Felix Salmon sets out today to attack the notion that when it comes to financial regulation “we can’t put all our eggs in one basket.” But the core of his argument is based on a mistaken view of how regulatory failure contributed to our crisis.
The idea that we’d benefit from a diversity of regulatory agencies overseeing the financial sector formed the core of FDIC chair Sheila Bair’s argument on the New York Times op-ed page yesterday against a unitary systemic regulator. Salmon thinks this is nonsense.
Against Diversity And Regulatory Shopping
“To the contrary, we have to put all our regulatory eggs in one basket, because otherwise the phenomenon of regulatory arbitrage will simply result in a race to the least-safe basket, as well as competition between regulators to see who can be most accommodating to banks,” Salmon writes.
For Salmon “the most corrosive aspect of the US regulatory infrastructure” is the ability of financial institutions to engage in regulatory shopping. He thinks that the ability of financial institutions to choose between structures led to the crisis.
But there’s really very little evidence that regulatory shopping contributed to our problem at all. And, in fact, many of our most serious regulatory failures came from an over-concentration of authority rather than a lack of authority.
Let’s take the most popular example of regulatory shopping: AIG opting to have the Office of Thrift Supervision operate as its primary regulator. Since the OTS is regarded as a minor-league regulator, this is seen by many as what allowed AIG to get too heavily involved in the credit default swap business that all-but wiped it out.
Would The Fed Have Fared Better?
The unstated assumption is that some other regulator might have seen the disaster looming and prevented AIG from doing this. There’s absolutely no evidence warranting this counter-factual assumption. How do we know that? Because the regulatory body who presumably should have been overseeing AIG–the New York Federal Reserve–also missed the looming disaster and allowed a huge number of the institutions operating under its oversight to collapse.
Again and again, we see that the crisis is really rooted in a problem of knowledge and foresight rather than something more amendable to a technical fix.
Felix also under-estimates the ability of banks to game single regulators. Take the game of using credit default swaps to improve balance sheets and meet Basel I capital requirements. Despite a unified set of requirements imposed internationally, banks were still able to conceal risk by purchasing credit default swaps on risky assets. What’s more, they were encouraged to engage in reckless securitization by these requirements. There’s simply no reason to think that a unitary regulator will bring an end to regulatory arbitrage.
The Price of Unity: No Diversity
What’s more, the lack of foresight among regulators means that divided authorities may be better than a unitary authority. As we’ve seen in the different responses of the Fed, Treasury and FDIC to this crisis, divided authority characterised by a considerable pluralism of theories and policy paradigms. This regulatory pluralism can be beneficial for discovering and avoiding future problems. Since we cannot expect any ultimate, perfect approach to financial regulation, keeping this dynamic alive is important.
All this means is that instead of trying to centralize and unify, we should be doing the opposite. We need to preserve at least some effective level of decentralization and regulatory diversity to keep the system open for regulatory innovation and changes in business environment.