Why is it so hard to regulate the banks? It’s less the complexity than the political power.

May 31st, 2015 at 10:47 am

Give a read to this incisive analysis by Adam Davidson on the challenge of regulating banks. It’s deceptively hard to write about this world as clearly as Davidson does here (I tried to do so in Chapter 7 of The Reconnection Agenda; not sure how well I succeeded). I think his conclusion is unduly pessimistic, or, more precisely, pessimistic for the wrong reason. The problem in regulating banks is less complexity–though that’s a real challenge–and more their political power.

(Also, as I stress below, in passing he gives us a great working definition of the concept of economic “rents,” one that confuses many readers.)

Davidson worries that we can’t effectively regulate the banking sector because if we try to do so with a light touch, they’ll easily evade the regulations. But if we then try to write complex regulations that get into nuanced corners of modern finance, the resulting intricacy will render the rules unenforceable. For example, under Dodd-Frank’s Volcker rule, we’re asking regulators to figure out if a deal made by an insured bank is legitimate “market making” on behalf of a client (e.g., finding buyers for a stock that the market isn’t moving on its own), and thus exempt from Volcker, or a risky bet that exposes taxpayers.

He points out that banks have the resources—deep pockets, bevies of lawyers—to tie up the regulatory process ad infinitum arguing cases like that. Moreover, they’re quick to point out that imposing such rules gums up the credit system and thus costs us growth and jobs. And they’ve got powerful politicians on their payrolls, as it were, to back them up.

That’s all true, of course, but my argument in The RA is that if we can get the four corners of Dodd-Frank firmly in place, we’ve got a good chance of busting, or at least dampening, the “shampoo cycles”—bubble, bust, repeat—that have repeatedly laid waste to economic recoveries both here and abroad. The idea behind the structure I advocate is that if you get some of the big stuff right, the parts you get wrong won’t create as much external damage.

Briefly, the four corners are (see chap 7 for details):

–When a bank gets kicked in its assets, it needs an adequate capital buffer. Significantly raising the amount of equity that banks must hold against losses will diminish their profitability but it is by far the first line of defense against the shampoo cycle.

–The Consumer Financial Protection Bureau must vigilantly protect against shoddy underwriting. If underpriced risk is the evil genius of financial bubbles, than bad underwriting is the work of her minions. As I stress in the book, this is not that complex an endeavor, and the CFPB is actually off to a good start, despite outside pressures pushing against their efforts.

–A Federal Reserve that trolls the waters for systemic risk. Former Fed chairs argued that the Fed couldn’t really spot bubbles and even if they could, they didn’t have the tools to do much about them without hurting growth. Chair Yellen disagrees, and Dodd-Frank creates a mechanism for the Fed to oversee this process. Importantly, she distinguishes between “macro-prudential” policies and macro-management ones.

A strong Volker rule. As noted, this one is tricky, and the “market maker” exemption has already had to be tightened a bit. I’m less confident about this corner of the architecture but if the other three are in place it may be less consequential.

I’m not saying any of these are simple—no one knows the optimal capital buffer ratio and spotting systemic risk is not obvious (though neither is it so obscure, as Dean Baker stresses re the housing bubble). But where I depart from Davidson is that the challenge is not substantive details. It’s politics.

Take capital buffers. Erring on the side of caution would suggest taking what the experts recommend—something around 10-15% of assets as a buffer zone—and adding another 5%. But remember that part above about the finance sector’s influence on politics?

That, not complexity, is what drives my pessimism in this space. Same with spotting and deflating bubbles before they explode and prohibiting glaringly obvious forms of underwriting that under-prices risk (“no-doc loans”; “exploding ARMs”; do those sound like prudent products to you?). None of this is beyond the scope of oversight; none is so complex that it couldn’t be accomplished.

The problem is less creating the switches; it’s blocking political power from paying people to fall asleep at them.

***

Here at OTE, I often point to the market failure of rent-seeking, a serious problem in advanced economies that’s closely associated with high levels of economic inequality and particularly pernicious in finance. It’s not an intuitive or particularly well-named concept, and people often ask me what it really means. I thought Davidson’s description was clear and resonant:

Generally speaking, businesses earn profits in one of two basic ways. The first is by providing goods and services more productively than others and selling them at a price people are willing to pay. The second is by seeking rents. “Rent,” in the economic sense, refers broadly to any excess benefits that people and businesses receive simply because they have power over something that others need. Patents are a form of rent, as are cable ­TV monopolies.

For economists, rent­-seeking is everywhere, and is a common way that economies go awry. Crudely speaking, productivity enhancement is good, because it makes society richer over all. Equally crudely, rent­-seeking is bad, because it makes the people who are already rich even richer. Rent-­seeking tends to be a force against innovation and for stagnancy, in large part because its focus is on the past — on maintaining power and influence gained long ago, often at the expense of innovation. Businesses built around rent­-seeking don’t try to increase the size of the pie; they just want to make sure they get a bigger slice. (If a company doesn’t seem to care about your opinion of it as a customer, there’s a good chance that it is seeking rents.)

I’m not sure about that last part. It’s certainly true at the company level. The fact that Comcast can tell you that they’ll come fix your internet connection sometime between 10 and 5 suggest a level of monopolistic market power that reeks of rent-seeking. But there’s another reason we all have lots of customer interactions where it seems like the firm doesn’t care about our business: the principal-agent problem. It’s not rents, but it’s another form of market failure.

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13 comments in reply to "Why is it so hard to regulate the banks? It’s less the complexity than the political power."

  1. SeattleAlex says:

    How very Elizabeth Warren… Or Bernie Sanders of you. No seriously we need one of those two to ever make any headway here am I right?!?!


    • Wondering says:

      Probably, yes. But the reason there only seems to be 2 people on the right side is because it is hard to maintain a connection with the people when a person enters the world of US politics/investment.

      Our political class and investment class have merged, and ultimately it is dangerous for the entire world.

      There are a lot of flat-earthers at the top who believe that the US’ comparative advantage is rent seeking.

      That model has failed and will continue to fail in the future.

      We in the US are no smarter than anyone else.


  2. Smith says:

    Are you not ignoring the fundamental change in banking that occurred in 2008 as an emergency response to the financial collapse? All the investment firms were converted into bank holding companies in order to reassure the market that the government would and could prevent any more Lehman Brothers like bankruptcies. Aren’t many regulation issues associated with that new system of banking? Previously the creation and growth of shadow banking in the late 90’s and 2000s allowed an uninsured and unregulated system to threaten the economy. Yet now that the crisis has passed, we could begin an orderly return to the older stable system, before we had to insure Morgan Stanley and Goldman Sachs http://dealbook.nytimes.com/2008/09/21/goldman-morgan-to-become-bank-holding-companies/ and before we repealed Glass Steagall.

    Complexity is the result of trying to allow the financial system to continue to gouge everyone else for their outsized share of the economy while preventing them from wrecking the economy in their quest for an even greater share.

    You seem to also ignore the Supreme Court decision in 1978 affecting interest rates on consumer credit, the bank deregulation act passed in 1980, and laws affecting ability to discharge student loans in 1990s, and 2005 bankruptcy act. When you allow banks to make bad loans and high risk loans because they can charge high interest to recover losses, and the loans can never be dismissed, you remove moral hazard. The affect isn’t neutral, it actually encourages making profits this way, and usually (because there are rich deadbeats too), that means preying on lower incomes.

    If one ignores all the fundamental changes in banking law that led to the crisis, the result is complexity. The simple solution is a restoration of the New Deal.


  3. Robert Salzberg says:

    Recognizing systemic risk is close to worthless compared with policies that prevent its formation. We need to both restore Glass-Steagall, which removes taxpayer insurance from insurance companies and investment banks, and we need to enforce existing anti-trust legislation in multiple industries including banking, telecom, and energy.


  4. Tammy says:

    I looks like I might need to start brewing the coffee and read Chapter 7 of The Reconnection Agenda along side IMF Working Paper Research Department What Is Shadow Banking? prepared by Stijn Claessens and Lev Ratnovski.


  5. Tammy says:

    It looks like I might need to start brewing the coffee and read Chapter 7 of The Reconnection Agenda along side IMF Working Paper Research Department What Is Shadow Banking? prepared by Stijn Claessens and Lev Ratnovski.


  6. Tammy says:

    I can totally relate only with no earpiece prompt.

    “As an occasional TV pundit, a creature that many readers may
    shrink from (after all, you are reading, not watching!), I often get
    asked big, fat, substantive questions and told I have 30 seconds to
    answer them (and if you go on for longer than that, as I’m wont to
    do, they yell ‘wrap!’ in your earpiece).”


  7. patrick says:

    how blithely we sail the prevailing wind
    privatization is the trend
    condemn to hell the public good
    they’d take it all if they could


  8. Wondering says:

    I’d like to begin my blog focus on international finance because the TPP is a pressing problem, but it is impossible to make a dent in that discussion in the short time that will be available before it passes. So I’ve decided to start the focus on domestic macro and built into international finance and trade after that is established.

    The behavioral interactions are easy to sort out with the right model, and they are extremely obvious and don’t require intense research. Just a bit of common sense and objectivity, with a slight creative (unconventional) tilt.

    I’m looking on track to begin that blog next week. I’ll point you to it then…


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