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Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.

Causes

In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

Core Approaches to Financial Regulation

In a book with James Barth and Gerard Caprio titled Rethinking Bank Regulation: Till Angels Govern, we argue that an approach to regulation that focuses on making sure financial institutions have sound incentives, promoting transparency, and empowering private sector oversight of banks works best to promote the efficient allocation of capital.

The recent crisis underscores the value of these recommendations.  The U.S. authorities enacted and maintained policies that created incentives for financial institutions to take excessive risk, making financial markets more opaque and adding to the difficulty investors face in monitoring and influencing financial institutions.

Yet, many U.S. policies were implemented in the name of “free markets.”  This is nothing but false advertising, as I argue in The Sentinel: Improving the Governance of Financial Regulation.  It is a misappropriation of the phrase “pro free market” to argue that removing any single regulation in isolation will necessarily improve the operation of financial markets when many other regulations, market imperfections, and government interventions will persist. In the messy real world, widespread informational asymmetries impinge on the perfect functioning of financial markets. In the real world, politicians have always -- and will always -- meddle in the financial system to tilt the flow of society’s savings toward preferred ends.  In the real world, we are unlikely to create a financial system that is free from political interference and the distortions created by those interventions.  Thus, in the real world, we must focus on how a regulatory change will affect incentives.  Embracing an ideological tenet that fewer regulations are everywhere and always better than more regulations will lead to disaster, as we are currently experiencing.

Systemic Change

We need a systemic change, as argued in “The Sentinel: Improving the Governance of Financial Regulation” and my forthcoming book with James Barth and Gerard Caprio, tentatively titled “Guardians of Finance: Making Them Work for Us.”  Since the regulatory authorities knew their policies were destabilizing the global financial system, had the power to change their policies, and chose not to reform their policies, we need a fundamental change in the regulatory system.

I propose the creation of a new institution, which I label the “Sentinel.”  Its sole power would be to acquire any information necessary for evaluating the state of financial regulation.  Its sole responsibility would be to continuously assess and comment on financial policies.  Critically, and uniquely, the Sentinel would be independent of both politically and financial markets.  Senior members would be appointed for staggered terms to limit political influence.  To shield it from market influences, senior staff would be prohibited from receiving compensation from the financial sector after completing public service for a lengthy period of time.

Yes, we really do need another regulatory institution.

In capitals around the world, lobbyists shape legislation, and the revolving door between industry and regulatory agencies spins rapidly, which is powerfully illustrated by the career histories of Federal Reserve and SEC officials. No existing entity—including the Federal Reserve—has the independence, prominence, and information to challenge existing regulatory agencies on financial policy matters.  The current monopoly on regulatory power and information amplifies the danger created by these conflicts of interest.

The Sentinel would stand above this fray.  Its prying eyes would reduce the ability of regulators to obfuscate regulatory actions, enhancing accountability and hence regulatory performance.  Moreover, although the Sentinel would not set any policy, it would provide an objective, independent assessment of policy. This would have been enormously valuable during the decade-long series of policy gaffes that contributed to the current crisis. 

While no panacea, the Sentinel would improve the regulatory apparatus.  It will increase the likelihood that regulatory authorities will implement policies that foster the provision of growth-promoting financial services while avoiding the financial shenanigans associated with crises.

Finance has a direct impact on who can start a business and who cannot, who can pay for education and who cannot, who can attempt to realize one’s economic aspirations and who cannot.  It shapes the opportunities available to individuals and the overall rate of economic progress.  In a dynamic economy, we face the complex, and consequential, challenge of creating a regulatory regime that continually adapts to incentivize financiers to provide the financial services necessary for economic growth.  Focusing regulatory policies on transparency, incentives, and competition and incorporating the voice of an independent institution will get us closer to that goal.

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