-backed securities. The securities industry trade group opposed many of these interpretations, but ultimately lost out in court.

Why is ”Deregulation” the Trend?

What is interesting is that ultimately the fight between banks and securities firms netted out to widespread financial deregulation -- not increased regulation of some categories of financial institutions or some rough equilibrium . Why did this occur? Part of this is because as Glass-Steagall slowly dissolved (it is grave intellectual error to blame its demise only on Gramm Leach Bliley – the Glass-Steagall wall started to be dismantled over two decades with regulatory actions big and small) the larger firms moved from a “if you can’t beat ‘em, merge with them” attitude. (For a comprehensive account on the tectonic shifts in financial regulation in this period, see Art Wilmarth).

Shadow Banking and Why Regulatory Walls Crumbled

But there are other reasons that explain deregulation triumphant from the 1980s through the current crisis. The compartmentalization of financial institutions into Depression-era regulatory boxes faced an onslaught from both economic and technological factors. As I noted above, I am writing on how legal change contributed to shadow banking. Although above I limited the “shadow banking system” to securitization, I actually define it more broadly to include a range of additional financial instruments – asset-backed commercial paper, shares in money market mutual funds, credit derivatives, repos – that connected household and commercial borrowers to investors in capital markets. These instruments thus formed bypasses around traditional depository banks that borrowed from depositors and loaned to businesses and households. The rise of the shadow banking system is really the history of the demise of financial regulatory compartmentalization. Again, legal change mid-wifed the birth of these instruments and helped them grow together from disparate financial markets into a system that pumped credit in one direction and credit risk in the other.

Legal change is not the only part of the story, however. The unleashing of financial risk in the 1970s, including because of the collapse of Bretton Woods, oil shocks and inflation generally, created demand for financial products that would allow individuals and businesses to manage risks via markets while mitigating market risk. At the same time technological advances, both “software” (think finance theory like Black Scholes) and “hardware” (think computers and telecom innovations), enabled capital markets to become more “complete.” (See Gilson & Whitehead).

These various forces combine to give rise to the array of shadow banking instruments that provided fresh competition for banks. This competition and economic conditions disturbed the Depression era balance and bargain in which banks received a both a regulatory license (which was protected by various laws that restricted entry and dampened competition among banks) and government subsidies (including deposit insurance) – but were subject to an array of laws designed to limit bank risk-taking (among other things). Borrowers and lenders flocked to the new instruments (this capital flight representing one form of regulatory arbitrage) and old regulations on bank competition and risk taking turned into straightjackets. So regulatory arbitrage set the stage for calls from banks for deregulation. This in turn prompted cycles of calls by non-banks and banks for deregulation and fresh regulatory arbitrage.

The turning of this great wheel of regulatory change can be seen in the origin story of the first shadow banking instrument: shares in money-market mutual funds. These funds first stole business from banks because they offered safe and liquid investments to rival bank deposits, but were not subject to Regulation Q, which capped the interest rates banks could offer depositors. Losing business, banks lobbied for the 1980 Depository Institutions Deregulation and Monetary Control Act, which demolished Regulation Q. A few years later, money market mutual funds responded by successfully convincing the SEC to allow them to price their shares with a fixed Net Asset Value, which would give investors the impression (or illusion) of the safety of bank deposits.  (For more, see Birdthistle)

The Big Reason Financial Institution Regulation is Different: Externalizing Cost onto Taxpayers

But there is more to the “deregulation” picture than regulatory competition in both financial and political markets. Perhaps the biggest driver of deregulation and the most important reason financial regulation is different than other forms of regulation is the presence of government subsidies, particularly government guarantees. Whereas interest group competition might check regulatory change, financial institutions have every incentive to externalize cost onto the most diffuse political group of all – taxpayers.

These government guarantees provide some of the thorniest problems in regulatory design. Even explicit guarantees – like deposit insurance – are difficult to measure and therefore difficult to counter. Implicit guarantees (Too-Big-To-Fail) are hard to detect with certainty ex ante. Yet they may also become self-fulfilling prophecies: if enough market participants act like the guarantee exists, they will structure their financial investments accordingly and make it hard for a government not to bail out the firm. At the same time, their implicit nature gives them plausible political deniability for the guaranteed and the government guarantor alike.

Now everyone and their tio understands this Big Picture point today in the wake (or in the interlude) of the financial crisis. But financial regulation is an ongoing process. At some point, the spotlight turns off (and many legal scholars will move on to other things). Where will everyone and their tio be in ten years when bank regulators issue interpretations of obscure statutory and regulatory provisions? Saule’s work is so important because it reminds us that incrementalism – including bad incrementalism – is a persistent feature of financial regulation.

Now put that insight together with Kim’s recent research on what is happening with the Volcker Rule rulemaking process – a process that is high profile, backed by a prominent policy entrepreneur, and coming relatively soon after a financial crisis. Regardless of what you think of the merits of the Volcker Rule, the greatest and ever present challenge for the financial regulatory process is countering the incredible incentives for financial firms to externalize risk onto the taxpayer.

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.

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?

The Sausage Making of Financial Reform

Does financial reform need reforming?  How would we even know? What mode of analysis might yield insight into this question?  

Two possibilities come readily to mind.  One, which I will call the “sausage approach,” analyzes output by examining the merits of particular financial reform provisions.  If the sausage -- the financial reform -- appears unwise on the merits, then one might be able to infer procedural problems of financial reform from this conclusion.  For example, a provision that appears overly favorable to the big banks might lend itself to an inference that the legislative outcome is the result of special interest influence.  In contrast, one that appears to impose costs in excess of its benefits might be attributed to pandering by elected officials. 

The other method, which I will call the “sausage-making approach,” examines inputs by observing the process of financial reform more directly. Do industry groups appear to be attempting to influence outcomes?  At what stage of the lawmaking process?  Do lawmakers appear receptive to those overtures?  Is there a meaningful counterbalance to influential industry voices?  What is the public salience of the reform?  Does the public appear interested? Involved?  Are relevant public interest groups (PIGs) engaged in the issue? 

Most Dodd-Frank analyses have so far been of the sausage variety.  Numerous books and articles substantively critique Dodd-Frank against alternative statutory schemes, debating which course is wiser.  Though these analyses are essential contributions to the literature, the substantive method has a serious drawback: there is little agreement on what the ideal response to the financial crisis should have been.  Moreover, the Dodd-Frank sausage is not yet finished and will not be for many years to come.  Given that so much of the substantive effect of Dodd-Frank depends on still-pending regulatory rulemaking, the sausage method is especially unsatisfying at this stage of Dodd-Frank’s existence. 

In a new working paper, Don’t “Screw Joe the Plummer”: The Sausage Making of Financial Reform, which I just barely managed to get up on SSRN before our forum launched, I direct the sausage-making approach at section 619 of the Dodd-Frank Act, popularly known as the Volcker rule and frequently touted as one of the most important pieces of modern financial reform.  Although the sausage-making approach has some limits, which I’ll come back to later, it has the advantage of neutrality on the Volcker rule’s merits.  In other words, the Volcker rule makes for an interesting financial reform case study, not because it is wise – that may or may not be the case.  Rather, the congressional maneuvering that accompanied the Volcker rule’s passage and the importance of proprietary and fund activities to banks’ bottom line signaled that the provision had the potential to illuminate questions of whose voice gets heard on a major issue of financial reform as the sausage is really getting made.

As part of this examination of Dodd-Frank sausage making, I analyze the roughly 8000 public comment letters received by FSOC on the Volcker rule and the meeting logs of the Federal Reserve, the CFTC, the SEC, and the FDIC. This analysis reveals a surprising level of public activity, but also a stark difference in investment by financial institutions versus all other actors in influencing Volcker rule implementation.  As I will come back to in later posts, the normative implications to be drawn from that analysis are in the eye of the beholder, and I expect that other forum participants, particularly Brett and Cristie, will be addressing this normative question in a more robust way than my sausage-making method allows.

But, nonetheless, there is much understanding to be gained from a sausage-making examination of the Volcker rule. For example, the public comment letter analysis reveals that a consortium of PIGs managed to generate a surprising level of Volcker rule interest among private citizens, who sent in letters by the thousands.  But, 7316 (or 91%) of those comments are a virtually identical form letter. 

The comment letters from private citizens that were not a form letter reveal a great deal – people are angry about the economy, about the plight of working Americans, and about the politicians who allowed the financial crisis to develop.  The banks are “fools,” hogs,” and “criminals” out to “screw joe the plummer [sic]” and should be “put in jail,” receiving no more “bailouts with citizens’ money.” Political officials fare little better.

Presumably these comments reveal something to FSOC, both about public attitudes and about the power of the relevant PIGs on this issue.  But at the same time, as I will discuss in more detail in my next post, the contrast with the meticulously drafted, argued, and researched – though far less numerous -- letters from the financial industry and its representatives is stark.  In comparison, the citizen letters are short and provide little evidence that citizen commenters even understand, or care, what proprietary or fund investment is, much less the ways in which FSOC interpretation of the Volcker rule’s complex and ambiguous provisions might govern such activities.