Thank you for reading my blog. I am in the process of turning this blog into a group format in which others interested in regulation and its reform can also contribute more easily. As a result, we have created a new blog, entitled theParetoCommons. The name combines the economic concept of Pareto Efficiency, which refers to a situation in which it is impossible to make one person better off without making someone else worse off, and the Tragedy of the Commons, a term coined in 1968 by Garrett Hardin and referring to the (very common) situation in which common interests are neglected when no one has a direct personal incentive to protect them, even though we all depend on those commons. This concept–“theParetoCommons”–captures, I hope, the ideal goal of good regulation, in which common welfare is optimized without hurting legitimate interests.
Please join me at the new blog, and thank you for your interest.
There was a time when we worried that concentrations of economic power would destroy competition and even distort the political process. Yet despite the fact that such distortions are in fact occurring in the financial arena, for one, we seem either less concerned or less aware of the problem than when antitrust enforcement was a far more common event. In an excellent opinion piece Reuters columnist, John Kemp has noted that corporate economic power has led to the steady weakening of the regulatory state.
Rather than the state as an overbearing Leviathan, a more accurate characterisation of modern regulatory agencies and legislatures is a hollowed out husk, thoroughly penetrated by the tentacles of private interest.
The powerful players who have captured the global economy defend this turf well and not without a good deal of aggressive bluster. Deutsche Bank, one of the largest financial conglomerates in the world, is a financial institution at the center of the action. The conglomerate narrowly escaped failure during the financial crisis (though unlike some of its American counterparts the organization did manage to survive without direct government assistance). One might have thought that such a near-death experience would serve to chasten its Chairman and CEO, Josef Ackermann. Not so. Mr. Ackermann has been active in vocally opposed reforms to the global bank regulation regime even as he acknowledges the need for stricter regulation.
Last year Mr. Ackermann repeatedly rejected the notion that very large banks constitute a greater threat to financial stability. In his view it is “interconnectedness,” not size, that is the problem (as if very large financial institutions are not exponentially more interconnected than small ones!). At the Davos World Economic Forum in January Mr. Ackermann was among the bankers vociferously opposing major regulatory reforms. More recently, Mr. Ackermann has joined other senior bank executives in warning global reformers that imposing stricter capital requirements on banks will threaten global recovery unless done slowly and with “grandfathering” (of his own bank, no doubt). Proposals to impose strict leverage limits have, in his opinion, “grave conceptual weaknesses.”
Mr. Ackermann has good reason to equate our interests in global recovery with the interests of Deutsche Bank. According to Peter Eavis’ column Heard on the Street, carried today by Dow Jones, Deutsche is by American measures substantially less capitalized than our own behemoths, including Citigroup, JP Morgan Chase and Bank of America. Deutsche was also one of the most highly leveraged of the large banks at the time of the financial crisis. Deutsche’s subsidiary in the US, Taunus Corp., the ninth largest bank holding company in the United States with $360 billion in assets, is both the least efficient of the large banks and has the worst, “negative” capital situation (i.e., it would be bankrupt without the support of its parent). The American Banker’s most recent efficiency rankings show Taunus as moving from an already poor position in 2008 to an abysmal number 148 out of 150 bank holding companies.
In defense of the Senate financial reform bill’s efforts to strengthen capital regulations, Sheila Bair, head of the FDIC and the agency at the front line of bank failures, recently referred to an “unnamed foreign bank” has having “negative Tier 1 capital.” It turns out that she was referring to Taunus which, as the Wall Street Journal noted today has a “negative 7.58% capital ratio. Without the rather unimpressive support of the capital of its parent, Deutsche Bank, Taunus’ condition as a standalone bank would be very concerning.
Capital requirements have been aptly described by Jaime Caruana, the General Manager of the Bank for International Settlements, as the “speed limits of banking.” It is no wonder that they are so adamantly opposed or undermined by banks that cannot or do not seem willing to comply with them.
An excellent recent blog by an industry insider is timely for turning a spotlight onto the fact that large organizations, whether governmental or private, are not necessarily rational or efficient. The author of the blog is a financial executive. However, as he rightly points out the revelations from a different industry of systemic failure at, and over promising-under delivering by, BP come as no surprise at all because such problems are perhaps inherent in almost all large organizations.
Despite a wealth of evidence to the contrary, much debate about regulating markets still proceeds on an assumption that market participants are rational actors who will make decisions that are genuinely optimal to their interests and that the aggregate forces of the market will correct for individual mistakes, ultimately leading to an efficient outcome. The assumption of rationality, though not necessarily fundamental to the efficient market hypothesis because irrationality and efficiency are two different things, is nevertheless dangerous in the debate about how to regulate very large institutions. When large companies like the biggest banks and oil companies make mistakes the market does not correct adequately. On the contrary, we all end up being on the hook, whether as taxpayers, unemployed workers, or fishermen in the Gulf.
One critique of the efficient market hypothesis tends to focus on the fact that market participants act irrationally from a cognitive perspective. In other words, evidence demonstrates that we do not make rational decisions but often (perhaps always) act on the basis of impulses we do not even perceive until after we have acted. I am not a behavioral psychologist so I won’t presume to expand on this science. But there is another dimension to market actor dysfunction that deserves more attention, namely that considerable inefficiencies, ranging from “groupthink” to outright chaos, tend to develop within many large, rapidly growing organizations. Those of us with experience of the actual operations of such organizations are sometimes struck by the naiveté displayed by some theorists who seem to assume that large and complex organizations act as “rationally” as individual persons. While such theorists are indeed aware that different incentives within organizations lead to inefficiencies the attention accorded these inefficiencies is thin indeed given all the things that really happen inside such organizations.
In a working paper I have elaborated in much more detail on what leads to dysfunction in large financial institutions. Companies develop serious dysfunction as a result of many factors. They often grow too rapidly through lateral “hyper-combinations” rather than through planned and carefully developed, organic growth. They diversify into areas in which the management is not sufficiently versed. Their technology platforms sometimes have to be converted within unreasonable timeframes. Often, because of cost constraints or the purse vanity of the acquiring company, the conversions are made to unsuitable and less efficient platforms. Employees with essential knowledge get laid off as part of the “efficiencies” promised from mergers. New combinations can drift without any coherent culture for years and even when the culture is established is carries with it the danger of groupthink and, in the case of regulators, “cultural capture.” Executive egos (and compensation) can grow faster than their abilities as their companies acquire grandiose proportions. So-called “agency costs” begin to accumulate: executive incentives begin to diverge from the interests of shareholders and they can also become out of touch with the facts on the ground. Promises to shareholders are often unfulfilled because they were unrealistic in the first place. Perhaps worst of all, the regulators cannot keep up and the new organizations simply become too complex to regulate, at least with the resources currently available to regulators. In the financial world this leads inevitably to the creation of risk-generating behemoths that, ultimately, become too big to fail as well.
So in the real world size, and how such size is attained, really does matter. As unAmerican or “parochial” as this might sound to some, regulating this path of growth is a vital public interest. It is naive in the extreme to assume that the natural forces of the market can ensure that such growth will be regulated without externalizing much of the corresponding dangers onto the public at large.
There are many reasons to oppose introducing or increasing regulation, reasons that, depending on the context, are sometimes good or sometimes bad. Among the good reasons might be that
– new regulation is purely punitive,
– it has been hastily crafted with little understanding of the business that is to be regulated,
– regulation is too rigid or too flexible, permits too much or too little discretion to regulators, or relies on the wrong techniques,
– the proposed new regulation is merely protective of the industry, designed to keep out the competition,
– the regulators will not be properly funded,
– the market is working well and the event spurring possible regulation is an isolated one, or
– the costs of regulation might significantly exceed any benefits.
There are many more potentially relevant considerations. If advocated thoughtfully, these are all are important issues in designing, supporting or opposing regulatory regimes. We see this debate playing out in the fields of financial, environmental and energy regulation right now.
There is, however, one old shibboleth deeply entrenched in the popular mind and always trotted out by right wing organizations, namely that less regulation is always good. A debate on this issue has surged again in the blogosphere, with an assertion that, when properly interpreted, the recent 2010 Heritage Index of Economic Freedom suggests that America’s supposed leadership in economic success since 1980 is attributable to deregulation. One need not get into whether what we see all around us, with one disaster after another, really supports the blogger’s # 1 ranking for America to question whether the data can really be interpreted in the way suggested. A powerful refutation of the entire interpretation has been posted in one of my favorite blogs today. There the author demonstrates that many of the countries to which the Index refers and which do even better in the Heritage Index rankings than the United States are themselves also regulated with what is recognized by people who understand the issues to be strong, good quality regulation and good quality regulators.
The most comprehensive and widely respected economic and historical study of the long history of financial crises around the world clearly demonstrates that a weakening or failure of regulation, when accompanied by rapid financial market liberalization has always led to disaster, the United States being only the most recent example. The book, This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff, is one of the best written since the financial crisis of 2008 and is well worth spending some time with.
So the question really becomes not whether we should have regulation whether we have good regulation. The belief that we somehow ought to pursue an idealistic “state of nature” in which economic freedom would guarantee efficient an safe prosperity is one that holds a deep and romantic grip on our minds– until something goes wrong. The financial crisis, BP Gulf Spill, the recent Upper Big Branch coal mine disaster in West Virginia, and yesterday’s revelations that even so august a company as Johnson & Johnson tried to cover up a recall of Motrin remind us of the deep truth of Hobbes’ words of long ago, that in a state of nature the life of man is “solitary, poor, nasty, brutish, and short.”