Some ‘good’ principles of financial regulation

Readers of this blog know the extent of my love for banking regulation. I love regulation. I really do. Otherwise I wouldn’t have much to write about.

Irony aside, I recently read a very good paper by Calomiris (Financial Innovation, Regulation, and Reform, 2009, which you can find here) that made me give regulation a rethink (to be frank, I was disappointed that there’s not much about financial innovation in this paper, but the rest is pretty good).

Calomiris is a free-market guy. He makes it clear is most of his papers, this one included:

The risk-taking mistakes of financial managers were not the result of random mass insanity; rather they reflected a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. Risk-taking was driven by government policies; government’s actions were the root problem, not government inaction.

He is right. But he also seems to be a ‘realist’ (if ever this really means anything). He considers that, given our current distortive institutional framework, the best thing we can do is to mitigate its effect through proper regulation. He writes:

If there were no governmental safety nets, no government manipulation of credit markets, no leverage subsidies, and no limitations on the market for corporate control, one could reasonably argue against the need for prudential regulation. Indeed, the history of financial crises shows that in times and places where government interventions were absent, financial crises were relatively rare and not very severe.

[…But] it is not very helpful to suggest only regulatory changes that are very far beyond the feasible bounds of the current political environment. […] Absent the elimination of [all the policies described above], government prudential regulation is a must.

In a way, he has a point. Whereas I’d like to see the implementation of a free banking system, I also have to admit that this possibility is pretty unlikely to ever reoccur (unless a once in a thousand years financial collapse suddenly strikes). Which led me to think about a ‘second best’. This ‘second best’ solution should follow the principles I described here (where I argued in favour of a stable rule set and regulatory framework) and here (where I agreed with Lars Christensen and John Cochrane and argued against macro-prudential regulations). This is what I wrote:

Stable rules are a fundamental feature of intertemporal coordination between savers and borrowers, between investors and entrepreneurs. In order for economic agents to (more or less) accurately plan for the future, for entrepreneurs to develop their business ideas and anticipate future demand, for savers to invest their money and know that their property rights are not going to disappear overnight and accordingly plan their own delayed consumption and provide entrepreneurs with directly available funds, the economic system needs a stable and predictable rule framework. Production and investments take time and as a result involve uncertainty, which should not be exacerbated by an instable rule set. The rule of law is part of this framework. Monetary policy, financial regulation and government policies should follow the same pattern, instead of being discretionary.

What I am about to describe is a non-exhaustive list of ‘good’ principles of regulation that fit (to an extent) a free-market framework. I may update the list over time. Following the principles above, and even though not perfect, a ‘second best’ solution would have to be:

1. As least distortive as possible (i.e. introducing as few loopholes and incentives to game the rules as possible)
2. As stable as possible (i.e. no discretionary powers), and
3. As simple, transparent and clear as possible (i.e. a few clear and straightforward rules are better than a multitude of obscure and complex ones)

On the monetary policy side, despite its flaws, NGDP targeting seems to be the only ‘easily implementable’ policy that meets the three criteria. I won’t discuss it here (see The Money Illusion, The Market Monetarist, Worthwhile Canadian Initiative, and many other blogs for more information). On the slightly ‘less easily implementable’ side, the ‘productivity norm’ would nonetheless be an even better alternative (see George Selgin’s implementation here, from page 64 onwards).

What about financial and banking regulation? In order to respect the three fundamental rules described above, regulators should:

1. Define few transparent, straightforward limits and ratios based on objective and easily measurable criteria that are neither pro- nor counter-cyclical
2. Not impose their own perception of risk to the market
3. Not vary regulatory limits and requirements over time
4. Not publicly shame financial institutions that respect regulatory requirements even if borderline-compliant: the regulators’ role is to make sure that institutions respect the requirements, period
5. Publicly make clear that regulations only represent minimums, that regulators are only here to make those minimums respected, and that it is the role of market actors to identify stronger from weaker institutions within those regulatory-defined limits
6. Not interfere with financial institutions’ strategy and internal organisational structures: harmonising business models takes the risk of weakening the whole system
7. Refrain from making any comment unrelated to the (non)compliance of institutions to regulatory requirements
8. Allow the market process to run its course and not institutionalise moral hazard by implementing bailout and other backstop mechanisms

Banking regulation is divided into micro-prudential and macro-prudential regulation. The former provides individual banks with rules they have to respect at all times, independently of the performance of the whole economy. The latter provides all banks with rules that vary according to the state of the economy, independently of the performance of each bank. Following the principles above, fixed and straightforward sets of micro-prudential regulations may be acceptable. On the other hand, most macro-prudential regulations would be eliminated given their discretionary component and their variability over time. It is indeed very hard for regulators to identify bubbles and other excesses (see White, 2011, here). They have a poor track record at it. Discretion could well prevent a bubble from growing too much but it could also prevent a genuinely growing market to reach its full potential. Regulators suffer from the central planner’s problem. As Hayek said in his essay The Use of Knowledge in Society:

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.

I can already hear the rebuttals: “but counter-cyclical macro-prudential policies would help mitigate the bust after the boom!” To which I would respond: “how do you identify a ‘boom’?” For a bust to occur, a boom must be unsustainable. Solid and sustainable growth may well happen and should not be interfered with by counter-cyclical regulations that would in fact not be counter-cyclical at all in this case. Nominal stability is primarily the role of monetary policy, which should promote a stable framework to the real economy. An unsustainable boom is likely to emanate from nominal instability. The goal of regulation is not to mitigate the effects of destabilising monetary policies.

Of course, this does not mean that one should not strive to reduce political and regulatory distortions. ‘Idealists’ (if ever this also means anything) are a necessary part of a healthy democratic process. Moreover, too much compromise can be dangerous: where to fix the limit? Because the very distortive sources are still present, crises can still occur and provide extra arguments to further expand the regulatory burden.

PS: I’ll provide examples of regulations that comply or not with those principles in a subsequent post. This post would have been too long otherwise!