A political economy view of financial regulation

Andrea Prat

09 March 2009

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It is not only financial markets that have collapsed. Our trust in financial regulation is at an historical low. My macro and finance colleagues have generated a lively and informative debate on Vox about how to reform the rules that govern our financial systems. Let me add a political economist’s perspective.

Many failed countries have state-of-the-art constitutions. The success of regulation depends not only on the quality of the rules but also on the incentives of the people who are supposed to enforce them. In particular, the risk of regulatory capture has long been recognised as crucial, and it is a textbook regulatory concern (Laffont and Tirole 1993).1 There is also a large empirical body of evidence showing that lack of independence has a serious impact on regulatory outcomes (Dal Bó 2006).

There is no doubt that the present system of financial regulation needs improvement. But we also need to analyse the incentives of regulators to apply existing rules. If they are weak or even go in the opposite direction, even the best set of rules faces an uphill struggle.

To shed light on the possible presence of regulatory capture, it is natural to ask two questions.

Did regulators make full use of the rules they had, given the information they had?

I have no doubt that, even with only the rules and information they had, regulators could have been more incisive. The most obvious case in point is the Madoff affair. The SEC had information – it was tipped off repeatedly by reliable sources about a potentially enormous Ponzi scheme. The SEC also had a well-established regulatory framework at hand – securities fraud law. Why was such a classic and macroscopic alleged violation not investigated?2 In the UK, Paul Moore, who was head of group regulatory risk at HBOS, reported serious concerns about the amount of risk taken by his bank (Mr Moore was subsequently dismissed by HBOS). Given that the information came from a reputable source, why did the Financial Services Authority (FSA) not pursue a matter of such potential importance with the energy it deserved? If they had, they might have saved the British taxpayers billions of pounds in bailout money. One may object that regulators did not have the powers to compel commercial banks to change their strategy. Still, at a minimum the FSA and the SEC could have spoken up. Would we be where we are if shareholders, creditors, and depositors had been warned in clear terms about the kind of risks their banks were taking with their money?

How much conflict of interest do financial regulators face?

Every public agency faces a trade-off between independence and the need to recruit the best talent available. But in the case of financial regulation, the potential conflict of interest seems much higher than for other areas of government. Sir James Crosby, the former CEO of HBOS, the bank that dismissed the whistleblower Paul Moore, was also on the board of the Financial Services Authority (the overlap lasted from 2004 to 2006). Simply put, the head of a regulated institution was overseeing the regulator. In other areas, such as competition policy, this would be unthinkable – can you imagine the CEO of Microsoft becoming a Commissioner of the FTC? The presence of links between regulators and regulated firms is still there. Currently, three of the eight non-executive FSA board members appear to be also employed by financial institutions.3 Industry ties are unavoidable, but is it really necessary to have a managing director of a leading investment bank on the FSA board?

Financial regulation does not enforce itself. On one side, we have sophisticated institutions that stand to gain billions and can access the best lawyers and accountants. On the other side, we need competent and motivated regulators, who are willing to dig deeper and to take an adversarial stance when needed. Looking forward, what can we do to make sure that financial regulators face the kind of incentive structure that guarantees that they will make full use of the set of rules that we will endow them with?

  • We cannot evaluate the risk of capture in financial regulation, unless we know how things have been so far. Existing regulatory bodies should throw their books open so we can see data on the tip-offs they received and on the outcome of their investigations, if any. For instance, it would be useful to know exactly what kind of information the FSA had, or could have had, about risk taking in other banks besides HBOS.
  • We also need information on industry connections of their top management (before, during, and after their time with the regulator), in order to check whether there is a systematic link with the vigour of regulatory activity.
  • Based on the outcome of the study in the first point, we need a clear policy on conflict of interest, both in terms of present industry ties and future industry ties (the well-known revolving door problem). This policy should be well publicised and it should reassure the public that the regulators will only have the public interest in mind.

Performance pay is not the flavour of the month. But we should think of novel ways of incentivising regulators by giving them a direct stake in the health of the financial sector. Once we have a consensus on appropriate measures of systemic stability, they could form the basis of a long-term high-powered compensation scheme that would guarantee that regulators put the interest of the public first.

Footnotes

1 Part V – The Politics of Regulation – occupies almost one-third of Laffont and Tirole’s textbook.

2 It has also emerged that the regulators received reliable information about the Stanford affair back in 2003.

3 Fisher, Blackrock; Miles, Morgan Stanley; Stevenson, Equitas and Merchant Trust. Source: FSA website biographies

References

Jean-Jacques Laffont and Jean Tirole, A Theory of Incentives in Procurement and Regulation, MIT Press, 1993.

Ernesto Dal Bó, “Regulatory Capture: A Review,” Oxford Review of Economic Policy 2006 22(2):203-225

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Topics:  Financial markets

Tags:  incentives, financial regulation, regulatory capture

Richard Paul Richman Professor of Business and Professor of Economics, Columbia University; and Co-Director of CEPR's Industrial Organization programme

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