Stephen Carter, a professor at the Yale Law School and an accomplished novelist, wrote a Bloomberg column based on a conversation with a medium-sized business owner he met on a plane. The gist of the column is that the businessman isn’t hiring more workers because he’s worried about the regulations changing on him. From this, Carter draws a general lesson about business and government:

“For medium-sized firms like his, however, there is little wiggle room to absorb the costs of regulatory change. Because he possesses neither lobbyists nor clout, he says, Washington doesn’t care whether he hires more workers or closes up shop. . . .

“Recessions have complex causes, but, as the man on the aisle reminded me, we do nothing to make things better when the companies on which we rely see Washington as adversary rather than partner.”

Jim Henley (hat tip Brad DeLong) has already pointed out the silliest thing about this column: anyone who has a growing business and isn’t hiring more people, and isn’t hiring them because he’s not sure about future regulatory changes, is making a mistake (or perhaps is in a very unusual business that is heavily exposed to some very particular and very concrete regulatory risk).

Since Henley concludes, “The article reminds me of the criticism that intellectuals tend to lack real-world business experience,” and since I am also going to be a law professor, I’ll point out that I worked at McKinsey for three years and later co-founded a software company where I worked for seven years. It’s not a terribly long business career, but it’s longer than that of most academics and pundits. And at no point in any context did the concept of regulatory risk ever arise as a significant factor. When real businesses think about whether or not to enter new markets, build new factories, hire more people, etc., their overriding question is: will people buy enough of the stuff I’m selling? That is question number one, two, and three, and everything else is relegated to the “other factors” at the end. (And for real businesses today, the biggest “regulatory risk” is that the government will fail to solve the health care problem, since growing health care costs are the biggest cost that businesses don’t have control over.)

I have two additional points to make. The first is that Mr. Business Owner’s complaint is really a futile complaint about the fact that the world changes. He doesn’t hire workers because the regulations can change. He can’t decide what to invest in because Washington created “a climate of uncertainty.” More tellingly, he can’t plan to sell his company because “he doesn’t even know from one year to the next what the capital gains rate is going to be.” Do you know what you call a political system where regulations and tax rates can change? I was going to say, “democracy,” but really it’s any political system. The closest thing you can have to long-term certainty is a country with a dictator who is powerful, secure, and mentally stable. In a democracy, when a new party takes power, policy can change. Most of us think that’s a good thing. Calling the government an adversary because of a fundamental principle of democratic government seems, well, a bit un-American.

Oh, and that capital gains tax rate? It was 28 percent from the Tax Reform Act of 1986 until 1997; then it was 20 percent until the second Bush tax cut of 2003; and it’s been 15 percent since. It might go back up to 20 percent if the Bush tax cuts expire in 2012. If that’s too much uncertainty for him to deal with, then he needs to get into another line of work.

Second, its a mistake to ascribe too much importance to what a real businessman says. Objectively speaking, regulatory uncertainty has never been a particularly important business consideration, and it is not unusually high now. (Quick, name five regulations proposed by the Obama administration that will significantly increase the cost of labor.*) Yet I am sure that there are many businesspeople just like Carter’s seatmate, who are failing to hire and are blaming their decision on regulatory uncertainty.

Why? Because they watch Fox News, too. If you watch enough people telling you that the Obama administration is raising the cost of doing business, you start to believe it, just like if you watch enough people telling you that Obama was not born in the United States, you start to believe that, or if you watch enough people telling you that Iraq has weapons of mass destruction, you start to believe that. And once you believe that the Obama administration is raising the cost of doing business, and you believe that this is creating a lot of uncertainty, you slow down your hiring. But in that case, the uncertainty wasn’t created by Washington; it was created by Fox News.

The counter-argument is: that couldn’t happen, because Mr. Business Owner is putting his money where his mouth is; since he’s making business decisions, he must be acting rationally, ergo there must be regulatory uncertainty.

Does this argument even need a response? As Larry Summers once said, “There are idiots. Look around.” People make stupid decisions all the time when making decisions that affect the bottom line, and companies are no different. Because of competition, successful businessmen might make slightly fewer stupid decisions than other businessmen, but it’s only a few. There are so many factors that go into building a successful business, many of them uncontrollable, that there’s no reason to assume that someone who has done moderately well is any better at judging the impact of government policy on future profitability than you are. (Secret for all those other law professors out there: there are smart businesspeople, and there are dumb ones, just like in every other occupation.)

I’m not doubting that Mr. Business Owner really believes that regulatory uncertainty makes it too risky to hire more people. But his saying so doesn’t make it so. Well, one might say, the fact that he believes it is the problem, and so the government needs to do a better job convincing business that it’s on their side. But I’m not buying that either. The problem is that the conservative media have been trumpeting the talking point that the anti-business Obama administration is creating regulatory uncertainty, and they’ve been doing it so loudly and for so long that lots of people actually believe it. And if businesspeople aren’t hiring because of that belief, then it’s the conservative media — and people who repeat their talking points — that are to blame.**

* One area where firms might legitimately be worried about new regulation is in consumer financial services, since there there is a whole new regulatory agency to worry about. But while those regulations may affect what services may be offered and at what price, they are unlikely to affect labor costs, which are what Mr. Business Owner was worried about.

** After writing this last paragraph I realized that Will Wilkinson (hat tip Kevin Drum) beat me to it.

I’ve already introduced you to the Springfield biomass plant proposed by Palmer Renewable Energy (PRE). The issue in that post was PRE’s witnesses’ apparent unfamiliarity with the voluminous evidence that ambient air pollution increases both the incidence and the severity of asthma, along with other diseases.

In addition, PRE is claiming that their biomass plant won’t increase air pollution, anyway. In this press release gracefully repackaged as a news story by the Springfield Republican, we read, “The average annual impact on emissions such as nitrogen dioxide, sulfur dioxide, and particulate matter would be minuscule, Valberg and Raczynski [PRE's environmental consultants] said.”

Wow. Power plants have only a minuscule impact on emissions? In 2005, electricity generation was responsible for 73 percent of sulfur dioxide emissions, 21 percent of nitrogen oxides emissions, and 11 percent of fine particulate matter (PM2.5) emissions. And biomass plants are less efficient, per BTU, than plants that burn coal or natural gas.

Well, maybe this power plant won’t have a lot of emissions. At least, that’s what you would think on reading the draft conditional approval granted to the plant by the Massachusetts Department of Environmental Protection. According to that report, the proposed plant will emit less than fifty tons per year of nitrogen oxides and less than 100 tons per year of carbon monoxide, making it a “non-major source” of air pollution.

But if you read that report carefully, what you find is that the estimates of future emissions come from the developer’s own application. For example, see PDF pages 17-18 on nitrogen oxides, which read like marketing literature for the “high efficiency regenerative selective catalytic reduction system” that is the centerpiece of the argument for low emissions. This is like approving new drugs without clinical trials.

What’s perhaps more disturbing is that the Springfield plant was classified as a major source (which triggers additional review under 310 C.M.R. 7.00 Appendix) after its initial application — and the introduction of new technology magically changed it into a non-major source. So the lesson is: if you don’t get it right on your first try, keep trying until you do. Because no one is checking.

I just read Michael Pollan’s book, In Defense of Food, and what struck me was the parallels between the evolution of food and the evolution of finance since the 1970s. This will only confirm my critics’ belief that I see the same thing everywhere, but bear with me for a minute.

Pollan’s account, grossly simplified, goes something like this. The dominant ideology of food in the United States is nutritionism: the idea that food should be thought of in terms of its component nutrients. Food science is devoted to identifying the nutrients in food that make us healthy or unhealthy, and encouraging us to consume more of the former and less of the latter. This is good for nutritional “science,” since you can write papers about omega-3 fatty acids, while it’s very hard to write papers about broccoli.

It’s especially good for the food industry, because nutritionism justifies even more intensive processing of food. Instead of making bread out of flour, yeast, water, and salt, Sara Lee makes “Soft & Smooth Whole Grain White Bread” out of “enriched bleached flour” (seven ingredients), water, “whole grains” (three ingredients), high fructose corn syrup, whey, wheat gluten, yeast, cellulose, honey, calcium sulfate, vegetable oil, salt, butter, dough conditioners (up to seven ingredients), guar gum, calcium propionate, distilled vinegar, yeast nutrients (three ingredients), corn starch, natural flavor [?], betacarotene, vitamin D3, soy lecithin, and soy flour (pp. 151-52). They add a modest amount of whole grains so they can call it “whole grain” bread, and then they add the sweeteners and the dough conditioners to make it taste more like Wonder Bread. Because processed foods sell at higher margins, we have an enormous food industry pushing highly processed food at us, very cheaply (because it’s mainly made out of highly-subsidized corn and soy), which despite its health claims (or perhaps because of them) is almost certainly bad for us, and bad for the environment as well. This has been abetted by the government, albeit perhaps reluctantly, which now allows labels like this on corn oil (pp. 155-56):

“Very limited and preliminary scientific evidence suggests that eating about one tablespoon (16 grams) of corn oil daily may reduce the risk of heart disease due to the unsaturated fat content in corn oil.”

With this fine print disclaimer:

“FDA concludes that there is little scientific evidence supporting this claim. To achieve this possible benefit, corn oil is to replace a similar amount of saturated fat and not increase the total number of calories you eat in a day.”

Unfortunately, nutritionism is pretty much bogus science. The major claim of nutritionism over the past thirty years–that fat is bad for you–turns out not to have any foundation at all.*

What does this all have to do with finance? Roughly speaking, read academic finance for nutritionism; the financial sector for the food industry; subprime loans, reverse convertibles, and CDOs for highly processed food claiming to improve your health but actually killing you; current disclosure laws for the FDA-approved health claims on corn oil; thirty-year fixed-rate mortgages and index funds for the neglected, unsubsidized, unadvertised fruits and vegetables in the produce section; the OCC and OTS for the FDA; and the long-term increase in obesity and diabetes for the long-term increase in household debt.

In both cases, you have an industry that earns profits by convincing people to do things that are not in their long-term interests; that, in the process, creates negative externalities for the rest of society; and that has cowed regulators into submission, if not outright cheerleading. In both cases, the industry defends itself from critics by saying that it is simply providing what customers want, and hence any new constraints (even, say, accurate organic labeling laws) constitute a paternalistic intrusion into people’s economic freedom. And in both cases, the industry claims that if it isn’t allowed to continue on its current course, the economy as a whole will suffer. (After all, our corn- and soy-based diet is what enables the industry to provide huge numbers of calories at low cost.)

One big difference is that when it comes to the food system, there is a fair amount you can do to protect yourself and your family from its unhealthy effects (if you have the money). With the financial system, it’s a bit harder.

* It’s a bit more complicated than that, so before you take this as advice, read Part I, Chapter 5.

It’s been widely noted that financial reform is now entering a new phase as the action moves from Congress to the regulatory agencies that will write the hundreds of rules necessary to implement the reforms. During the congressional fight, the financial sector had a huge advantage in money and lobbyists, but we had one advantage: the fact that there was (from time to time) a lot of media coverage, and Congressmen care at least a little about public opinion.

In the rule-writing phase, the banks still have a huge advantage in money, lobbyists, and lawyers–and are hiring as many ex-regulators as they can to press their case. As our friend Jennifer Taub writes at The Pareto Commons:

What lies ahead, over the next year and beyond, will require far larger armies of lawyers, economists, finance experts and just plain able bodies and minds to monitor and influence the rulemaking process. Rumor has it that one bank alone plans to set up 100 teams of employees, tasked with particular rule makings. And that is just one bank.

Unfortunately, however, the pressure of the public spotlight is largely off, tilting the battlefield in favor of industry.

Our best hope is that the people in the regulatory agencies really do want to do the right thing, which is quite possible for people like Gary Gensler and Sheila Bair, and soon we’ll have John Dugan out of the OCC. This is a big reason why we don’t need neutral arbiters as the heads of these regulatory agencies–we need real advocates who will take the side of ordinary people and the real economy against a financial sector that is still too big and too predatory.

Yes, this is code for Elizabeth Warren, but it’s not just about Elizabeth Warren. The regulators in all these agencies should realize that they are going to spend the next two years fighting against the Wall Street banks and their legions of lobbyists. If they do their jobs right, they will never work in the financial sector again (except maybe at a hedge fund or a buy-side investment consultancy). And if they’re not up for that fight, we need someone else who is.

There has been a lot of criticism of regulatory agencies in the past couple of years, from the Office of Thrift Supervision and the Securities and Exchange Commission (Madoff who?) to the Minerals Management Service. But most of the people in these agencies are not evil; on the contrary, I believe (without a ton of evidence in support at the moment) that a majority are conscientious, hard-working, and civic-minded, and a significant minority are actually quite good at what they do. So why do they get things so wrong?

A few days ago, Leslie Kaufman of The New York Times wrote an article describing how the Fish and Wildlife Service “signed off on the Minerals Management Service’s conclusion that deepwater drilling for oil in the Gulf of Mexico posed no significant risk to wildlife.” This sounds like classic incompetence, or corruption, or both.

But the report itself, it seems, was not so far off, at least in its details. The report assessed spills of up to 15,000 barrels of oil. As Kaufman paraphrases,

“In its 71-page biological assessment, the Minerals Management Service concluded that the chances of oil from a spill larger than 1,000 barrels reaching critical habitat within 10 days could be more than 1 in 4 for the piping plover and the bald eagle, as high as 1 in 6 for the brown pelican and almost 1 in 10 for the Kemp’s ridley sea turtle. When the model was extended to 30 days, the assessment predicted even higher likelihoods of habitat pollution. . . .

“‘Heavily oiled birds are likely to be killed,’ the assessment said.”

Fifty-one days after the well explosion, the amount of oil spilled is probably somewhere between one and three million barrels.

So what happened? Probably two things.

First, someone at MMS decided that they would only model spills of up to 15,000 barrels, even though BP’s permit to drill the well estimated a worst-case scenario of 162,000 barrels per day.

Second, the local FWS office “considered that any likelihood under 50 percent would not be enough to require the protections of [the] office.”

This second decision seems incredibly stupid. After all, why 50 percent? And let’s say you review four reports for four different things, each of which says there is a 25 percent chance of something bad happening. At that point, the chances of something bad happening rise to about 70 percent. You always rule out the possibility of stupidity at your peril. But another possibility is that FWS had been told it could only act in cases where the risk was greater than 50 percent, because some political appointee had decided that that was the meaning of some statute.

In other words, it doesn’t take a lot of meddling to produce these terrible results. One political appointee or middle manager sympathetic to industry sets the parameters of a study. Another political appointee sets the threshold for action. And look what happens.

It’s like saying that all regulations have to pass cost-benefit analyses, and then setting the rules for how to do those analyses. (In general, it’s much harder to measure the benefits of regulation–because it involves the value of, say, clean air–than the costs of regulation.) Like saying you have to discount future lives at a rate of 7 percent per year, which makes it possible to justify putting any amount of toxins into the ground (or the plastic products we eat out of), because the health effects are decades away.

We all know what the results look like.

First there was the financial crisis. Then there was the West Virginia mine explosion. Now we have the BP oil leak. In each case, we were treated to news stories about the cozy relationships between the industry and the regulators who were supposed to be regulating it. (Here’s the latest New York Times story on how the Minerals Management Service was captured by industry — a problem that has existed for a long time, but that the Obama administration apparently did little to fix.)

Occasionally people say that the story we tell in 13 Bankers is really the same in every industry. That would not surprise me. I do think that the financial sector is unusual for a couple of reasons. One is that the interconnections between the major financial institutions make each one too big to fail in a way that, say, Enron was not. Another is that modern finance is so complex that it makes it easier for industry lobbyists to run roughshod over congressional opponents. But the problem of regulatory capture is obviously not restricted to finance, and it is a problem that we are seeing all over.

I’ve been meaning to write about this, but I haven’t had and won’t have the time. Arianna Huffington wrote an article on the parallels between the financial crisis and the West Virginia mine disaster. Lawrence Baxter has two recent posts (on his new blog) on regulatory capture and the role of regulation. Obviously this problem is not easily solved, especially in the wake of the Citizens United decision, which gave corporations even more influence over our political life. But hopefully the BP oil leak will produce a wave of anger — and a demand for answers — similar to what the financial crisis gave rise to.

Ezra Klein focuses on this passage from  John Judis’s review of regulatory policy in the Bush and Obama years:

“Bush stopped weighing the costs and benefits of deregulation and issued an executive order allowing OIRA to intercede before agencies made their initial proposals, thereby providing industry lobbyists with a back door to block regulations. OIRA also instructed agencies to discount the value of future lives in constructing cost-benefit analyses by 7 percent a year, so that 100 lives in 50 years would only be worth 3.39 current lives. (Such logic can be used by conservatives to argue that the present cost of regulating greenhouse gases outweighs the future benefits of stopping climate change.)”

There is a normative argument against valuing lives in cost-benefit analysis; some people think it’s just wrong. I don’t agree with that; I think that in practice, you either value lives implicitly or you do it explicitly, and so you might as well do it explicitly. And for what it’s worth, the practice of valuing lives is firmly entrenched in our legal system; the amount you pay in damages if you kill someone negligently depends primarily on that person’s future earning potential, and also on the monetary value of the benefits that other people gained from his or her life.

There is another argument against discounting future lives, however. The basic premise of discounting is that money in the future is worth less than money today. This has two components. One is the time value of money: $100 with certainty one year from now is worth about $99 today, because you can invest $99 in an FDIC-insured account at about 1% and get back $100 in a year. The second is risk: Future events are not certain, and the less certain they are to occurthe less valuable they are to you.

Does this apply to lives, however? If a regulatory agency says, this rule will cost industry $1 billion in present-value terms, but it will save 1,000 lives twenty years from now, is that any different from saying it will save 1,000 lives today? That seems wrong to me; you can’t take, say, 900 lives now, put them in the bank, and get back 1,000 lives in twenty years. I can see the counterargument, though: once you’ve agreed to value lives in monetary terms, you can translate those 1,000 lives twenty years in the future into some amount of money twenty years in the future, and you can discount that back to today.

But if we’re going to do that, let’s at least do it right. A discount rate of 7 percent?

I assume that’s a real discount rate, not a nominal one, since anyone doing this kind of spreadsheet over decades would use real terms to avoid inflation uncertainties.* A discount rate of 7 percent means that 100 lives in ten years are worth roughly 50 lives today. Is that justified?

By the time value of money theory, the government (or industry) could put aside money in an account today and use it to pay benefits to the survivors of dead people at some point in the future when the deaths occur. But if we’re going to use that logic, we need to look at the risk-free rate of return. Over the last five years, the ten-year Treasury yield has generally been between 4 and 5 percent. Call that 4.5 percent. Inflation has been in the low 2 percent range, so at best this is a risk-free return of 2.5 percent.

But it gets worse than that, because the real value of lives is continually increasing. This is because GDP grows faster than inflation, and faster than inflation plus population growth. The rest of GDP growth is productivity growth, which means that people produce more and, on average, they earn more (even if the median workers doesn’t). Since the legal value of a life is primarily based on future income, this means that the real value of a life increases roughly with productivity. Productivity growth runs at about 2% per year. So if you are getting 2.5 percent on your risk-free investment, 2 percentage points of that just goes to make up for the fact that the people your policy is killing are getting more expensive, which means your discount rate should be 0.5 percent. (The numbers don’t quite add up here, since I think population growth is actually around 1% per year. So let’s say your discount rate should be 1 percent — still a lot less than 7 percent.)

But that’s just the time value of money — shouldn’t we also be discounting for risk? But I think that’s wrong. In the corporate finance model, you look at the volatility of the expected cash flows. Let’s say you have an investment that has an expected return of $1 million in ten years with some probability distribution around $1 million. The textbook says you should adjust your discount rate based on that probability distribution — the wider the distribution (the riskier the investment), the higher the discount rate. This makes sense because of basic risk aversion. In the financial context, the more risky the project, the higher the expected return has to be to justify it.

Now let’s translate this into lives. Say you have a policy that is likely to kill 1,000 people in ten years, but it might kill more or it might kill fewer. Should that be counted as fewer lives than a policy that is certain to kill 1,000 people in ten years? In other words, does risk aversion mean that we should prefer policies that kill variable numbers of people to policies that kill certain numbers of people? That doesn’t make sense to me, and hence discounting for risk doesn’t make sense to me in the lives context.

That leaves us with a discount rate of 1 percent, not 7 percent. And instead of 3.39 lives today, you get 60.80 lives today. That’s a big difference.

(If the 7 percent is nominal instead of real, you don’t deduct inflation from the 10-year Treasury yield; however, then the value of lives grows because of both productivity and inflation, so you end up roughly in the same place.)

* It might make sense to use nominal terms if some of your future values were fixed in nominal terms. But in a situation like this, where all of your future values are fixed in nominal terms, I can’t see any reason to do the calculations in nominal terms.

At present, the debate among economists over whether our financial regulations should protect institutions on the basis that they are “too big to fail” (TBTF) still rages.  Like many other economists, I distrust the reasoning behind the TBTF justification and rue the fact that the measures taken to prop up the U.S. financial system have made the largest banks even larger, while small banks are failing at record levels.  In my first guest post I argued patchwork attempts to strengthen financial regulation without a “clean sheet” review were likely to be inadequate.

In this second post I look past short term bailouts and address the broader issue of establishing regulation of TBTF firms.  Policymakers are faced with challenge of establishing a large regulator that retains the specialized expertise needed to manage complex markets – specialization more often found in a network of smaller agencies.  To do so they will need to address the size and complexity of the financial sector itself.  As before,  I turn to examples from the utility industry, specifically the establishment and repeal of the Public Utility Holding Company Act of 1935 (PUHCA), that provide lessons for crafting regulation of complex industries.

There should be no question that any firm considered too big to fail must be regulated thoroughly and effectively.  This is unquestionably the $64 trillion question.  We cannot give an explicit or implicit government guarantee to rescue a private firm without whatever control is necessary to prevent moral hazard.  But what if the need to impose appropriate regulation itself becomes a limit on the allowable size or complexity of firms?  In short, can a firm be too big to regulate? 

In any such discussion it is important first to distinguish between several dimensions of big.  The first dimension is the multiplicity of products and markets in which a company is involved.  In context, this means companies that operate in commercial and investment banking, trading, insurance, and dozens of other product lines that are all “financial,” but which have different attributes, externalities, and regulatory requirements.  Call this “firm complexity”.

“Organizational complexity”, the second dimension, tends to follow firm complexity, but it isn’t the same.  This dimension has to do with the number and diversity of business structures owned by a single parent company.  The larger and more varied the number of corporate entities owned or controlled by a single parent, the more layers of vertical ownership; and the more complex the cross-ownership claims, the more complicated the structure.   

The third and final dimension is “structural bigness”.  This is about having a large market share in a well-defined product and geographic market.  This is the traditional meaning of big in the industrial organization field of economics.  It is bigness within a market, or market dominance.

For most financial (as well as non-financial) products, structural bigness is policed by competition (antitrust) laws.  (The insurance industry has enjoyed an antitrust exemption that Congress is now reconsidering.)  Because I assume these laws will continue to be enforced, I assume structural bigness is not a factor in making a firm too big to regulate.

For the other two dimensions of bigness, product and organizational complexity, it’s a different story.  In a nutshell, when the range of one firm’s market and organizational activities grows too large, it often becomes politically or administratively impossible to do a good job regulating it, whatever the particular tools and processes regulators use.

Firm complexity challenges regulation because it requires regulatory agencies with enormous resources to understand the linkages between extremely different financial product markets.  To regulate a firm engaged in insurance, banking, investment banking, trading, and other products, a single regulatory agency will have to possess an unbelievably broad range of skills, tools, and resources.  This is not to deny that there is a careful balance to be struck between too much and too little regulatory overlap, acknowledging sometimes conflicting problems such as regulatory capture and forum shopping.

It is politically unimaginable that the U.S. would ever establish a single financial sector super-regulator (an outcome far beyond the Fed getting the job of policing systematic risk).  However, if we will rely on multiple specialized agencies to police one market at a time, then we have the current patchwork quilt that never allows narrowly specialized regulators to see the linkages between markets.  It also encourages firms to create products that fall in the cracks between agency jurisdictions and that no agency understands well enough to monitor.  Placing limits on the number of markets a firm can operate in may reduce synergies and scale economies, but there should be no argument that it makes regulation far more likely to succeed.

For purely practical reasons, organizational complexity also makes regulation ineffective.  As businesses get successively more complex and varied business structures, the ability of regulatory agencies to understand the company’s financial position simply fades away.  It is well-documented, for example, that Enron built a financial structure so complex that regulators could never understand what it was up to, even following its downfall.  To cite one example, when the investigative staff of the U.S. Federal Energy Regulatory Commission (FERC) was directed to look into Enron’s electricity trading practices, here’s what they had to contend with:

The complexity of the issues confronting Staff and the agencies cooperating with the Commission is such that more time would be required to fully understand Enron’s and other market participants’ activities in the energy markets.  For example, we spent a considerable amount of time analyzing Enron’s massive information technology (IT) systems that were used to harness information and use such information for Enron’s advantage.  In short, the IT systems were functionally equivalent to the IT systems of a national trading exchange, e.g., a stock exchange, coupled with the credit and risk systems of a large national bank, and linked to a large telecom company.  The IT systems were designed to keep transactional data, such as a telecom IT system much do with telephone service customers such as customer service, billing, scheduling, and provisioning, but also link it to a sophisticated, on-line trading platform, and calculate the credit and risk exposure of each transaction.  Because Enron traded 1700 different products on-line around the world, the trading had to be linked together in a secure manner.

Although Staff has focused its energies on relevant data, the size of the task is enormous.  For example, as described herein, Staff is now reviewing approximately 1.8 terabytes (TB) of data, which is equivalent to the amount of data produced by a large telecom company.  In addition, because the data had to be easily accessible to Enron employees, we are also reviewing nearly 1,000 spreadsheets that were populated with data from the IT systems.  The spreadsheets were approximately 40 megabytes (MB) each and dozens were created daily.[i]

Fortunately for the FERC, its objectives in the investigations were confined to Enron’s role in the Western power crisis of 2000-2001.  No full accounting of Enron’s actions was sought, and none has yet been produced. 

The question of the size and institutional division of the analytic resources needed to properly regulate financial markets was the subject of my prior guest post.  In this area, it is interesting that a National Institute of Finance has been proposed to create an independent body of expertise usable by regulators.  Other regulated industries have this, such as the National Regulatory Research Institute, the Institute of Public Utilities at Michigan State University (MSU), and the Regulatory Assistance Project for energy regulators.

Structural Limits in the Utility Industry

The energy utility industry has struggled to find the right balance between enabling effective regulation and allowing market and organizational complexity.  Starting in the late 1880s, municipalities and small industrial firms began installing electric systems that were seldom larger than a handful of plants and lines.  In the first part of the 20^th century, industrial titans like J.P. Morgan and Samuel Insull did what we would now call a roll-up:  they purchased dozens of small systems and assembled them into massive holding companies.

Although most of the local subsidiaries of these utilities had rates set by state or local regulators, these agencies could not understand or control enormous multistate holding companies.  With massive, complicated holding companies, regulators could not determine the true cost of serving customers and therefore could not determine the true cost of serving customers and therefore could not set good cost-based rates.  Complexity gave holding companies the tools to overleverage their companies, mislead investors and regulators, overcharge regulated, captive customers and subsidize unregulated lines of business. 

Following the ’29 crash, Congress asked the U.S. Federal Trade Commission (FTC) to investigate the financial practices of utility holding companies.  The 101-volume FTC report found 19 categories of financial misdeeds, including:

. . . the issuance of securities to the public that were based on unsound asset values or on paper profits from intercompany transactions; the extension of holding company ownership to disparate, nonintegrated operating utilities throughout the country without regard to economic efficiency or coordination of management; the mismanagement and exploitation of operating subsidiaries of holding companies through excessive service charges, excessive common stock dividends, upstream loads and an excessive proportion of senior securities; and the use of the holding company to evade state regulation.[ii]

In what one historian called “the most bitter legislative battle of Roosevelt’s first term,” Congress passed the Public Utility Holding Company Act of 1935, known as PUHCA.  PUHCA essentially banned complex financial holding company structures for utilities, gave the new Securities and Exchange Commission (SEC) authority to approve utility mergers and security issuances, and made it extremely hard for utilities to buy or engage in non-utility lines of business.  Drawing on the notion that utilities had large scale efficiencies, but only if systems were physically connected, it also required that all mergers between utilities created integrated systems.

These strong restrictions were based on a consensus that it was simply not realistic to try and regulate the rates and securities of extremely complicated holding company structures.  It was “the very heart of the title,” said the Senate Report accompanying PUHCA, to “simply…provide a mechanism to create conditions under which effective Federal and State regulation will be possible.”[iii]  Over the next 11 years, under federal supervision, the large holding companies were slowly divided and sold.

Although it is likely that the utility industry lost some efficiencies from the bright-line prohibitions introduced by PUHCA, there is little question that increases in efficiency continued.  Over the fifty years following the passage of the Act, the industry grew by a factor of 100, the average power plant grew more efficient by a factor of five, and pollutant emissions (other than CO2) declined by a factor of 10,000.  Real electricity rates dropped nearly continuously throughout the period.  And if the industry was missing scale economies, this was surely more the case in the third of the industry that was publicly owned or a cooperative, where are still nearly 3,000 separate systems, as opposed to only about 140 investor-owned firms.

Many a utility CEO loathed the shackles PUHCA put in place.  Utilities with interstate operations could rarely get permission to diversify into non-utility businesses, thus hampering shareholder growth.  Utilities that did not cross state lines were exempt from PUHCA, and these intrastate firms often dabbled in insurance, real estate development, fuel production, and other non-utility lines of business.

From this experience, we have something of a laboratory comparing utilities allowed to diversify and utilities that were not.  I think it is a fair to say that the utility economics literature has not found large gains in new product synergies where PUHCA was not binding.  Utilities inside a single state went through a wave of diversification in the 1970s, were largely unsuccessful, and have since primarily abandoned non-utility businesses.  It could not have been costless, but PUHCA appeared to have its intended effect, making regulation relatively simple, practical and effective until the late 1970s.

PUHCA Repeal

As deregulation of utilities (along with financial markets) gained currency in the 1980s, the industry pushed to repeal what it felt was an aging and unnecessary statute.  The arguments for repeal were good.  Financial regulation was far more comprehensive and seasoned by the 1990s than it was in 1935, with almost no one seeing the decay in its effectiveness now so apparent.  Federal and state utility regulation was also now far more accomplished.  Most of all, the requirement for physical integration made no sense in an industry that was intentionally de-integrating in order to introduce competition in parts of the sector.  The economic structure of the industry was at odds with the Act.

PUHCA was repealed in the 1992 energy bill, but many of its provisions, meant to protect against excessively complex utilities, were essentially transferred to the FERC and state regulators from the SEC.  Federal and state regulators were guaranteed access to utility holding companies’ books and records, and the FERC cannot allow a merger that impairs the effectiveness of state regulation.  Many state regulators discourage their regulated utilities from engaging in non-utility lines of business, and nearly all of them require a separation between non-utility and utility assets so that losses in unregulated lines of business don’t affect the financial viability or rates of the regulated part of the firm.  For a recent example, see this press release regarding the recent EDF-Constellation deal.

Technically, the removal of the physical integration requirement and other industry changes have enabled mergers and acquisitions.  Between 1993 and 2007[iv] there was a wave of utility mergers, with 84 U.S. to U.S. combinations completed and a handful of acquisition of U.S. utilities by foreign companies.  Warren Buffet’s holding company has purchased one utility, the Texas Pacific private equity firm recently purchased the former Texas Utilities Company, and several foreign utility holding companies now own state-regulated U.S. firms.  Ownership of deregulated power generators is even more diverse.

Nonetheless, there are still strong limits on trades between utilities and non-regulated subsidiaries in a single holding company.  State and federal regulators require that the regulated entity.  And lately, the pace of utility mergers and acquisitions has slowed to a crawl.  Many in the industry believe that this is because state regulators are starting to once again feel that utilities were becoming too big to regulate.

Relevance to Financial Regulation

Regulation of the financial sector is a vastly more complex problem than regulating electric or gas utilities.  There are dozens of products deeply interconnected in several different ways in a geographically global system.  It is clear this complex, interconnected system needs far better regulation than it has today.

Many of the financial regulatory reforms under discussion involve limits on “bigness” as I have defined it.  The Baseline Scenario has long been a strong voice for limiting bank size based roughly on overall systemic risk; more recently, the idea seems to have been embraced by Mssrs. Volker, Greenspan, and Soros; (Two of my Brattle Group colleagues, George Oldfield and Michael Cragg, have also voiced this view.  See “Life Boats for the Banks–Let the Holding Companies Swim,” in The Economists’ Voice.).  Still others call for no absolute size limits, but rather higher capital requirements the larger and riskier the institution.  Chairman Bernanke, for example, calls for an approach that preserves “the economic benefit of multi-function, international [financial] firms.”  

Among these bigness policies, Mervyn King’s (and others’) proposal to separate commercial and investment banking (so-called utility and non-utility banks), comes closest to the policies that guide energy utility regulation today.  Under King’s proposal, commercial banks would be limited in the amount of risk they could take on and would receive protection against failure, while investment banks would have fewer constraints on risk but would receive no survival guarantee  

While this is analogous to energy utility regulation, and may be a good idea for financial regulatory reform, it cannot be a complete solution.  Even with good separation of “boring” and “non-boring” banks, (somewhat different) regulation will be necessary for both types of firms, and close coordination will be necessary for all financial regulators.  In addition to limits on “boring” banks, it may be necessary to limit, or at least oversee, the riskiness or size of “non-boring” financial entities, however they are defined.  Vexing questions regarding the need for transparency, common clearing platforms, and position limits, in all financial product markets, remain. (See these comments from David Brooks, Sophia Grene, Brooke Masters, and Gillian Tett.

The interconnections between disparate financial products and markets and the need for overall prudential regulation creates an extremely complex tradeoff between multiple regulators who have the resources to specialize — and can serve as checks on each other — and the danger of missing the big picture or letting new markets and risks develop in the cracks between their jurisdictions.  In this context, limits on firm size and complexity help by lowering the difficulty of assessing risks and policing activities within a single sprawling firm, in addition to reducing systematic risk.  One has to wonder at passages like this in the Financial Times:

Then there is the idea of obliging the biggest, most complex banks to draw up “living wills” – certificates that would lay out a blueprint for how a bank should be wound up in the event it should fail, perhaps forcing it to ring-fence certain operations, such as its retail and investment banking, in separate subsidiaries.  Regulators are determined the chaos that followed the collapse of Lehman Brothers a year ago should not be repeated.  It has yet to be decided what form a living will should take, but the very notion has many banks up in arms that they will have to spend months, even years, untangling the complex corporate structures they have evolved both to comply with local regulations and to maximize the tax efficiencies.[v]

If the banks that have complete self-knowledge and control will take years to simplify their own structures, how will regulators do it during a crisis?     

In short, limits on the complexity and product offerings of commercial banks may well be an essential part of the solution, but it is nowhere near the entire solution.  

By Peter Fox-Penner

[i]               See “Initial Report on Company-Specific Separate Proceedings and General Reevaluations; Published Natural Gas Price Data; and Enron Trading Strategies.” Docket No. PA02-2-000, Federal Energy Regulatory Commission, August 2002, p. 9.

[ii]               “The Regulation of Public-Utilities Holding Companies.” Division of Investment Management, U.S. Securities and Exchange Commission, June 1995, p. 3.

[iii]              Ibid, p. 9.

[iv]            “EEI 2008 Financial Review,” The Edison Electric Foundation, 2008, p. 45.

[v]               See Patrick Jenkins, “Banking on the Future,” The Financial Times, Future of Finance Section, October 19, 2009.

Paul Krugman’s speaking notes are here. Ben Bernanke’s are here.

Bernanke’s speech is largely a defense of the Federal Reserve’s monetary policy in the past decade, and therefore of the old Greenspan Doctrine dating back to the 1996 “irrational exuberance” speech–the idea that monetary policy is not the right tool for fighting bubbles. The Fed has gotten a lot of criticism saying that cheap money earlier this decade created the housing bubble, and I think it certainly played a role.

But I actually agree with Bernanke here:

“[T]he most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”

(Note that the purpose of stronger regulation, according to Bernanke, is to constrain the housing bubble that he denied existed at the time–not to protect consumers.)

The problem, for the Greenspan-Bernanke legacy at least, is that the Fed is also the chief regulator of the financial system, with jurisdiction over all bank holding companies and primary responsibility for consumer protection statutes applying to all financial institutions. Here Bernanke makes a partial attempt at an apology:

“The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.”

In other words, we did nothing until 2005, and then we didn’t do much. [Also see Update 2 below.]

I don’t really care about apologies. The more important question is what Bernanke and the Fed will do in the future. On that front, he has this to say:

“The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.”

There are basically only two things in this paragraph, one of which is disingenuous at best. Bernanke claims that he is getting serious about consumer protection, yet he has lobbied against the Consumer Financial Protection Agency, which everyone who is serious about consumer protection wants. I’m disappointed that Bernanke would stoop to this kind of misleading rhetoric.

The other thing is a lot of talk about systemic risk. Yes, systemic risk is important. But all the words I hear about it, and the fact that the importance of systemic risk is one of the few things that everyone can agree on, are making me start to worry. Specifically, I wonder if a lot of regulatory apparatus aimed at systemic risk will serve as a distraction from old-fashioned regulation of individual institutions. Yes, it’s true that the thing that hit us in 2008 was systemic risk. But it’s also true that regulators already had the power to supervise Citigroup, Bank of America, Wachovia, Washington Mutual, Lehman Brothers, Bear Stearns, and Countrywide and force them to pare back their risky activities–and didn’t. Talking about systemic risk is a way of passing the buck–of excusing regulatory failure by saying that regulators didn’t have the authority to look at systemic risk. But the fact remains that someone looked at Citigroup’s range of businesses and its asset portfolio and decided it was a healthy bank.That was at least as big a problem.

I’ve been on the fence about Bernanke’s confirmation, mainly because I’m not so optimistic we’ll get anyone better from a policy standpoint, and we could certainly get someone worse from the standpoint of intelligence, knowledge, thoughtfulness, and work ethic. But now that I’ve read this speech, I’m against confirmation.

Update: I should clarify one thing. I am sure there are better people out there. I’m less confident about whomever Obama and his advisers would pick. This is a deeply centrist administration, at least on economic issues, and one that is absolutely not going to make a major policy shift anytime soon; whether or not we agree with them, their current message is that they have done a good job fixing the financial system and running the economy. So I think that if Bernanke by some miracle were not confirmed, Obama would take pains to appoint someone with the same policy positions.

Update 2: Mike Konczal at Rortybomb points out what Bernanke left out of Bernanke’s defense of the Fed: the fact that the Fed actively ignored warnings going back to 1998. Funny how a factually correct statement can be deeply misleading.

By James Kwak

“Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time.  In this game, regulatees tend to make more moves than regulators do.  Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.

“Thirty years ago, regulatory arbitrage focused on circumventing restrictions on deposit interest rates; bank locations; charter powers; and deposit institutions’ ability to shift risk onto the safety net.  Probably because regulatory burdens in the first three areas have largely disappeared, the fourth has become more important than ever.  Today, loophole mining by financial organizations of all types focuses on using financial-engineering techniques to exploit defects in government and counterparty supervision.”

Large banks can increase the benefit to them of the government safety net by becoming larger, more complicated (less transparent to regulators), and more politically powerful; yet, as Kane observes, they do not exhibit increasing returns to scale. The implication? “As institutions approach and attain TDFU [too difficult to fail and unwind] or TBDA [too big to adequately discipline] status, value maximization leads them to trade off diseconomies from becoming inefficiently large or complex against the safety net benefits that increments in scale or scope can offer them.” In other words, mega-banks take on the inefficiencies of being complicated, unwieldy, bureaucratic, etc. because they are compensated for by greater safety-net benefits.

In this interpretation, the point of structured finance is not just to reduce capital requirements, but to make it harder for regulators to estimate systemic risk implications and easier for them to ignore what is going on. Unfortunately, regulators do not face incentives that motivate them to take appropriate corrective action. Instead, “history shows that top supervisory officials that respond in a market-mimicking way [that is, the way private creditors would respond] to these signals [of financial deterioration] at TDFU firms must expect to be pilloried rather than praised both in congressional hearings and in the press.” Instead, Kane proposes that heads of regulatory agencies be paid in part through deferred compensation that would potentially be forfeited based on the performance of the institutions they supervised during the subsequent years, including the years after they left office.

One conclusion we can draw is that the bigger and more complex a bank, the harder it will be for regulators to adequately monitor what is going on, and this is one reason that banks make themselves big and complex (it doesn’t just happen by itself). This seems important to bear in mind in assessing the likelihood that current regulatory reform proposals will do the job they are supposed to do.

By James Kwak

In fact, I’d recommend it over anything I’ve written this morning, so why don’t you head over now.

By James Kwak

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Or does it have the same true economic exposure? If things go badly, yes, since Protium will default on the loan. If things go well, however, Protium’s investors get all the upside since they get the residual cash flows after the loan is paid off. So Barclays is left with all the downside and none of the upside. In return for giving away the upside, they should have gotten a good interest rate on the loan. The interest rate is LIBOR + 275 bp, and I have no way of calculating if that’s a good rate or not. But even assuming it is a good interest rate, this is what Nassim Taleb calls a nickels strategy – picking up nickels (the nice interest rate) in front of a steamroller (the risk of the assets falling in value).

Finally, we have the other kind of arbitrage. Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want. Given the size of Barclays, the shareholders won’t notice $40 million here or there, especially if it looks like it’s coming from someone else. Everyone wins.

By James Kwak

• retail deposits
• loans to retail customers, including mortgages
• retail insurance, including annuity products
• any custodial service beyond traditional settlement (i.e., if you hold something after T+3, you’re a custodian)

If you do any of those, then you are a Boring institution, you can do all Boring services, you face some significant regulations, and you get bailed out when necessary. If you do none of those, then you are an Exciting institution, you can do almost anything you want, and there is an ironclad rule preventing the government from bailing you out. Boring institutions cannot offer Exciting services (I think) and Exciting institutions cannot offer Boring services (that’s certain).

It feels like a modern version of Glass-Steagall (although I’m probably not doing it full justice) – create an explicit linkage between tight regulation and a government backstop, and protect the part of the financial system that affects ordinary people.

A key requirement of this system is that you have to be willing to accept the consequences of the collapse of an Exciting institution. I’m not sure that Taunter has sufficiently sealed off the real economy from Exciting firms, however. For example, suppose an Exciting firm offers revolving credit accounts to companies that they dip into to make payroll (to smooth out fluctuations in cash flow over the month). I don’t think this qualifies as Boring in Taunter’s scheme. But if the Exciting firm goes down, suddenly thousands of companies might be unable to make payroll.

I’m not saying this is a fundamental flaw; maybe the lines just need to be drawn differently. Or maybe I’m missing something. In any case, it’s an interesting way to think about the problem, especially for people who want to combine closer regulation of financial services that affect ordinary retail customers with free markets and financial innovation for sophisticated actors.

By James Kwak

1. Traditional CBA counts all dollar benefits equally, despite the fact that the marginal utility of a dollar depends a lot on who is getting it; a dollar more for a poor person provides a lot more utility than a dollar more for a rich person.
2. Long-term or uncertain benefits, no matter how large (like preventing the inundation of every coastal city) are typically discounted down to zero.
3. Benefits that are difficult to quantify because there is no market for them (like feeling better because you are healthy) never get counted. (This is the one I know best because it’s one of the things my wife specializes in.)

Matt Yglesias also comments.

By James Kwak

Bond Girl’s “Filling the Financial Regulatory Void” provided insight into human deficiencies in the current financial regulatory system. But it overplays the human failings of regulators and concludes with a proposed solution that, in all likelihood, would turn out worse than the current situation. But first, in the interest of full disclosure, I should tell you that I retired two years ago from a management position in the enforcement division at the SEC after 27 years. So I was (and in my heart, I suppose I still am) a financial regulator. That background probably should be taken into account by anyone who reads this response.

There is no doubt that “regulatory capture” exists and is a meaningful factor in the recent failures of our regulatory system. Many of us in the enforcement division dealt with the problem regularly when we sought input from those in the agency who were responsible for regulating aspects of the securities markets. Over time, regulatory policies and practices had emerged that seemed to contradict the purpose if not the letter of the law. In other cases, over-arching issues (e.g., increases in fees charged by investment companies despite growth that should have resulted in economies of scale and decreasing fees) simply were not addressed in any meaningful way.

But the majority of regulators I worked with were critics of the problem of “capture,” not victims. Much of the problem arose from decades of deregulation dating back to the beginning of the Reagan administration. Elected deregulators appointed their own kind to head regulatory agencies and they, in turn, removed career regulators from management positions and replaced them with appointees who had worked in or represented the regulated industries. These new managers and, in many cases,the people they recruited and promoted, advanced or adhered to a regulatory scheme that, at least with respect to the most important issues, advanced the interests of the regulated.

Bond Girl is right, the industry “captured” the regulators and the regulatory system. But not in the passive sense that true regulators over time came to identify too closely with the interests of the regulated. This is not a case of financial regulators falling victim to the Stockholm syndrome. The vast majority of capture resulted from intentional efforts by the finance industry to advance their narrow interests at all costs and defeat meaningful regulation. Unfortunately, we live in a country that can be bought from the top down and the finance industry exploited the situation very successfully. But do not blame the regulators. Career regulators are as much the victims of these events as the public’s economic welfare.

The creation of paid social entrepreneurs to perform regulatory functions will not enhance regulation nor reduce “capture”. I’ve sued too many CPA’s over the years for bad audits to believe the answer lies in creating a new class of auditors. Audit clients often “capture” their auditors. The result is bad audits resulting in uncorrected and undisclosed financial fraud. The victims are always the shareholders and the market. Besides, using money to “incentivize” a new, private class of regulators plays directly into the hands of the finance industry. No matter what the regulatory fee structure may be, government will never be in a position to compete with the financial industry when it comes to “incentivizing” regulators-for-hire.

We need to look elsewhere for solutions to the problems that hamper our financial regulatory system.

• First, we need to look at the structure of the finance industry. Commercial banks got into trouble in large part because they warehoused (often off the books) toxic securities underwritten by their investment banking counterparts within the holding company structure. Similar abuses in the past resulted in separating investment banking from commercial banking. We should try it again. Insurance should be split off as well.
• Second, no institution should be allowed to become too big to fail. Those that have already achieved that status should be broken up.
• Third, we must put in place an effective financial consumer protection agency which can counteract the worst consumer practices of a too powerful industry.
• Fourth, investment banks should be made to eat what they kill. Public ownership of investment banks coincided with the industry’s decline into extremely reckless risk taking. Investment bankers should be required to own a significant percentage of the equity in the institutions in which they work (something approaching 50%, to pick a number). Having a significant portion of their net worth tied up in such stock would provide an incentive to carefully identify and measure risk. It should also reduce outsized compensation for investment bankers.
• Fifth, there should be greater limits placed on the ability of political appointees to oust career regulators. Make capture more difficult.
• Sixth, more financial products and firms should be subject to government registration and reporting.
• Seventh, regulators should not be forced to wear conflicting hats. One cannot promote an industry while protecting the public from it. Don’t ask regulators to be industry cheerleaders. Limits can be placed on regulators to ensure that they not act without consideration of the impact of their actions. But over-regulation is not what got us in this position. Cheerleaders purporting to be regulators did.
• Finally, the government should adopt a bonus plan for regulators, run by regulators (who would rotate off after short, fixed terms, to prevent back-scratching among board members) to provide incentives for regulators to excel at the job of regulation. Recognized, protected and incentivized regulators will resist capture.

By James Coffman

Update: Bond Girl responds.

Update 2: I (James) had the author’s name wrong – it should be Coffman, not Coffey.