September 13, 2011
Adaptive Regulation and Channeling Politics
Posted by Erik Gerding

Here is my third contribution to the Faculty Lounge Online Forum on the legislative and regulatory process of financial reform.  Check out the posts by the other contributors including, Kim Krawiec (Duke),  Christie Ford (Univ. British Columbia), Brett McDonnell (Minnesota), Saule Omarova (North Carolina), and Dan Schwarz (Minnesota). 

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.

This has turned into my most controversial proposal when I go to workshops. Law faculty (possiblythe more liberal ones) have thrown up all over this. Pay for performance in executive compensation has been enormously controversial. But the lesson I take away from that is not that incentives don’t work, but rather that we need to be extremely careful in designing incentive structures.

Of course, many people work in the public sector for reasons other than monetary compensation. Moreover, we need to ensure that compensation, promotion and retention devices are not punitive and don’t encourage overly risk averse behavior by regulators. Yet the deep antipathy from the professoriat to even thinking about regulator compensation is a little disappointing.

Norms and Intellectual Capital

I have taken a second angle at looking at addressing individual regulator behavior that is somewhat in tension with the rational actor basis of the compensation model. We need to pay more attention to prevailing norms in the public sector. These norms can be just as powerful a force in shaping official decisions as allocating money, credit, or blame.

Two lessons should be underscored. First, public service can be a noble calling. Second, regulators by necessity need to exercise judgment (see my earlier post for a sense of the problems with over-reliance on “automatic” regulations). One of the things I’ve noticed in editing the drafts of my book chapters is how assumptions about regulators creep into my own text. I’ve excised all references to “bureaucrats.”

What can we do to foster norms among regulators and to develop intellectual capital inside agencies? I explore a few ideas including creating more think tanks and policy planning staffs inside agencies. The Federal Reserve Banks have active research arms and the military branches have various graduate colleges. Lawyers inside agencies should have something similar. We should also regularly secund regulators to counterpart agencies in other nations to build cross-border relationships and foster innovative thinking.

Automatic Regulations

In my last post, I wrote about the dangers of excessive reliance on automatic regulations. This shouldn’t be construed as opposition to countercyclical capital requirements, loan loss reserves and the like, but more as a caution of their limitations. We need fairly good – not perfect – economic models for countercyclical regulations to work. There is a danger of putting too much of regulation on autopilot, including what engineers call the “automation bias.” In the wake of some transportation disasters, engineers have worried that automated safety systems have lulled human drivers into a false sense of security. Again, judgment by regulators is necessary (Amar Bhide has written on the dangers of removing judgment from financial market participants).  A more modest countercyclical proposal would be to make regulator budgets countercyclical. I proposed this in my first law review article, in which I argued that the SEC’s budget should be tied to overall market cap to allow it to keep up with deal flow during boom times.

In the end, automatic rules are a piece of the puzzle but no panacea. I hate to sound like a broken record, but automation will not remove the need for regulator interpretation, enforcement, and judgment. We legal scholars need to bring a little bit of (legal) realism to policies championed by economists.

Institutional Re-design

I also propose a number of institutional devices designed to counter the regulatory cycle that Brett describes. To ensure that deregulation is thoughtful, I look at “double-key” approaches in which two different agencies must sign off on a repeal of a regulation. To some extent, Dodd-Frank has already incorporated this idea as several provisions condition the ability of one agency to grant exemptive relief on consent from other agencies (this is the hazard of taking so long to write a book -- some ideas no longer look so novel). Still, there are ways regulators can grant exemptions (forbearance, interpretative letters, no-action letters) that might skirt what Dodd-Frank considers "exemptions."

I also discuss “soft” countercyclical approaches, including what I call “memento mori” devices. These rules would be triggered by financial booms and would require individual regulators to state what actions they are taking to “remove the punch just when the party gets starting.” Lastly, I look at using technology to create fairly radical transparency of financial regulation. This follows some of my work of financial risk models. Complete ex ante transparency of regulatory decisions may not be always desirable (for example during a bank panic), but we need to think hard about ex post transparency.

# # #

None of these proposals may be wholly satisfying. Still reform needs more than critique. Thankfully there are financial regulation scholars, like Cristie, who are deeply immersed in public law.

Administrative Law, Financial Crisis, Financial Institutions, Legal Scholarship | Bookmark

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