Missing Elements in US Financial Reform

In the paper, Missing Elements in U.S. Financial Reform: A Kubler-Ross Interpretation of the Inadequacy of the Dodd-Frank Act, which was recently made publicly available on SSRN, I summarize the incentive conflicts that led creditors and internal and external supervisors to short-cut and outsource due diligence. It is instructive to think of excessive financial-institution risk-taking as a disease, Congress and regulators as doctors, and the Dodd-Frank Act as a treatment plan. The success of any treatment plan depends on how completely the problems it targets have been diagnosed and how effectively the therapy prescribed can ameliorate these problems.

The Act purports to reduce systemic risk by expanding and reallocating regulatory authority. But officials’ way of thinking about systemic risk neglects the pivotal role that political pressure and their own incentive structure play in generating it. During the pre-crisis housing bubble, regulatory and supervisory entities misdiagnosed and mishandled the buildup of systemic risk in part to transfer subsidies to financial institutions, homeowners, and builders. When the bubble burst, regulators billed taxpayers for financial-institution losses without weighing rescue costs against those of alternative programs and without documenting how their program would distribute benefits and costs across the populace. Along with the policy of near-zero interest rates (which also help to recapitalize insolvent institutions), the rescue policies chosen inflicted substantial losses on depositors, on future taxpayers, on pension plans, and on persons living on interest income.

The Act’s treatment plan presumes that the current crisis was caused by “defective” risk management at private institutions. This narrow theory of blame is inadequate in four ways. First, it excuses safety-net officials for caving to political pressure to expand the safety net during the bubble and subsequent crisis. Second, without addressing ongoing weaknesses in their incentive structures, it calls upon government agencies that failed society during the buildup (such as the SEC) to devise and enforce rules tough enough to prevent their clienteles from engendering future crisis. Third, by accepting this assignment without protest, agency leaders have set their staffs up to be scapegoated for future crisis. Fourth, the theory accepts the unlikely hypothesis that the interest-rate and default risk inherent in long-term nonrecourse mortgage instruments can be fairly and efficiently financed for years on end by short-term debt protected by the safety-net guarantees.

To make firms and regulators accountable to the citizenry, I call for a series of informational reforms designed to exploit econometric advances in the measurement of contingent liabilities. This program has three components: (1) expanding the range of information that financial institutions generate and report; (2) separating bureaucratic responsibility for measuring growth in the safety net from responsibility for limiting safety-net growth; and (3) improving the tools and incentives of safety-net managers.

Complete and authentic incentive reform requires more precise mission statements and oaths of office for regulatory personnel. I propose that these statements and oaths should embody five ethical duties. I argue further that financial institutions should concede an express obligation to help the government to develop and use reliable metrics for preparing interval estimates of the ex ante value of their safety-net support and to report these estimates at regular intervals to supervisory agencies. In turn, I urge that a truly independent Office of Financial Research (OFR) be established whose mission statement would oblige it to identify publicly the ways in which regulation-induced innovation might be undermining the current structure of regulatory authority. Its task would be to challenge and vet the methods used and the subsidy calculations reported by private firms for reasonableness much as Internal Revenue Service personnel challenge and vet personal and corporate tax returns.

Recruitment and reappointment processes for top regulators typically generate a substantial trail of political debts. Far from emphasizing job skills (such as financial acumen, mental toughness, and loyalty to the taxpaying and voting public), high officials are screened first and foremost for connections and for their anticipated loyalty to the agenda of the President who appoints them. For these reasons, the US and other countries would be well advised to make regulatory careers more prestigious by establishing the equivalent of a publicly funded academy (i.e., a nonmilitary West Point) for financial regulators and welcome cadets from anywhere in the world. Reinforced by appropriate changes in regulators’ oaths of office and a system of deferred compensation, such an academy would raise the prestige of regulatory service and instill a stronger and broader sense of communal duty in safety-net managers than this generation of officials has shown during the current crisis. In view of the damage financial crises can cause, it is unfortunate that regulators have not been trained and incentivized as carefully as military, police, firefighting, and nuclear-safety personnel.

The fiscal deficits that nontransparent safety nets engender cannot be sustained forever. Knowledge of officials’ bailout reflex encourages opportunistic financial firms to foster regulatory weakness. Most of the profits that the financial industry reported in 2002-2007 turns out in retrospect to have been income transfers extracted from ordinary taxpayers and from families whose breadwinner were thrown into unemployment. Good stewardship requires that financial-institution managers and federal regulators embrace joint responsibility for identifying and disclosing taxpayers’ stake in financial firms. Unless taxpayers’ stake is made observable, incentives to confront the distributional consequences of regulation-induced innovation will remain weak.

The full paper is available for download here.