Focusing More on Outputs and on Markets: What Financial Regulation Can Learn from Progress in Other Policy Areas

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Focusing More on Outputs and on Markets What
Financial Regulation Can Learn from Progress in
Other Policy Areas

• Lawrence J. White
• Stern School of Business
• New York University
• lwhite_at_stern.nyu.edu
• Presentation at FDIC, Arlington, VA, November
  30, 2007

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Overview

• Background on regulation (in general)
• Examples, in other areas of regulation, of
  success stories that focused on outputs and
  markets
• Examples of four proposals for reforms of
  financial regulation that would have focused on
  outputs and markets (but have not been adopted),
  and one area of successful flexibility bank
  reserve requirements and the Fed Funds market
• Conclusion

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Classifying types of regulation

• Economic regulation
• Health-safety-environment regulation
• Information regulation

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Economic regulation

• Control over prices or profits or entry or exit
• The Civil Aeronautics Boards (CAB) former
  regulation of the airline industry
• Bank regulators former ceilings on deposit
  interest rates, limits on entry, branching
• The Securities and Exchange Commissions (SEC)
  former restrictions on which bond rating
  companies can become a nationally recognized
  statistical rating organization (NRSRO)

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Health-safety-environment regulation

• Control over production processes or inputs or
  outputs
• The Federal Aviation Administrations (FAA)
  safety requirements for airlines and pilots
• Bank regulators safety-and-soundness regulatory
  requirements for banks
• The SECs minimum capital requirements for
  broker-dealers and competency requirements for
  securities brokers

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Information regulation

• Control over the types and formats of information
  
• Department of Transportations (DOT) regulation
  of fare announcements by airlines
• Bank regulators interest rate disclosure
  requirements
• SECs disclosure requirements for publicly traded
  companies

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Where does corporate governance regulation fit in?

• The goal of corporate governance regulation
  assuring investors of a fair outcome is not all
  that different from the safety goals of the FAA
  or the Consumer Product Safety Commission (CPSC)

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Classifying regulatory implementation

• Command-and-control regulation Centrally devised
  (macro) solutions imposed at the micro level
  often one-size-fits all
• Technology standards (inputs oriented)
• All firms must adopt a specific technology
• Performance standards
• All firms must meet a specified level of
  performance, but can choose their technologies
• Bubble concept
• The firm is judged on its aggregate performance
  (put a plastic bubble over the entire firm), not
  on the performance of individual units

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Regulation of the auto industry exemplifies all
three concepts

• Vehicle safety standards embody technology
  requirements and performance requirements
• Vehicle pollution control requirements embody
  performance requirements
• Vehicle fuel mileage requirements (CAFE) embody
  the bubble concept

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Going beyond command-and-control embracing
outputs and markets

• Cap-and-trade system for controlling SO2
  emissions
• Electromagnetic spectrum auctions
• Dedicated-access-privilege programs for
  fisheries

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Cap-and-trade system for SO2 emissions

• Replaces command-and-control with much greater
  flexibility
• National aggregate maximum amount of annual SO2
  emissions has been allocated among electric
  utilities
• They can trade SO2 emissions permits among
  themselves
• This encourages greater efficiency and innovation
• The SO2 program has been highly successful

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Electromagnetic spectrum auctions

• Replaces Federal Communication Commissions (FCC)
  command-and-control allocation of broadcast
  licenses
• Auctions have allowed greater flexibility in use,
  greater efficiency
• Auctions have generated tens of billions of
  dollars for the federal treasury
• Spectrum auctions are considered highly successful

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Dedicated-access-privilege (DAP) programs for
fisheries

• Fisheries are a watery commons and often suffer
  from the tragedy of the commons
• Response of the National Marine Fisheries Service
  (NMFS) has been command-and-control regulation
  for overfished fisheries
• DAP programs are like cap-and-trade
• Set an annual total allowable catch TAC
• Allocate TAC among fishermen
• Allow trading of the allocations
• DAP programs in U.S. and especially abroad have
  been highly successful

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Financial regulation

• Financial regulation is not different from other
  regulation
• Financial regulation sometimes encompasses
  technology standards and sometimes encompasses
  performance standards often one-size-fits-all
• Where are the programs that emphasize outputs
  and markets?
• Bank reserve requirements and the Fed Funds
  market
• And some proposals
• Benston/Kaufman proposal for mandatory
  subordinated debt for banks
• Klausners proposal for CRA reform
• Ronens proposal for financial statement
  insurance (FSI)
• My proposal for NRSRO reform

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Bank reserve requirements and the Fed Funds market

• Depository institutions are required to hold
  funds in reserve as vault cash or as deposits
  at the Federal Reserve, calculated as a fraction
  (e.g., 10) of their deposits
• The Fed Funds market permits banks to buy and
  sell excess reserves and thus provides
  flexibility in meeting the requirement
• Floor and trade

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Capital requirements for banks

• Depository institutions are required to hold
  minimum levels of capital (net worth) as a of
  assets
• Capital is a direct buffer that protects
  depositors (or the deposit insurer) against
  reductions in asset values
• Capital represents the owners stake in the bank
  a greater stake reduces the incentive for
  risk-taking

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The Benston/Kaufman 1988 proposal for mandatory
subordinated debt

• As part of their capital requirement, depository
  institutions should be required to issue a
  tranche of subordinated debt
• Sub debt would bring a set of stakeholders who
  would lose from the down side of risk-taking but
  not gain from the up side
• Sub debt holders might restrain risk-taking by
  owners (or managers on owners behalf)
• Regulators might use the yields on subordinated
  debt to help identify problem institutions
• The Benston/Kaufman proposal has never been
  implemented

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The Community Reinvestment Act of 1977

• The CRA requires banks to meet the credit needs
  of the local communities in which they are
  chartered consistent with safe and sound
  operation of such institutions
• The CRA is command-and-control regulation
• Technology standards from 1977-1995
• Performance standards since 1995

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Michael Klausners 1995 reform proposal

• A banks CRA annual commitment would be
  specifically defined as a dollar amount of loans
  originated and/or held
• The obligation could be transferred to other
  lenders a market could develop
• Consciously modeled on the SO2 cap-and-trade
  program
• Klausners proposal has never been implemented

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Current accounting/auditing arrangements the
problem

• Investors and creditors rely on financial
  statements
• Auditors are hired (and can be fired) by
  corporate boards of directors, who are selected
  by managements
• Managements always favor rosy scenarios
• Auditors face an inherent conflict of interest
• After-the-fact liability suits are an imperfect
  solution
• Sarbanes-Oxley command-and-control regulation is
  not a satisfactory solution

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Joshua Ronens 2002 proposal

• Companies would purchase financial statement
  insurance (FSI) from a competitive insurance
  market
• The insured amount and the premium would be
  public information
• FSI ends the auditors conflict of interest The
  FSI insurer would hire the auditor and would be
  interested in the truth
• Rosy scenario means premiums that are too low
• Pessimistic scenario means that the insurer would
  be underbid by an insurer with a more accurate
  auditor
• Ronens proposal has not been acted upon

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NRSRO regulation

• The bond rating industry was subject to
  protective regulation by the SEC, 1975-2006
• In 1975 the SEC created the category nationally
  recognized statistical rating organization
  (NRSRO) and grandfathered Moodys, SP, and Fitch
• The NRSRO category created an artificial barrier
  to entry
• The SEC never defined NRSRO
• When it proposed a definition (in 1997 and 2005),
  it focused on inputs
• The NRSRO designation process was opaque

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My 2002 reform proposal

• Plan A abandon the NRSRO category and allow
  financial markets to form their own judgments as
  to reliable bond ratings and rating companies
• Plan B retain the NRSRO category, but the SEC
  must cease being a barrier to entry and must
  certify NRSROs on the basis of outputs
  efficacy in predicting bond defaults rather
  than inputs
• This proposal was not acted upon but the new
  (Sept. 2006) NRSRO law may reduce the barrier to
  entry or not

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Conclusion (1)

• An outputs and markets orientation would be
  worthwhile for financial regulation
• There are successful examples in other regulatory
  areas
• Bank reserve requirements and the Fed Funds
  market are an example of successful application
• The mandatory sub debt proposal, Klausners CRA
  proposal, Ronens FSI proposal, and my NRSRO
  proposal show that these ideas are more widely
  applicable to financial regulation
• There are surely more areas of financial
  regulation where these ideas could be applied

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Conclusion (2)

• My message to financial regulators and policy
  makers and to financial sector researchers
• Think expansively and creatively!
• Think outputs and markets!