Focusing More on Outputs and Focusing More on Outputs and on Markets: What Financial on Markets: What Financial Regulation Can Learn from Regulation Can Learn from Progress in Other Policy AreasProgress in Other Policy Areas

Lawrence J. WhiteStern School of BusinessNew York Universitylwhite@stern.nyu.edu

Presentation at FDIC, Arlington, VA, November 30, 2007

OverviewOverview

Background on regulation (in general) Examples, in other areas of regulation, of

“success stories” that focused on outputs and markets

Examples of four proposals for reforms of financial regulation that would have focused on outputs and markets (but have not been adopted), and one area of successful flexibility: bank reserve requirements and the Fed Funds market

Conclusion

Classifying types of regulationClassifying types of regulation

Economic regulationHealth-safety-environment regulationInformation regulation

Economic regulationEconomic regulationControl over prices or profits or entry or

exit– The Civil Aeronautics Board’s (CAB) former

regulation of the airline industry– Bank regulators’ former ceilings on deposit

interest rates, limits on entry, branching– The Securities and Exchange Commission’s

(SEC) former restrictions on which bond rating companies can become a “nationally recognized statistical rating organization” (NRSRO)

Health-safety-environment Health-safety-environment regulationregulationControl over production processes or

inputs or outputs– The Federal Aviation Administration’s (FAA)

safety requirements for airlines and pilots– Bank regulators’ safety-and-soundness

regulatory requirements for banks– The SEC’s minimum capital requirements for

broker-dealers and competency requirements for securities brokers

Information regulationInformation regulation

Control over the types and formats of information – Department of Transportation’s (DOT)

regulation of fare announcements by airlines– Bank regulators’ interest rate disclosure

requirements– SEC’s disclosure requirements for publicly

traded companies

Where does corporate Where does corporate governance regulation fit in?governance regulation fit in?The goal of corporate governance

regulation – assuring investors of a fair outcome – is not all that different from the safety goals of the FAA or the Consumer Product Safety Commission (CPSC)

Classifying regulatory Classifying regulatory implementationimplementation Command-and-control regulation: Centrally

devised (macro) solutions imposed at the micro level; often “one-size-fits all”– Technology standards (inputs oriented)

All firms must adopt a specific technology

– Performance standards All firms must meet a specified level of performance, but can

choose their technologies

– “Bubble” concept The firm is judged on its aggregate performance (put a

plastic bubble over the entire firm), not on the performance of individual units

Regulation of the auto industry Regulation of the auto industry exemplifies all three conceptsexemplifies all three conceptsVehicle safety standards embody

technology requirements and performance requirements

Vehicle pollution control requirements embody performance requirements

Vehicle fuel mileage requirements (CAFE) embody the bubble concept

Going beyond command-and-Going beyond command-and-control: embracing “outputs control: embracing “outputs and markets”and markets”“Cap-and-trade” system for controlling

SO2 emissionsElectromagnetic spectrum auctions“Dedicated-access-privilege” programs for

fisheries

““Cap-and-trade” system for Cap-and-trade” system for SOSO22 emissions emissionsReplaces command-and-control with much

greater flexibilityNational aggregate maximum amount of

annual SO2 emissions has been allocated among electric utilities

They can trade SO2 emissions permits among themselves

This encourages greater efficiency and innovation

The SO2 program has been highly successful

Electromagnetic spectrum Electromagnetic spectrum auctionsauctionsReplaces Federal Communication

Commission’s (FCC) command-and-control allocation of broadcast licenses

Auctions have allowed greater flexibility in use, greater efficiency

Auctions have generated tens of billions of dollars for the federal treasury

Spectrum auctions are considered highly successful

““Dedicated-access-privilege” Dedicated-access-privilege” (DAP) programs for fisheries(DAP) programs for fisheriesFisheries are a watery commons and often

suffer from “the tragedy of the commons”Response of the National Marine Fisheries

Service (NMFS) has been command-and-control regulation for overfished fisheries

DAP programs are like “cap-and-trade”– Set an annual “total allowable catch” TAC– Allocate TAC among fishermen– Allow trading of the allocations

DAP programs in U.S. and especially abroad have been highly successful

Financial regulationFinancial regulation Financial regulation is not different from other

regulation Financial regulation sometimes encompasses

technology standards and sometimes encompasses performance standards; often “one-size-fits-all”

Where are the programs that emphasize “outputs and markets”?– Bank reserve requirements and the Fed Funds market– And some proposals

Benston/Kaufman proposal for mandatory subordinated debt for banks

Klausner’s proposal for CRA reform Ronen’s proposal for financial statement insurance (FSI) My proposal for NRSRO reform

Bank reserve requirements and Bank reserve requirements and the Fed Funds marketthe Fed Funds marketDepository institutions are required to hold

funds “in reserve” as vault cash or as deposits at the Federal Reserve, calculated as a fraction (e.g., 10%) of their deposits

The Fed Funds market permits banks to buy and sell “excess reserves” and thus provides flexibility in meeting the requirement– “Floor and trade”

Capital requirements for banksCapital requirements for banks

Depository institutions are required to hold minimum levels of capital (net worth) as a % of assets– Capital is a direct buffer that protects

depositors (or the deposit insurer) against reductions in asset values

– Capital represents the owners’ stake in the bank; a greater stake reduces the incentive for risk-taking

The Benston/Kaufman 1988 The Benston/Kaufman 1988 proposal for mandatory proposal for mandatory subordinated debtsubordinated debt As part of their capital requirement, depository

institutions should be required to issue a tranche of subordinated debt

Sub debt would bring a set of stakeholders who would lose from the down side of risk-taking but not gain from the up side

Sub debt holders might restrain risk-taking by owners (or managers on owners’ behalf)

Regulators might use the yields on subordinated debt to help identify problem institutions

The Benston/Kaufman proposal has never been implemented

The Community Reinvestment The Community Reinvestment Act of 1977Act of 1977The CRA requires banks to “meet the

credit needs of the local communities in which they are chartered consistent with safe and sound operation of such institutions”

The CRA is command-and-control regulation– Technology standards from 1977-1995– Performance standards since 1995

Michael Klausner’s 1995 reform Michael Klausner’s 1995 reform proposalproposalA bank’s CRA annual commitment would

be specifically defined as a dollar amount of loans originated and/or held

The obligation could be transferred to other lenders; a market could develop– Consciously modeled on the SO2 “cap-and-

trade” programKlausner’s proposal has never been

implemented

Current accounting/auditing Current accounting/auditing arrangements: the problemarrangements: the problem Investors and creditors rely on financial

statements Auditors are hired (and can be fired) by

corporate boards of directors, who are selected by managements– Managements always favor rosy scenarios

Auditors face an inherent conflict of interest After-the-fact liability suits are an imperfect

solution Sarbanes-Oxley command-and-control regulation

is not a satisfactory solution

Joshua Ronen’s 2002 proposalJoshua Ronen’s 2002 proposalCompanies would purchase “financial

statement insurance” (FSI) from a competitive insurance market

The insured amount and the premium would be public information

FSI ends the auditor’s conflict of interest: The FSI insurer would hire the auditor and would be interested in “the truth”– Rosy scenario means premiums that are too low– Pessimistic scenario means that the insurer would be

underbid by an insurer with a more accurate auditorRonen’s proposal has not been acted upon

NRSRO regulationNRSRO regulationThe bond rating industry was subject to

protective regulation by the SEC, 1975-2006 – In 1975 the SEC created the category “nationally

recognized statistical rating organization” (NRSRO) and grandfathered Moody’s, S&P, and Fitch

The NRSRO category created an artificial barrier to entry

The SEC never defined NRSRO– When it proposed a definition (in 1997 and 2005),

it focused on inputsThe NRSRO designation process was opaque

My 2002 reform proposalMy 2002 reform proposal Plan A: abandon the NRSRO category and allow

financial markets to form their own judgments as to reliable bond ratings and rating companies

Plan B: retain the NRSRO category, but the SEC must cease being a barrier to entry and must certify NRSROs on the basis of “outputs” – efficacy in predicting bond defaults – rather than inputs

This proposal was not acted upon; but the new (Sept. 2006) NRSRO law may reduce the barrier to entry – or not

Conclusion (1)Conclusion (1) An “outputs and markets” orientation would be

worthwhile for financial regulation There are successful examples in other

regulatory areas Bank reserve requirements and the Fed Funds

market are an example of successful application The mandatory sub debt proposal, Klausner’s

CRA proposal, Ronen’s FSI proposal, and my NRSRO proposal show that these ideas are more widely applicable to financial regulation

There are surely more areas of financial regulation where these ideas could be applied

Conclusion (2)Conclusion (2)

My message to financial regulators and policy makers and to financial sector researchers: Think expansively and creatively! Think “outputs and markets”!