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Wednesday, March 24, 2010

Rules versus Discretion in Financial Regulation

Mike Konczal says we need rules regulating leverage, discretionary authority isn't enough:

Putting Stronger Limits into the Dodd Bill, by Mike Konczal: ...Current regulators and industry leaders will tell us that the financial capital markets are up to The Swanson Code, the “I’ll know trouble when I see it” system; however we want there to be clear rules...
Ryan Avent and Kevin Drum both look at the Dodd Bill and are left a little worried about financial reform. ... Here’s one thing that is probably worrying them. This is language from the final House Bill, HR 4173 (giant pdf, page 44):
(3) LEVERAGE LIMITATION.—The Board shall require each financial holding company subject to stricter standards to maintain a debt to equity ratio of no more than 15 to 1, and the Board shall issue regulations containing procedures and timelines for how a financial holding company subject to stricter standards with a debt to equity ratio of more than 15 to 1 at the time such company becomes a financial holding company subject to stricter standards shall reduce such ratio.
Here’s the equivalent language from the Dodd Bill (giant pdf, starting page 25):
(2) DUTIES.—The Council shall, in accordance with this title….(H) make recommendations to the Board of Governors concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures, and overall risk management for nonbank financial companies and large, interconnected bank holding companies supervised by the Board of Governors
In both bills, regulators have discretion in how to set limits, as determined by internal risk managers. In the House Bill though, there’s a strict limit: no systemically risky firm can have leverage greater than 15-to-1. In the Senate, the FSOC will make recommendations to the Federal Reserve. The Federal Reserve will do like, whatever it wants – it could follow the recommendations. Or it could not.
This solution in the House Bill is a satisficing solution – there are almost certainly firms that could handle being leveraged 16-to-1. However we don’t trust the regulators to be able to detect that firm and also not bend the rules for firms that couldn’t handle that leverage. So we write down a clear rule.
And these clear rules are exactly what the lobbyists are going to go after. ...

In this case, I like rules rather than discretion. One reason is to limit the damage that the next financial shock can do, with less leverage, there is less to unwind, and less overall damage. Strict limits on leverage help to set bounds on the damage that a financial shock can cause. But another reason -- making resolution authority credible -- is only indirectly related to leverage.

One of the things almost everyone agrees on is the need for resolution authority for large, systemically important banks. As Ben Bernanke recently said:

... because government oversight alone will never be sufficient to anticipate all risks, increasing market discipline is an essential piece of any strategy for combating too-big-to-fail. To create real market discipline for the largest firms, market participants must be convinced that if one of these firms is unable to meet its obligations, its shareholders, creditors, and counterparties will not be protected from losses by government action. To make such a threat credible, we need a new legal framework that will allow the government to wind down a failing, systemically critical firm without doing serious damage to the broader financial system. In other words, we need an alternative for resolving failing firms that is neither a disorderly bankruptcy nor a bailout. ...

But this must be a credible, time-consistent threat. That is, when the time comes to actually implement this policy and use the resolution authority, will the government actually do it, or will fears of what might happen to the financial system lead government regulators to the more familiar route of bank bailouts? I think this is a real problem (and one of the reasons over and above traditional worries about maintaining competitive markets why I'd like to see size come under more scrutiny -- how large do banks need to be in order to provide the needed financial services at the lowest cost?). But this is less likely to be a problem if the bank's leverage ratio is lower. With lower leverage, the fear of causing a wider panic when using resolution authority to "wind down" a bank that is in trouble is also lower, making such action easier to take.

Neither of the reasons given above for limiting leverage -- limiting the damage a financial shock can do and making resolution authority credible -- require rules rather than discretion to be accomplished. Discretionary authority can always choose to mimic the strict rule limiting leverage, so in theory discretion ought to be at least as good as a rule. But discretion has it's own problems, regulatory and ideological capture among them, and in this case I have more faith in a rule.

    Posted by on Wednesday, March 24, 2010 at 11:18 AM in Economics, Financial System, Regulation | Permalink  Comments (20)


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