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A little learning is a dangerous thing;
drink deep, or taste not the Pierian spring:
there shallow draughts intoxicate the brain,
and drinking largely sobers us again.
Alexander Pope (1688-1774)
An essay on Criticism

new blog and web site

Dear Readers,

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.

Lawrence Baxter


taking regulation seriously

There are signs that more people are starting to understand what it takes to build good regulation. We have to start taking the profession of regulation, and professional regulators, seriously. For thoughtful commentary, see James Surowiecki’s column in the current issue of the New Yorker.

economic capture and the myth of overbearing regulation

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.

why banks will always be different: banks as “government supported enterprises”

During the era of financial deregulation running from 1980 to the financial crisis of 2008 the financial industry morphed so much that there were some who argued that banks were essentially little different from other types of financial institutions such as securities firms and insurance companies. Each of these industries and others within the same universe offered products and services that competed directly with one another. Banks were able to develop funding sources that complemented and in some cases replaced their traditional source of funds, namely insured deposits. Banks, it seemed, were no longer “special,” as leading banker and bank regulator E. Gerald Corrigan had once so eloquently demonstrated (on which, see further below).

The strong current of deregulation encouraged the mindset that banks are really just like other financial and even commercial enterprises. This had at least two consequences. First, it became harder to understand why banks would ever have to be bailed out in times of crisis. After all, such special treatment is seldom extended to other industries–at least not without great political disagreement. Second, the view emboldened bank executives in their belief that regulation was largely an unnecessary intrusion into the functioning of the market. It was assumed and advocated that ordinary market forces ought to apply to banks in the same way as to other forms of business. The resulting political mood is distaste for any kind of emergency action by federal banking regulators to save a failing financial institution.

This kind of thinking has distorted the debate on financial reform because it is fundamentally mistaken. Banks are still special. Like all significant financial institutions they are different from other kinds of enterprise because the financial system is different from commerce. But even more important and unlike other financial institutions they are unique in various ways, and this special status changes significantly the dynamics of their regulation as well as their status in the markets. There are three reasons: (1) banks continue to play a special role in the economy; (2) their inherent interconnectedness creates and cannot ever eliminate systemic risk; and (3) banks are, long have been, and likely always will be “government supported enterprises” (not government sponsored enterprises like Fannie Mae and Freddy Mac).

The first point is one developed by E. Gerald Corrigan in the 1982 annual report of the Federal Reserve Bank of Minneapolis. Mr. Corrigan observed that banks provide a unique combination of functions in the economy: they issue highly liquid transaction accounts (checking and other payment mechanisms); they are backup sources of liquidity for all other institutions, including other banks and through the Federal Reserve System; and they are the transmission belt of monetary policy. These are complicated concepts that would require much greater elaboration elsewhere, but for the moment I would assert that, notwithstanding all the changes in the industry, this assessment remains valid. Mr. Corrigan defended his position, successfully in my opinion, 18 years later after his initial assessment had been called into question because of all the deregulation taking place.

The second point–interconnectedness leading quickly to systemic risk–is illustrated by the example everyone can now recognize, namely the collapse of Lehman Brothers on September 14, 2008. Lehman was an investment bank, not a commercial bank, yet when it failed the world’s lending markets instantly froze and we were plunged into what David Wessel has called the “Great Panic.” Banks, whose interconnected lending is enormously extensive and has to be if the modern financial system is going to be efficient, were not going to keep lending to each other when they did not know the extent of each other’s exposure to Lehman’s failure. This is the essence of a systemic failure. But do not assume that it takes a great failure like Lehman to generate dangerous consequences for the financial system: just today the Financial Times carries a story about a small, seemingly insignificant bank in C√≥rdoba, Spain, whose seizure by the Spanish regulators even weakened the Euro for a moment. The fact is that even smaller banks are deeply interconnected within the domestic and, in most cases, international financial system, and their weakness or, worse, failure, can threaten us all.

The third reason banks are special, and perhaps the most important of all for public policy purposes, is that they are supported in various ways by the government and, in turn, by the public. This support is far more extensive than is the case beyond the financial system. The support comes from the government maintenance of federal deposit insurance, the federal reserve system, the very fact that they are regulated for safety and soundness, and a too big to fail policy that is impossible to eradicate without breaking banks down into much smaller sizes. Do not be misled by the fact that banks pay for deposit insurance through premiums. The reality is that the full faith and credit of the United States stands behind the insurance funds, no matter what is protested publicly, and the FDIC logo is a powerful brand for attracting low cost deposits from the public because we know we will get our money back even if the bank fails. In some years banks have not even had to pay premiums for this insurance system. Banks also fund the activities of the Federal Reserve System, but without the elaborate mechanisms created by the regional reserve banks and the Board and regulatory bureaucracy in Washington the payments system and the backup liquidity provided to banks (and even other financial institutions) on a continuous basis would not exist. For these very reasons banks are regulated to ensure that they do not take unsafe actions (of course this has not worked so well recently, but the system actually does work quite well in more stable times).

The last element–public subsidization–is perhaps the most ignored yet important one of all and has been vividly illustrated by the rating agencies, who have indicated that they will continue to accord higher credit ratings to very big banks because, in their (correct) assessment, such banks will still be bailed out when push comes to shove. In other words, the credit rating agencies have concluded that the new reform legislation will not end the public subsidy known as too-big-to-fail (TBTF). This means that these banks will continue to have access to less expensive funding than they would otherwise have if they were going to be treated as ordinary commercial entities that face bankruptcy when they get into trouble. And this subsidization not only takes various forms, including through programs such as the Troubled Asset Relief Program (TARP) where taxpayers remain on the hook notwithstanding some recent repayments, but it is also extensive, running into $billions per year.

So what are the consequences for public policy and legal accountability? There are too many to delve into here, but two leap out. First, those bankers who assert that regulators should get out of the way–and amazingly there appear still to be some–are conveniently overlooking the facts that their businesses depend vitally on the government and that without public backup they would not enjoy the kinds of profits (and personal compensation) the financial industry generates, even now. Secondly, the legal obligations of directors and CEOs to their shareholders are more complicated than is the case with other kinds of business because the shareholders are not the only stakeholders. This is true even when the Treasury does not own equity or debt in troubled institutions (as it does in some cases); it is true in general. Banks are a different kind of “GSE”–government supported enterprises–and because of this banks will always end up having to be treated as special in various ways.

some reality about really big “rational actors”

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 naivet√© 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.

the next act: after congress passes the financial reform package

In the early 1990s as part of his monumental reform efforts for Peru, the international economist Hernando de Soto conferred with a federal agency in Washington DC on new rulemaking procedures he wanted to institute for his country. I was one of the people invited to the discussions. With all the jejune cockiness of a young professor, I proceeded to explain that he might not want to emulate American rulemaking procedures. Far from ensuring that statutes would be applied in a fully informed, expert manner, these procedures can often turn into expensive, slow quagmires in which industry and other interest groups are able to secure advantages they did not gain in Congress and losers were sometimes then still able to get courts to strike down all this work through the process of judicial review. Perhaps Mr. de Soto might want to avoid this result? I did not really notice the kindly smile spreading across de Soto’s face but when he had finished listening to me patiently he said, “but this is precisely the point! We want to stop the process in Peru. Every time a bureaucrat wakes up there he issues a new rule, and our government is bogged down in such bureaucracy!”

This lesson leaps to mind as I contemplate the next phase after Congress enacts the final financial reform bill in early July and the President gives it his signature. After the fanfare the media and the public will likely turn their attention elsewhere, reasonably assuming that the great work of reform is done. Au contraire, it will be in the arcane forums of regulatory notice and comment procedure that we will see some of the most important advances or, more likely, setbacks of the entire reform process. As Joe Adler in this morning’s American Banker reports (proprietary content, unfortunately), the financial regulators, as well as new ones created by the legislation, will be required to develop well over 100 rules and they will be required to develop many of these rules very rapidly. These rules will address such critical matters as systemic risk, consumer protection, emergency Fed lending authority, the Volcker rule, risk retention for institutions that securitize loans, concentration limits for large firms, interchange fees for debit card issuers, and credit reporting and resolution plans for large financial institutions. The average reader might be forgiven for yawning. Surely, one might ask, the proper parameters will have been set by Congress? Well yes and no: nowhere is the old adage more true than in financial regulation: the devil is in the details. And rulemaking, even with the best of intentions, can sometimes bring a reform process to a halt.

And it is here that the industry is most adept at lobbying. While technically open, the notice and comment procedures for rulemaking are much more difficult for laypeople and the media to track and far less exciting to monitor and influence than partisan votes in Congress. But banks and brokers understand their importance and they are well placed to redirect enormous resources. So the results are quite likely to skew in their favor.

This is not all bad. Of course the industry should have influence over the way legislation is applied to it, and we surely want regulators to be properly informed before they make regulations. But consumers and the media will take this process for granted at their peril. It would take the strongest of regulators to be able to ensure that less well represented interests are properly safeguarded, and I don’t think we have yet left the financial regulators in so strong a position. Indeed, some of the new regulators, including the newly-combined federal thrift and bank agency, consumer protection agency and systemic risk council, have not yet even been created!

less government or good government?

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.”