Let's Make Financial Regulators Work For Us

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Despite spending hundreds of billions of dollars to bail out many of the world's major financial institutions, and issuing thousands of pages of new regulations, policymakers have still not addressed the fundamental flaw in financial regulatory systems.

In the fifteen years before the 2008 global financial crisis, financial regulators made decisions and took actions that they knew, or should have known, were destabilizing financial firms, with little notice by the public. This systemic failure was very profitable for the executives of financial firms, but it wrecked havoc on national economies.

Consider some of the missteps of U.S. regulators. After 1996, the Federal Reserve allowed banks to hold less capital by purchasing "insurance" against potential losses (in the form of credit default swaps) from companies such as AIG that were highly rated by credit rating agencies. This allowed banks to grow bigger and put more funds into higher-yielding but riskier assets, creating bigger bonuses for executives. This practice was allowed to continue even though the Fed could not assess the financial viability of the companies selling the insurance, and even as the market for such insurance was growing from less than $1 trillion in 2001 to more than $60 trillion in 2007.

The Securities and Exchange Commission performed no better. From 2004 until the crisis hit, it told governments that it was supervising the major investment banks and assured investors that the firms were financially sound. These official assurances made it far too easy for the companies to tap capital markets to fund ever riskier activities, and at relatively low rates. At the same time, the SEC was reducing its ability to supervise these complex financial conglomerates by eliminating its risk management office and assigning only seven persons to oversee firms with $7 trillion in assets.

The outcome of these regulatory actions: in 2008, the five biggest investment banks either failed or survived with federal bailouts that cost taxpayers tens of billions. And the Federal Deposit Insurance Corporation, despite being required by law to take prompt corrective action, delayed acting in numerous cases despite its own evidence that banks were taking excessive risks, so that too many ended up as costly failures.

Some blame financial innovation or regulatory gaps due to too many regulators in the U.S. as the cause of the failures. However, in Iceland and Ireland, each with a single regulator and little financial innovation, there were more severe crises. And in the U.K. a single regulator watched as banks grew their assets at what were known to be reckless rates. The common element across very diverse countries was regulators that embraced bad policies and did not use the powers that they had.

Why do regulators do such a poor job? Some say it's the lure of money, arguing that regulators interpret rules in a manner that will lead to future, lucrative job offers. We don't think this is the crux of the problem.

We believe financial regulators are biased in favor of the firms they are supposed to regulate. They, like sports referees, fall prey to home crowd bias. Home teams win most of the games, and this is not due to climate, familiarity with the field, or to the positive effect of fans on player performance. Instead, as demonstrated by Tobias Moskowitz and Jan Wertheim in Scorecasting, the home team advantage arises because referees are human, and humans tend to conform to the views of the crowd. For financial regulators, banks are the cheering home field crowd.

A solution to reducing referee bias in sports was the introduction of electronic monitoring of balls and strikes in baseball and the challenge flag in football. This works because transparency is an antidote, or at least a counterweight, to home crowd bias. Why not take the same approach in finance as in sports?

A new approach is surely needed since financial crises have become more frequent and costly over time. We believe that the public desperately needs what we call a "Sentinel" to provide an on-going independent, informed, and expert assessment of financial regulatory performance to reduce the home crowd bias. Independence entails a guaranteed budget and staggered long-term appointments, to insulate the agency from short-term politics. And it must also be made independent of financial markets by simultaneously providing its employees with competitive salaries and prohibiting them from working for private financial firms for many years after leaving.

To provide sufficient regulatory oversight, this agency must have the legal authority to demand immediate access to any and all information available to regulators, and it must have the multidisciplinary expertise to assess that information. Currently, no such entity has the expertise and information except the regulators themselves-and they are not independent of the influences of financial firms. Although our sentinel would have no direct regulatory authority and could not change any rule, it would have the obligation, power, and credibility to question publicly any "call" by regulatory "referees."

It's time to make a break from the past. Let's finally make a change that makes financial regulators work for us.

The authors are affiliated with Auburn University and Milken Institute, Williams College and Brown University, respectively. They are the authors of Guardians of Finance: Making Regulators Work for Us, MIT Press, February 2012. Barth, a senior finance fellow at the Milken Institute, was chief economist of the Federal Home Loan Bank Board/Office of Thrift Supervision; Levine is a member of the Council of Foreign Relations; Caprio was the Director of Operations and Policy Department, Financial Sector Vice Presidency, World Bank.


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