A Non-Quixotic Defense of Regulatory Complexity

One of the frequent “flavors du jour” of financial regulatory reform is a call for simplification and consolidation of the American financial regulatory system. The current advocate of consolidation is Senator Christopher Dodd, the chairman of the Senate Banking Committee. Before him, the US Treasury’s “Blueprint for Reform”, released in March 2008, even before the severity of the current crisis was recognized, similarly called for simplification.

Such advocacy is understandable, and is surely well-intentioned. But it is misguided, since regulatory consolidation would likely entail more costs than benefits. There is a greatly underappreciated strength to the current regulatory structure – a beneficial receptivity to innovation in many dimensions – that would likely be lost (or at least greatly weakened) in consolidation.

Conceding the obvious

Let me begin by conceding the obvious: The American financial regulatory system is quite complex. Any attempt to describe the landscape of financial regulation is an exercise in frustration, because the system is so complicated:

• There are five federal regulators of depository institutions (OCC, [1] OTS, FDIC, NCUA, and the Federal Reserve), as well as one or more depository regulators in each of the 50 states;
• The states regulate mortgage lenders/originators that are not depositories, but so does the Federal Reserve;
• There is a separate regulator (FHFA) for Fannie Mae and Freddie Mac and the Federal Home Loan Bank System;
• There are two federal agencies (SEC, CFTC) that deal with securities and related financial instruments, as well as 50 state securities regulators (and 50 state attorneys general);
• The regulation of insurance companies is exclusively the domain of the 50 states;
• Pension funds are regulated by two federal agencies (PBGC, DOL), and again all 50 states have a say; and
• Consumer fraud in financial products can be the responsibility of most of the federal agencies that have already been mentioned, plus yet another federal agency (FTC), as well as the 50 states.

There are overlapping responsibilities and jurisdictional disputes galore. Indeed, any attempt to diagram these multiple agencies and their responsibilities ends up looking far more complicated than a 1930s radio wiring diagram.

Let me concede a second obvious point: This crazy-quilt pattern does add to costs: the costs of compliance by financial services companies, and the costs of the regulatory system itself. I’ll even concede a third point: The presence of multiple regulators opens the door to the possibility of “forum shopping” by regulated institutions that are looking for the least burdensome regime, which might then trigger a “race to the bottom” by regulators that want to preserve the sizes of their regulatory fiefdoms, regardless of the costs. So, how can one defend such an obviously faulty system?

Diversity Encourages Innovation

There is an important advantage to the complicated regulatory structure that is never mentioned by simplification proponents: the duplication of agencies provides alternate outlets for someone with a good idea – whether it’s a better way to regulate or a better financial instrument. Just as a monopoly in the private sector can be an impediment to new ideas, so can a monopoly in government regulation.

In essence, with a single consolidated regulator, that single agency’s “no” is the end of the line for someone with a better idea. By contrast, multiple regulators mean multiple chances for a good idea to take root. In this context, forum shopping and regulatory competition can mean a race to the top.

A few anecdotes can illustrate the benefits of diversity and alternatives in regulation. In the 1970s, the introduction of exchange-traded financial derivatives happened in Chicago, on exchanges that had previously handled agricultural and minerals futures, and under the regulatory jurisdiction of the CFTC. This was not a coincidence. These new financial instruments were seen as competition to the stocks and bonds that were traded in New York and that were under the jurisdiction of the SEC, which was usually sympathetic to the concerns of the New York-based brokerage community. Had there been only one regulator – which surely would have been the SEC – the development and flourishing of these instruments would have been restricted and delayed.

A second anecdote also focuses on the 1970s: one of the regulatory legacies of the 1930s was the legal requirement that the Federal Reserve (through its “Regulation Q”) place ceilings on the interest rates that banks (and, starting in 1966, savings and loan [thrift] institutions) could pay on deposits. The Congressional intent was to restrict banks’ competition for deposits, which had (mistakenly) been thought to have encouraged unprofitable lending by banks and to have contributed to the wave of bank failures in the early 1930s.

The consequence of the Reg Q ceilings for a roughly competitive banking (and thrift) industry was exactly what is taught to freshmen in Economics 101: a shortage of supply (of deposits) by households and businesses, an excess of demand (for deposits) by banks and thrifts, and the development of less efficient ways of inducing households to bring and keep their deposits in banks and thrifts, such as offering them toasters, which began in the 1960s as a response to Reg Q’s ceilings when market interest rates were appreciably higher than these ceilings. The ceilings also spurred efforts to develop a safe and liquid financial alternative to deposits that would appeal to households and businesses.

The breaking of this gridlock started with a different regulator: the NCUA, which in the early 1970s placed no restrictions on the interest rates that credit unions could pay to their depositors. This competition then put pressure on thrifts, which received some exemptions, and then on banks, which also received some exemptions.

Equally important, in the early 1970s the SEC granted its approval to the innovation that satisfied the search for a safe liquid alternative to deposits: the money market mutual fund. When market interest rates rose sharply in the late 1970s, depositors left banks and thrifts in droves and invested instead in the money funds, whose interest returns reflected market rates, and Reg Q’s fate was sealed.

In the early 1980s, most of Reg Q was (finally) repealed, and banks and thrifts could pay market rates on their deposits (although a vestige of Reg Q remains today in the prohibition on banks and thrifts from paying interest on business checking accounts). The competition inspired by the NCUA and the SEC surely hastened the demise of this inefficient regulatory restriction.

A third anecdote involves regulatory expertise in the 1990s concerning methods of measuring and regulating the interest rate risks that are embedded in the fixed-rate mortgages that are held by depository institutions. In this respect, the OTS (which regulated thrifts) had far better knowledge of the problems and regulatory procedures for dealing with those interest-rate risks than did the commercial bank regulators (the OCC, FDIC, and Federal Reserve) at the time. It took a while for the latter to catch up.

One more anecdote closes this set: In the mid 1990s, the Office of Federal Housing Enterprise Oversight (which was the regulator of Fannie Mae and Freddie Mac until 2008) developed dynamic stress tests to determine the capital adequacy of the two secondary mortgage market enterprises. For over a decade it was the sole US regulatory agency to employ stress tests. The five federal regulators of depository institutions were focused instead on more static capital requirements.

In early 2009, however, the US Treasury decided that the 19 largest commercial and investment banks should be subjected to stress tests, so as to determine the state of their capital adequacy. It now seems likely that stress tests will now be a standard part of the bank examinations that regulators regularly conduct for all banks and thrifts and their holding companies.

In sum, there is a potentially large benefit to regulatory diversity and a corresponding cost to consolidation: the loss of innovations in multiple dimensions.

Regulatory Error

The threat to innovation from regulatory consolidation is just one facet of a larger issue: regulatory error. Although a consolidated regulator would mean that the entire system would benefit when that regulator makes a good decision, it would equally mean widespread negative consequences when that regulator makes a mistake. An acknowledgement of the possibility (likelihood?) of regulatory error is an argument for regulatory diversity.

A more recent anecdote illustrates this point: over the past decade there have been laborious efforts to update the capital requirements that apply to US banks, by applying the framework of the “Basle II” rules. This framework, developed by the governments of the major industrial countries in the late 1990s under the auspices of the Bank for International Settlements ( located in Basle), allows large sophisticated banks to develop their own risk models (with regulatory oversight) that would determine capital requirements. It was widely reported that the Federal Reserve was a strong advocate of the new framework, while the OCC and the FDIC had substantial reservations about the low capital levels that were likely to result. The two agencies’ opposition delayed the implementation of the new capital requirements for commercial banks and thrifts, and likely avoided even greater damage to these institutions from the residential mortgage debacle.

This last experience highlights a further aspect of diversity: throughout this essay I have argued that multiple agencies provide more opportunities for beneficial innovations to take root and eventually spread. But don’t multiple agencies also provide more opportunities for bad ideas to take root and spread, via forum shopping and the regulatory race to the bottom?

As I conceded initially, a race to the bottom can’t be ruled out as a possibility. But, if we use a Darwinian perspective, good ideas are more likely to take root and spread – sooner or later – while bad ideas are more likely to whither (again, sooner or later) when exposed to the greater scrutiny that multiple agencies provide. And, again, from a Darwinian perspective, the presence of more regulatory agencies increases the prospects for the good ideas to gain and the bad ideas to lose.

Did Regulatory Complexity Contribute to the Debacle?

There is no credible argument that links American financial regulatory complexity to the residential mortgage debacle. Yes, there was too much regulatory laxity at too many regulatory agencies, especially with respect to capital requirements. But the multiplicity of regulatory agencies didn’t contribute to that laxity and, as just argued, may have even helped avoid even worse consequences. Further, although most European countries have more consolidated financial regulatory systems, those consolidated systems do not appear to have avoided the problems of the financial crisis any more successfully than did the diversified financial system of the US

In sum, the current effort to link regulatory consolidation to current efforts to reform financial regulation, so as to prevent a reoccurrence of a similar crisis, seems more in the spirit of Rahm Emanuel’s maxim of “never allow a crisis to go to waste” than a response to any logical or empirical connection between the debacle and regulatory complexity. Indeed, advocates of consolidation often are also advocates of the recent proposals to add a new federal consumer financial protection agency and a new federal charter (and associated federal regulatory agency) for insurance companies. These advocates apparently see no contradiction in their position, since the added diversity and duplication of these new agencies are considered positive attributes of the proposals.

A More Short-Term Argument

Whenever major structural changes in organizations – public or private – take place, valuable time and effort are lost as employees try to figure out their new positions and responsibilities, as well as maneuvering for choice assignments and even choice office locations. Some valuable employees may elect to leave the organization, which will necessitate new recruitment and additional training. The frictions of organizational change can be considerable.

A final anecdote is illustrative: in the late summer of 1983, the Federal Home Loan Bank Board (which, at the time, was the federal regulator of thrifts in the US) moved one of its twelve district offices from Little Rock to Dallas. In the abstract, this move made a great deal of sense: Little Rock was not a regional financial center; Dallas was. Dallas was the location of one of the twelve regional banks of the Federal Reserve System. The Little Rock office had had difficulties in recruiting personnel; recruiting in Dallas would surely be easier.

However, the move proved to be quite disruptive; and, in retrospect, its timing was abysmal. Insufficient numbers of seasoned personnel moved from the Little Rock office to Dallas, and recruiting and training their replacements took time. The regulatory functions of that office, which covered the examination and supervision (i.e., the safety and soundness) of thrifts located in the states of Texas, Arkansas, Louisiana, Mississippi, and New Mexico, suffered.

The new Dallas office required approximately two years to regain the full regulatory effectiveness that had been present in Little Rock. During the interim, too many thrifts in these states – especially in Texas – took advantage of the readily-apparent weakened oversight and monitoring, and expanded their assets and activities rapidly, with subsequent consequences that contributed greatly to the overall “savings and loan debacle” of the 1980s.

This argument, if taken too far, would seem to argue against any organizational change whatsoever. That, of course, is not my intent. But these inevitable costs of organizational restructuring should be recognized and should be included in the balancing of benefits and costs of any proposal to consolidate financial regulatory agencies.

An analogy

It is often claimed that the initial designers of a regulatory structure would never create the duplication and overlaps of jurisdiction that the current American regulatory landscape supports. This may well be true. But would this initial simplicity really be a wise course of action?

Consider the design of a modern passenger jet airplane. Such aircraft have duplicate systems – which are costly but deliberately designed for the aircraft in the initial stages, to protect against failures. Surely a modern financial system is at least as complex – and as worthy of protections against failures – as a modern jet airplane.

A Concluding Image

In Robert Bolt’s “A Man for All Seasons,” Sir Thomas More asks his son-in-law, William Roper, “What would you do? Cut a great road through the law to get after the devil?” When Roper replies affirmatively, More responds, “Oh? And when the last law was down and the devil turned ‘round on you, where would you hide, Roper, the laws all being flat?”

A monopoly regulator need not be the devil. Nevertheless, a monopoly regulator is still a monopolist, with all of the downsides of monopoly. Advocates of consolidation wholly ignore the loss of innovation, and the heightened costs from regulatory error more generally, when the protections that come with diversity and duplication are “all being flat.”

Those losses and costs, as well as the short-run costs from any reorganization, are likely to be substantial. Diversity, and even duplication, has its virtues.

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A glossary:

CFTC: Commodity Futures Trading Commission

DOL: Department of Labor

FDIC: Federal Deposit Insurance Corporation

Federal Reserve: Board of Governors of the Federal Reserve System

FHFA: Federal Housing Finance Agency

FTC: Federal Trade Commission

NCUA: National Credit Union Administration

OCC: Office of the Comptroller of the Currency

OTS: Office of Thrift Supervision

PBGC: Pension Benefit Guaranty Corporation

SEC: Securities and Exchange Commission

[1] A glossary of agency abbreviations and their full agency names is provided at the end of this piece.