Financial Regulation, Part Two: Rules

I concluded lmy last post with the question, "Do you really believe that ... this time we've fixed the too-big-to-fail (TBTF) incentive problem, that this time is different?" Presumably your answer depends on your feelings regarding the efficacy of Dodd-Frank's (DF's) increased capital requirements and intensified scrutiny of financial institutions.

Needless to say, I have my doubts.

Left to their own devices, lawyerly types (and politicians and regulators come disproportionately from that realm) tend to aspire to write exhaustive sets of rules that dictate what can and can't be done, when, and by whom. Economists call that a "complete contract." DF, at 2000+ pages, is an example of an attempt at such a complete contract, which financial institutions were forced to "sign."

One can entertain the idea of a complete contract in principle, but the idea of making rules to govern all possible contingencies is preposterous in practice. (Note that many important possible contingencies are surely not even remotely conceivable now -- more on that in the next post.) No one is so naive as to believe that DF is truly a complete contract, but the spirit of the attempt is one of complete contracting. Let's call it "rules-based" regulation.

Of course all legislation, regulatory or otherwise, must be rules-based. Rules, after all, are the essence of law. And rules, even massive sets of rules, can be very good things. There is little doubt, for example, that rules enforcing contractual and property rights can play a large role in generating economic prosperity. And there are some good entries in the DF rulebook.

But there are three key related problems with naive implementations of rules-based regulation, and it's important to be aware of them vis-à-vis DF. First, naive rules-based regulation is mostly backward-looking, effectively regulating earlier crises, with potentially very little relevance for future crises. It's terribly hard, as they say, to drive forward when looking only in the rear-view mirror. When the next major financial crisis hits, it will likely arrive via avenues that DF missed, and then DF will be augmented with another 2000+ pages of rules looking backward at that crisis, and so on, and on and on.

Second, naive rules-based regulation invites regulatory arbitrage. That is, as soon as rules are announced, firms start devising ways to skirt them. Indeed modern finance is in many respects an industry of very smart people whose job, for a given set of rules, is to work furiously to reverse-engineer those rules (they're doing it right now with respect to DF), devising clever ways to legally bear as much risk as possible while holding as little capital as possible, by finding and taking risks missed by the rules.

Third, naive rules-based regulation invites regulatory capture. That is, the regulated and the regulators get cozy, and the regulated eventually "capture" the regulator. First the regulators and regulated work side by side, implicitly or explicitly as in DF. Next the regulated are making "suggestions" for creative rule interpretation. Before long the regulated are helping to write the rules, crafting the very loopholes that they'll later exploit.

What to do? How to deal with the fundamental incompleteness of the regulatory contract? More specifically, given the long-term impotence of naive implementations of rules-based regulation, how really to thwart the adverse incentives of TBTF? If rules are unavoidable, and if naive rule implementations are problematic, are there better, sophisticated, implementations?

To be continued...