The Danger of Discretion

Justin Fox says that financial regulation should be simpler and should give less discretion to regulators.

The argument goes like this: the biggest flaw in current financial regulation is not that there is too little of it or too much, but that it relies on regulators knowing best. We regulate because financial systems are fragile, prone to booms and busts that can have harmful effects on the real economy. But regulators aren’t immune to the boom-bust cycle. They have an understandable habit of easing up when times are good and cracking down when they’re not.

As I’ve said before, the Obama Administration’s plan is likely to give us more sophisticated regulation, but if it doesn’t give us more powerful regulators with more incentive to stand up to the industry, all the sophistication in the world won’t matter. Regulators didn’t use the tools they had – the Fed could have policed risky mortgages (and raised interest rates), the bank regulators could have insisted on higher capital requirements, etc. – because they lacked the motivation to use them in the face of overwhelming opposition from the banking industry and, probably, the power to resist Congress and the administration, whichever party controlled them.

As Ezra Klein puts it: “When evaluating a particular financial regulation proposal, ask yourself this question: Would these regulations have worked if Alan Greenspan hadn’t wanted to implement them?” That’s a good question, although it’s a bit unfair: if you posit a regulator who doesn’t believe in regulation, then virtually any regulatory scheme is bound to fail. This is why Fox and Klein argue for ironclad rules that don’t leave room for discretion. In addition, though, I think we also need to think about how to make sure we get regulators who are not cheerleaders for or captives of the financial services industry.

By James Kwak

30 thoughts on “The Danger of Discretion

  1. James,
    “how to make sure we get regulators who are not cheerleaders for or captives of the financial services industry”

    That’s a good question. I think the problem of regulatory capture represents as much the power of the financial lobby as a meeting of the minds between regulators and the finance industry. My impression is that many of the people at the Fed, the SEC, and Treasury are rooted in neoclassical economics.

    This means that their default thinking is one of markets as being the best way to allocate resources, and an inability to fully comprehend the bubble mentality, let alone discern when a bubble is taking place. Greenspan might have been an extreme embodiment of this way of thinking, but I don’t think people can argue that Bernanke is much different.

    In my opinion, we need regulators areas like behavioural economics and finance (even psychologists) who can better grasp the pyschological underpinnings of bubbles and market failure, and can complement the current crop of regulators.


  2. I think the problem is what people expect regulations to do. I’m not sure there is such a thing as an “ironclad” regulation in the face of innovation because you are assuming that (1) it will be enforced, and (2) that those drafting the regulations can anticipate innovations and what aspects of the innovations will be a problem.

    Beyond that, I think what many people are looking for regulation to accomplish is to change the culture of the industry being regulated. Culture is a much bigger issue. But a politican cannot prescribe concrete steps to address cultural issues and take credit for implementing them.

  3. Moving financial information into a standard language such as XBRL and making it public would allow regulation to be crowd-sourced. In aggregate the crowd’s far less likely to have a Kool Aid drinking problem than characters like Greenspan, Summers, Geithner, Benanke, Paulson, et al.

  4. Discretion. What an excellent choice of words by James Kwak. A lot of leeway in that word, discretion. A lot of gray area. I think just the change of Presidential leadership will help quite a bit. I think regulators knew that under George Bush the unwritten policy was “if it’s not causing problems, don’t stick your nose in too deep and find problems”.

    I do think that the regulations and laws are important though. And I think attitudes drastically changed after the passing of Gramm-Leach-Bliley. It wasn’t an attitude change that “joe six pack” could feel on main street. But the bankers worked very hard to pass Gramm-Leach-Bliley, so I’m sure there were a few champaign bottle corks popped the night that Gramm-Leach-Bliley passed. I believe Gramm-Leach-Bliley was a nonverbal communication to regulators to say “well if you just look over that way for awhile, away from banks’ clandestine activities, you’ll save some sweat and angst”.

    Many people using this word “captive” talking about regulators relationship to bankers. I think it’s a problem. Some people say we should pay regulators more so we can attract better quality workers. But there will always be a large gap in salaries between those who work in service to the public (regulators) and those in the financial field. A raise in regulators’ salaries would help a little, but you’ll never close that big gap.
    Brooksley Born tried to fix things….. Brooksley Born wanted to do something….. she was a regulator was she not?? And in the future there will be another Brooksley Born. What will happen when the next Brooksley Born speaks out?? Will she be rebuked and muffled??

  5. maybe regulators should be more like the judiciary and be able to show legislative/executive tomfoolery for what it is ‘in a subtle way’ and just enforce the law without someone looking over their shoulder to see if one of their ‘special friends’ is in hot water
    cuz regardless its gunna be illegal for congress to pass unconstitutional laws that favor individuals over corporations or vis versa ‘not really but kinda’

  6. Another word for discretion is judgment and the ability to exercise good judgment is not easily evidenced by the credentials required to join the financial technocracy.
    How do you write an algorithm to provide good judgments?

  7. if the regulators have little discretion it will be extremely easy for the regulated to game the system. no way around it.

  8. The Financial Instability Hypothesis

    Janet Yellen, President of the San Francisco Federal Reserve, pointed out at the 18th annual conference honoring the work of Hyman P. Minsky that:

    “… with the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves.”

    Paul Krugman has also been re-reading Hyman Minsky’s most famous book Stabilizing an Unstable Economy.

    Central to Minsky’s view of how financial meltdowns occur is his Financial Instability Hypothesis (FIH) — what has come to be known as ‘an investment theory of the business cycle and a financial theory of investment’. But, what is it all about? Quoting from Minsky . . .

    “The theoretical argument of the financial instability hypothesis starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system… The focus is on an accumulating capitalist economy that moves through real calendar time…”

    Read more here

  9. I could think of a couple of big examples –

    depending on what the terms are of the regulated CDS that’s traded on the exchange, it will for example define Credit Events in a specific way. For example, any CDS contract will typically include “bankruptcy” of the company as a Credit Event and cause the contract to pay out – that seems reasonable. However, there is also the concept of “restructuring” where a company doesn’t default on its debt but restructures it because it is in bad shape. Should this trigger a protection payment under the CDS? It depends what risks you’re actually using the CDS to hedge, and therefore whether a restructuring event will actually cause you to lose money. So should restructuring be considered a credit event under the regulated contract or not? Being able to trade with or without it outside the regulated exchange might be useful. US names used to trade with a certain form of restructuring, Europe with a different version, and recently the US just moved to a standard contract which excludes no restructuring.

    Another example might be for loan CDS. At any point a company might pay back its loans. Should this cause the Loan CDS to terminate? What if the company prepays its loan but refinances it with a very similar loan immediately afterwards? Should the CDS just link to this new loan? Again, might be useful to have flexibility depending on what you’re trying to hedge. (and again, the market standard is slightly different for EUR and US, and has evolved over the last couple of years)

  10. Ana: “It depends what risks you’re actually using the CDS to hedge”

    Yes. If you are hedging against the risk that somebody does not pay you what they owe you, then you should be able to tailor the hedge and make it oven the counter. But if you are making a bet, then you should be restricted to standardized, exchange traded derivatives.

  11. This has been an illuminating set of exchanges on a singularly challenging yet vital issue. I glean from these contributions, set in the context of the public discourse post financial collapse (can soneone suggest a shorthand date a la 9/11, e.g the birth date of Milton Friedman or Alan Greenspan, the following precepts;

    1. Where an activity has shown itself manifestly a lethal threat to the public welfare, it should be prohibited by law unless there is an overwhelming case of its intrinsic social value, a value that cannot be provided by less dangerous means.
    2) Punishments must be as severe, as reliable, and as quick as reasonably possible, e.g. substitute criminal penalties for civil ones wherever possible.
    3) All regulations should stress simplicity and transparency as a matter of course, e.g. no passes for so-called customized derivatives.
    4) Address the matter of culture – corporate, regulatory, political – head-on. That is what FDR did producing durable changes that lasted 60 years. Mr. Obama clearly has no inclination or ability to do this.
    5) Appoint only people who feel deeply the need for basic changes, especially culural ones. On this, Obama gets an ‘F.’ See ‘4’ above. Poor Paul Volcker is reduced to giving speeches in Beijing the weeK that the White House’s ramshackle reform package is wheeled out of the garage.
    6) Learn the virtues of having the kind of convictions that lead one to relish a fight when necessary. Mr. Obama seems never to have experienced a personal conviction in his life and distains whomever has them – e.g. Paul Volcker whom Obama was shocked to discover “really knows his mind.”

    Rejecting these precepts, among other intellectual and political sins, raises the serious prospect of not just continued systemic financial risk, but also losing the opportunity of a century to restore the ethical underpinnings of American society – going forward, as we now say.

    Michael Brenner

  12. Alan,

    “…’how to make sure we get regulators who are not cheerleaders for or captives of the financial services industry’…”

    To imagine that any such an outcome is even possible within present structures using parliamentary means is a pipedream. We need a new constitution and new structures, the present ones have been so egregiously corrupted as to make a comedy of the use of the word “democracy” or the term “voter”. You’ll be assured that you’ll have “regulators who are not cheerleaders for or captives of the financial services industry” when mass demonstrations and the general strike bring about conditions whereby the whole present political class together with their lobbyist employers are confined behind razor wire awaiting a series of enormous show trials.

    And how far away from that configuration of events are we? Here’s some interesting speculation from naked capitalism yesterday:

    The flavor of the comments might assist any prognosticator as much as the substance of the article.

  13. Ted K writes:

    I think just the change of Presidential leadership will help quite a bit. I think regulators knew that under George Bush the unwritten policy was “if it’s not causing problems, don’t stick your nose in too deep and find problems”.

    Yes, it’s great to see Larry and Timmy stepping up to the plate and holding the banksters accountable. Oh, wait…

  14. You have a valid point, but I will take Geithner over Henry Paulson. And I don’t even know who Bush’s version of Larry Summers was. Maybe he asked Dick Cheney to tell him where the Dow Jones average was once a month.

  15. It is easy to understand the benefit of allowing people to, in effect, buy insurance against losses in value of assets they own.

    But why should CDS’s that are just “making a bet” even be allowed at all? We’ve seen the havoc that they can wreak as the notional values of these bets come to dwarf world economic output. And why should bets on these events, in which one has no stake, be any more enforceable than bets on sporting events and the like?

  16. The problem with discretion is that it makes it possible to use regulations at the “discretion” of the regulator(s), and therefore, sometimes used well and other times not. The general effect of the current state of regulation, in this regard, is that regulators stringently apply regulation to small firms but not to big ones. This makes for a very uneven playing field. There is a reasonable assumption on the part of regulators that large firms have more robust compliance departments and are more capable of self regulation. The unspoken aspect here is that small firms are easier to discipline and put out of business. The simply do not have the resources to counter incorrect or unfairly applied regulations.

    Also unspoken and unrecognized by those calling for increased regulation is how individuals employed by regulatory agencies advance in their organizations. As will any organization, performance is rewarded. In the case of regulators, performance is measured by how many firms you disciplined. Small firms are easy prey for ambitious individuals in the regulatory agencies. And so, any hope for a level playing field is gone.

    I am not saying that big firms never get disciplined. Of course they do. They get audited all the time. But the failure for regulators in the run up to the Panic of 2008 is not due to a lack of regulations. Far from it. Nor is it due to a lack of authority, at least not in most cases. Policy certainly played a role, but, the size of the institutions involved, Citi, AIG, etc, played the greatest role. For an agency to discipline a financial institution of that size takes enormous effort and expense. Simply put, Citibank could hire more and better paid lawyers than the government.

    While I have thought a great deal about this issue, I have not managed to see a possible answer. No matter what regulations and/or regulatory agencies you put in place, the small firms will always be easy prey for them, and the large firms difficult to discipline. Until this is addressed, however, the potential will remain for very large problems to grow inside of very large financial institutions.

    Another point on this subject is that removing discretion from the regulatory process means legislating mandatory disciplinary actions. This has not worked very well in things like drug sentencing because it has resulted in some extremely long sentences being handed out for relatively minor offenses. In some cases, small drug dealers end up with longer sentences than convicted murderers. This happened because drugs became a hot issue and the public wanted something done about it. Isn’t the financial world subject to the same kind of frenzies, and won’t we have the same kind of problems if legislatures are dictating strict penalties with no discretion on the part of regulators?

    So, James, I think, let’s not remove discretion and let’s think about what to do to level the regulatory playing field to remove the built in favoritism received by large companies.

    Finally, a word on unintended consequences. Lay on heavy regulations in the US with little of no way around them, and entrepreneurs who find them too restrictive and expensive to get around will leave the country for more liberal locations. Capital formation in the US has already been severely damaged by Sarbannes Oxley. Small companies mostly avoid the public markets today. This is an unhealthy state of affairs because access to capital markets is how they move up to become great companies. It is how Walmart grew, how Home Depot grew, etc. Lay on more heavy handed regs and we will simply drive more of our financial entrepreneurs to London and Shanghai.

    What we need, in addition to agencies capable and willing to take on large organizations, is a re-incarnation of the Glass Steagal act in modern form. Regulations forcing greater transparency for hedge funds would also be helpful, as would creating a specialized agency with cross jurisdictional power to regulate derivatives.

    Alas, Lawrence Summers says that the repeal of Glass Steagal while he was Treasury Secretary was not a mistake. So now that he is head of the president’s economic team, what are the chances we will get a new version of that great law? About zero, I’m afraid.

  17. Of course the regulators are themselves the biggest producers of systemic risks.

    Not only have they been feeding the “too big to fail” but also they also empowered the “too few to follow” credit rating agencies.

  18. The climate change bill that recently passed is the bad example of the reckless policy. This applies for the domestic producers and if it does not apply to the imported goods, there will be the collapse of domestic businesses and US jobs from uncompetive domestic production. The governments are saying that the bill will create the jobs but that is in the case that we also have the tax and fee on the imported goods that are from the high carbon foreign production .

    Therefore, government should tax on imported goods the same as the domestic producers on the carbon emission. If there is the tax on imported goods with the high carbon emission, it will create some jobs in domestic industry especially in alternative energy and maybe US can get the oversea income from creating the organization to inspect the carbon emission, get fee from the certificate, and sell the new alternative energy. The oil price will be much lower from lower demand; therefore if we apply the bill to all domestic goods and imported goods, we will have the more jobs, more foreign income (lower trade deficit) and lower price or lower cost of living and cost of production.

    The recklessness is not enforcement of the bill on foreign goods and foreign production and it turn the economic situation worse, rather than better.

  19. Young Econ,

    From a level playing field perspective, you are correct. However, inasmuch as products from countries like China, India, Russia, Mexico and much of the third world under your proposal done fairly, would be taxed almost out of existence because the pollution regulations in those countries are almost nonexistent, while ours are already incredibly stringent.

    Truly, from an economics point of view, this Cap and Trade bill, any way you slice it, drives away the relatively clean production of goods in the US to the big polluters in the Third World and places like China. The Third World produces CO2 and much more toxic wastes at something like six to twenty times the rate the US does based upon studies of how far pollution production has been reduced here in California.

    The net result of this bill is crippling of manufacturing capacity in the US and grossly more pollution on the planet.

    Way to go, Buraq and Nancy!


    “And that, my dear friends, is why today’s Wall Street conspiracy of banks and lobbyists, their well-paid pals in Congress and throughout the federal bureaucracies and regulators, plus their Trojan Horses in the White House, will continue driving America straight into the third meltdown Robert Shiller warns about: Our “vulnerability to bubble thinking is greater than it’s ever been … We recently lived through two epidemics of excessive financial optimism … the dot-com and the subprime … we are close to a third episode.””

    Capitalism without regulation is predation.

  21. As in Europe gas is sold for about twice the price than it is in the US, because of the much higher taxes there, do you suggest that Europe should slap a tax on US products?

  22. I don’t want to rain on the pro-regulation parade as an unintended consequence of my comments to follow, especially since the posts are all interesting and there is no doubt that a big fat finance sector causes harm to society at large. The evidence is clear that each crisis increasingly hurts poor people and nations and pensioners (as discussed in previous posts). However, regulating individual financiers is always “less liberal” than regulation via macro economic measures with use of broader fiscal and monetary policy tools. Setting up complex behavioral policing mechanisms is always less politically feasible than a straightforward macro-economic measure that tells us when finance is too big. The fact of the matter and the real problem, is that economic theory assumes away any possibility or discussion about excessive financial sector growth. Theory is built on identities and assumptions that fail to explain how or why there should be a distinction between financial markets and a “real economy”. Such terms as “real economy” and “shadow economy” have become popular over time to explain an increasingly undeniable and huge theoretical rift. Until there is willingness in academia to CONSTRUCTIVELY explore the failure of theory (even Mr. Greenspans admits there is failure of the theory) attempts to “regulate” can too easily be seen as a layer of communistic style government police. (Note – there are sweeping attempts in post-modernist circles to wipe out liberal theory altogether – this has proven to be relatively futile since over the past few decades it has led us no-where and perhaps even increased the shift to the right and reliance on 19th century theory rather than moving ahead of Keynes.)
    As for financial dealings, either people are playing straight or they are not – and a whole extra layer of regulatory police may simply encourage development of more intricate “machinations”(Keynes) on the part of financiers. On the other hand, if theory could, as I believe that it should, give us a simple, broad indication of what is ‘too much financial sector activity and growth’ then progressive taxation of the sector at large would have long ago prevented all sorts of human suffering in the US and around the world.
    There is ‘other’ academic home-work to do!


  23. Financial regulation is complicated on purpose, to mystify the lay person and provide loopholes for the sophisticated.

    The same can be said of the tax code.

  24. Hi James,

    Regulators ‘rooted’ in “psychology and finance working on the psychological underpinnings of bubbles and market failure” is a little bit 1950’s. If I were a financier I sure wouldn’t want to be ‘assessed’ by someone in that position who may think he understands my psychological state as well as my intentions in the marketplace… It is sometimes easy to see all the blatant ‘craziness’ of the market. But democracy really is at stake without some sort of neutral measure that is not personally directed at anyone – unless they are committing a crime. And clearly, given the spate of massive rip-offs that have ruined so many peoples’ lives, there is a need for more of that sort of regulating to catch those situations. Otherwise I think that liberal democratic and economic theory need re-structuring and expansion to be able to generate just a few new macro measures.

  25. Is part of your arrangement with the Post that if you write “The Hearing” you have to continually promote Ezra Klein’s opinion blog, even when he’s making thoroughly unoriginal and even tired, derivative points?

    You’re currently linking Real Time Economics, Calculated Risk, Greg Mankiw, Justin Fox and…. Ezra Klein? Which of these things does not belong? Which of these blogs is political first and substantive second?

    What’s going on James?

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