New Research: The Rule of Law in Financial Regulation

New Research: The Rule of Law in Financial Regulation

Financial reforms passed in the aftermath of the financial crisis were rooted in the logic that the market had failed disastrously, requiring technocrats and regulators to wield greater power to ensure the stability of the financial system.

But there is a necessary tradeoff between technocracy and the rule of law. Independent agencies run by experts have a natural appeal, but autonomy removes a degree of legislative accountability. Writing in Cato Journal, Charles Calomiris identifies the harms of such delegation:

Increasingly, our regulatory structure has been adopting processes that are inconsistent with adherence to the rule of law. These process concerns are rarely voiced by academics, but that is a strange omission. Appropriate regulatory process is fundamental to the ability of regulation to succeed because process defines the incentives of regulators, which are crucial to ensure that regulators act diligently in pursuit of bona fide objectives. Relying on regulatory processes that avoid transparency, accountability, and predictability increases regulatory risk and is likely to lead to poor execution of regulatory responsibilities, as well as create unnecessary regulatory costs and opportunities for politicized mischief. This is not merely a theoretical concern. As I will show, because recent regulation has increased regulators’ discretionary authority, and has reduced the predictability and transparency of regulatory standards, it has reduced the accountability of regulators. This has already resulted in abuses that not only deform our democracy but also impose unwarranted costs on the financial system and distract from legitimate problems that should be the focus of prudential and consumer protection regulation.

Calomiris focuses on four specific instances of regulatory failures enabled by broad or nonspecific legislative mandates for agencies with limited accountability.

First is the (agency formerly known as) Consumer Financial Protection Bureau. In addition to structural problems with the way the Bureau is designed, Calomiris cites the example of the Bureau’s efforts to combat discrimination in lending using statistical models, rather than a more thorough investigation of discrimination such as using testers to investigate specific instances.

Second, the now-defunct “Operation Choke Point,” first implemented by the Obama Administration and spearheaded by the FDIC, denied access to basic banking services to various industries engaged in “high-risk” activities, such as purveyors of pornography, payday lenders, “racist materials,” and some gun and ammunition dealers. All of this was done without legislation.

“Some observers may agree with Mr. Obama’s list of disfavored industries” writes Calomiris. “But now that Mr. Trump has taken office, will they agree with his list? Do we want our regulatory system to be a tool for attacking those our president dislikes? If not, it’s worth asking why the political abuse of regulation has become easier than in the past, and what can be done to stop it.”

Third is the Financial Stability Oversight Council (FSOC). FSOC is “charged to respond to systemic risks by recommending appropriate strengthening in regulatory standards, and designating, as appropriate, certain financial market utilities and nonbank financial institutions (or other firms) as systemically important…It is also empowered to break up any firms in the United States that it deems to be a ‘grave threat’ to systemic stability.”

These sound reasonable at first blush, but though it is tasked with identifying systemically important financial institutions (SIFI), there is no clear definition of what a SIFI is. Meanwhile, Calomiris notes that FSOC has been asleep at the wheel when it comes to the danger of another real estate bubble while instead being focused on “interconnectedness” in the financial sector.

Finally, Calomiris points to the stress tests conducted by the Federal Reserve, the most recent round of which were conducted this summer. A good idea in theory, these stress tests lack transparency in their methodology and can sometimes be changed on the basis of “qualitative judgment” outside of the already secret model.

Calomiris proposes a number of reforms to address these (and other) problems with financial regulation, but they all would harmonize regulatory authority with the rule of law. By eliminating “guidance” and replacing it with a more formal rulemaking process and greater accountability on the part of legislators, “[e]liminating the reliance on guidance also will reduce regulatory risk substantially, with favorable consequences for both growth and stability.”

Financial regulation is complicated and should rely heavily on the insights of experts (who are themselves not immune to the current misguided zeitgeist that governs thinking related to financial regulation), but this is still best done with transparency and formal rulemaking.

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By |2018-10-02T14:02:06-07:00October 2nd, 2018|Blog, Financial Regulation|