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Who regulates the regulators?

By Claes Bell, CFA · Bankrate.com
Tuesday, February 28, 2012
Posted: 1 pm ET

Ever since the Dodd-Frank financial reform law passed in 2010, there's been intense debate among politicians, economists, policy experts and banking industry professionals about the merits of the law. Opponents have called it a massive and burdensome assault on the banking industry and free markets generally; champions have said it's a necessary corrective to deregulation in the '80s and '90s and our best chance to prevent another financial crisis.

But Ross Levine, a professor of economics at Brown University, says that Dodd-Frank's approach doesn't attack the central problem that caused the breakdown of regulation prior to the financial crisis: regulator bias in favor of the financial industry. In his new book, co-authored with James Barth and Gerard Caprio, "Guardians of Finance," Levine outlines ways to reduce that bias and ensure the umpires of the financial markets are calling strikes fairly.

I had a chance to speak with Levine recently on the roots of the financial crisis, the flaws of Dodd-Frank, and how an independent agency to watch regulators could prevent the next financial crisis.

Tell me a little bit about your critique of the way Dodd-Frank is changing regulation and some of the things it's doing that in your view won't work.

We sort of liken Dodd-Frank to a quote from a railroad executive back in the 19th century when there were lots of accidents and there were calls on the regulatory authorities to enact regulation. He was very happy with the regulations because it looked like lots of stuff was getting done and there was lots of noise and there was lots of legislation, but in reality nothing was really being done and the railroad industry could go about doing whatever it wanted to after the regulations were passed.

Our assessment of Dodd-Frank is fairly similar. It's over 2,000 pages of regulations, much of it requiring studies by the Fed and the SEC and other institutions, but to a large degree our view is that if Dodd-Frank had been enacted 20 years ago, it would have made very little difference in that it ignores a fundamental problem with why financial regulation failed in the U.S. and around the world.

What was that?

Dodd-Frank doesn't address the fact that the financial regulatory authorities too frequently do not act in the best interest of the public and too frequently act in the best interest of the industry they're supposed to supervise and regulate.

So we're talking about regulatory capture here?

We're talking about regulatory capture, but when we talk about regulatory capture we do not necessarily mean something nefarious. So it doesn't have to be that the regulators are being paid off implicitly or explicitly. Now we recognize that, for example, if you look at the president of the New York Fed, every single president of the New York Federal Reserve, except for the first guy Benjamin Strong who died in office, after he left public service, went to work for a financial institution, typically within the district of New York.

But we actually focus on something a little different. There's a great book called "Scorecasting." It's by a guy named Tobias Moskowitz, who's a professor at the University of Chicago, and also Jon Wertheim, who is a writer for Sports Illustrated, and they tackle the question about why does the home team in sports win such a large percentage of the games.

This is all sports, all around the world, for which they can gather a massive amount of data. And what they find is that it has nothing to do with player performance. They find that the reason why the home team wins such a large proportion of the games in all sports is because of referee bias. Now referees are not biased for a particular team, they're biased in favor of the home crowd. And they're biased in favor of the home crowd not on all calls. But when the game is really close, and things really matter, the referees are biased in favor of the home crowd.

And the argument that they give, and I think that it's right, and it's applicable for financial regulation, is that referees and regulators are human. And it is an innate behavioral characteristic to conform to the community in which we operate. So these people are not cheating or lying or behaving in any way dishonorably. They genuinely adopt the view of the group.

And so that's their argument for where the bias comes from. Now if you look at this from the regulatory perspective, there's no question that the regulators are surrounded by the financial services industry. If you wanted to play this up, the general public has a hard time getting seats to this game, and if they do get seats, they are like far in the bleachers and their voices are not being heard. The home crowd is the financial services industry.

And you can see this everywhere. That's the community from which the regulators come. That's the community to which the regulators will go. On a daily basis, the regulators are supposed to interact with the financial services industry. At major conferences, whether it's the bank for international settlements at Switzerland, whether it's the Jackson Hole Conference by the Fed in Wyoming, this is regulators and private bankers. That is the community in which they operate, and that's a community in which they are supposed to operate.

And so we don't necessarily think there's something corrupt about this. There might be; we don't prove that there's not. But we believe that it's much more accurate and helpful in terms of designing policy to simply note that regulators are human beings subject to human influences, who would vehemently argue that they are honest.

So what's the solution?

I'll keep going with the sports analogy a little bit, and then I'll come back to that. In sports -- and this is fascinating -- so in baseball, for example, you can monitor the strike zone electronically and you can therefore see if an umpire is biased or not. What you can do is you can either tell the umpire that you're monitoring him or her, or not tell him. When the umpire knows that he is being monitored, the bias goes away. When the analyses have been done about the home field bias and the referee decisions in American football, when they added instant replay and the challenge flag, the bias diminished markedly, without having to use the challenge flag. This had an influence on the behavior on the umpires ahead of time.

Our view of sort of the fundamental problem with regulation is that the public and its representatives cannot assess financial regulation, because they have neither the information nor the expertise. You need economists and regulators and lawyers and people with private financial market experience.

The only entity with the collection of expertise that is capable of assessing financial regulation on a broad scale is the Fed. But the Fed is not independent; it's not unbiased. So the public has a lack of information, a lack of expertise and it has no mechanism through which to get an informed, expert independent assessment of financial regulation. It has no instant replay; it has no monitoring.

So it's a problem of who's watching the watchmen, essentially?

Exactly. And so No. 1 is to examine the problem. In terms of our proposal, solution is too strong of a word, but to improve things, what we suggest is the creation of a new entity. Now for fun, we call it a Sentinel. We build on the discussion by Madison in the Federalist Papers. He said that the way a democracy is organized, the public is supposed to look for its own interests through its representatives. But sometimes you need auxiliary institutions to act as a sentry on behalf of the public.

Our view is the public and its elected representatives can't, for the reasons I gave, assess financial regulation -- too complicated, too much information. The public can't do it. The finance department at Harvard couldn't do it alone. And so you need an auxiliary institution. We call it a Sentinel based on Madison's discussion of a sentry, but it's kind of a catchy name, not that we think that would be the actual name if it were taken seriously.

The Sentinel would have a few very simple characteristics: One, it would have one and only one power: It could demand whatever information it wanted from the regulatory authorities. So, important in it would have no regulatory authority. So the regulators could simply tell the Sentinel, if it criticized them, to bug off. Two, the Sentinel has to be independent. It has to be independent of politics, and it has to be independent of private financial markets. So the way I think to make it independent of politics is to design it like the Fed. And I think that works reasonably well.

The Fed, however, is not -- and it's not by design -- independent of private financial markets. Indeed, it's the banks that choose the president of the Federal Reserve, and if you look at how quickly people move from the Fed to the private financial industry, there's no way you can talk about the Fed as being independent of private financial markets. I mean, that's really an absurd assumption.

So the idea is to give them subpoena power over whatever documents they want from regulators, and with the release of reports on what the regulators are doing, do an "instant replay"?

Exactly. So it has three things, one power is information, the key characteristic is independence, so that people couldn't go work for the private financial services industry after being at the Sentinel. It would have one responsibility and this is, it would issue assessments of financial regulation. So it's like the instant replay, the challenge flag; it's an assessment. And so the regulators would know that an informed, expert entity is looking over their shoulder. I think that, like in sports, that would improve the performance of regulators, period, and it would allow a debate.

Right now, elected representatives and the public cannot challenge the Fed effectively because they don't know what the Fed is doing, the Fed doesn't have to tell them what it's doing, and if they happen to find out what the Fed is doing, the Fed has so much greater expertise on what's going on, there's no way to have a debate.

In my view, there's something quite dangerous about the way in which we choose policies governing the financial system in this country and in most countries. The financial system chooses who gets to use society's savings; it chooses the allocation of capital. By choosing the allocation of capital, it plays an enormous role in defining economic opportunities across the population. The entity that has the biggest influence on the rules of the game associated with that decision is composed of unelected and essentially unaccountable individuals, where the public cannot challenge it. How can that possibly be the right way to organize such an important policy in a democracy? That can't be the right way to do it.

If the financial crisis exposed the limits of how we do regulation today, what about the idea of the industry regulating itself? Has that been totally discredited?

That's a good question. There's a whole chapter about this in the book. So people frequently want to have an argument about whether markets work so well that you need essentially no government intervention, which is sort of like the Greenspan view. The alternative view oftentimes advocated is we need the government to sort of establish the rules of the game and be very interventionist in the financial sector. And I think that both of those views are demonstrably wrong and potentially dangerous.

Let me give an example. Much of work focuses on the detrimental effect of too much government involvement in the financial sector, but that doesn't mean that I adopt a view that the fewer regulations, the better. Let's start with the view that many people like, that the government should just not be involved in financial markets because markets work well. So let's forget about the problems with private financial markets. Let's assume that if the government didn't get involved in the financial markets, that things would be great.

Now, even if we embrace the religion of private financial markets, we won't necessarily embrace the religion that governments are perfect, which means that the probability of the government not intervening in private financial markets is zero. The Fed has a budget of a few billion dollars, so does the FDIC, so does the OCC, so does the Securities and Exchange Commission. We're talking about tens of thousands of regulators. We're talking about laws of every single type one can imagine. We're talking about, on a daily basis, 30 to 40 regulators being in the major banks on a daily basis.

So no matter what, even if markets are perfect, governments are not perfect. They are going to have lots of rules and regulations and interventions in the private financial market. I think most people can agree with that. Once you have lots of government intervention in the private financial markets, it doesn't follow logically that you would then just let markets go. You then can't have the assumption that the fewer regulations the better. It no longer follows. So if you believe in laissez-faire, you can only believe in laissez-faire only if the government doesn't get involved. If the government gets involved, you can no longer believe in laissez-faire.

Let me give one example: deposit insurance. Once you have deposit insurance, the depositors are no longer going to assess what's going on in the riskiness of the bank. Then you have a standard moral hazard problem and that then incentivizes the equity-holders to take on more risk. Once you have that situation, then there's sort of two choices, one of which is a bad choice. At that point, you can either say, "OK, the fewer regulations the better. The one regulation we have is deposit insurance, and now we're not going to get involved anymore." That's a disastrous decision, because the deposit insurance creates incentives for excessive risk-taking.

So that's what gives rise to another regulation, which is to limit the excessive risk-taking. You can't have one government intervention, for the example I gave, which is deposit insurance, then say, "Now the market is going to work perfectly and correct the destabilizing effect of the government policy." The market working perfectly doesn't mean that it's going to undo the destabilizing incentives of a regulation.

For example, if I come in with a crazy regulation that says we are going to save the banks if they invest in crazy collateralized debt obligations. Then the banks are going to invest in a bunch of crazy collateralized debt obligations, and you'll get a misallocation of capital. The free markets aren't going to correct the policy of the government.

So once you have certain types of government regulations that you're not going to get rid of, and we're not going to get rid of deposit insurance, then you need other types of regulations to counteract those effects. So regulation is a very complicated mixture and it's not amenable to a simple debate about fewer regulations are better than more. It doesn't make sense. One can only talk about the precise types of regulation within a given environment.

So the judgment should be effectiveness and not necessarily amount? It should be results-based?

Exactly. It can't be based on an ideology. Greenspan came with this ideology that essentially amounted to, the fewer regulations the better. And this makes no logical sense even within the pristine world of economic theory -- forget about the real world. It just makes no sense.

Follow me on Twitter: @ClaesBell.

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