A recent open letter from an SEC Commissioner reminded us of several absurdities of the U.S. financial regulatory apparatus. The Commissioner railed against the Treasury Office of Financial Research (OFR) report on Asset Management and Financial Stability. At the request of the Financial Stability Oversight Council (FSOC), the OFR sought to analyze activities in the asset management industry that could pose risks to the broader financial system.
The Commissioner complains that the FSOC and the international Financial Stability Board (which also is looking at whether large asset managers should be designated as systemically important financial intermediaries (SIFIs)) are dominated by bank regulators who “are intent on expanding the jurisdiction of their agencies led by certain constituent members by designating non-bank entities as systemically important with little or no input from the primary regulators of those entities.”
In an earlier post, we argue that regulating the activities of the asset management industry would be far more effective in limiting systemic risk than designating a handful of large managers as (global) SIFIs simply because they are big. We do not rule out designating asset managers as SIFIs, but note that the burden of proof will be high and likely based on operational considerations.
Unlike the SEC Commissioner, we also do not view it as “pure – and dangerous – folly” to pose the question about how the asset management industry – with an estimated $80 trillion under management globally – could be systemic. In fact, we think the FSOC is obliged by law (see Dodd-Frank Act Sec. 112 (a) (1) (A)) to “identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.” (Our italics.)
As scholars, researchers, and (in one case) former policy advisers we are hardly troubled by disagreement among lawmakers, regulators, supervisors, and others about how best to proceed in limiting systemic risk. The truth is that no one has a clear and reliable formula for how to identify, much less mitigate, systemic risk while promoting an efficient financial system. In the end, there are surely sensitive political tradeoffs between financial efficiency and safety. Moreover, in this particular instance, asset managers and banks are very different, implying a need for a different regulatory approach that preserves the enormous benefits to the U.S. economy from our enviably outsized and efficient nonbank sources of finance.
Rather, our concern is that the continued balkanization of the U.S. regulatory apparatus itself favors turf battles rather than cooperation among regulators. It facilitates shopping and capture by those being regulated, as regulators seek to keep existing clients and attract new ones. Ultimately, the current setup promotes regulatory arbitrage and creates systemic risk that can lead to a future financial crisis.
Following the 2007-2009 financial crisis, the U.S. government – both the legislative and executive branches – missed a once-in-a-lifetime opportunity to streamline the complex U.S. regulatory apparatus that adds to costs and uncertainty without ensuring financial stability. No country has a more complex and opaque regulatory structure than the United States. Indeed, no major economy is even close. In addition to the array of federal regulators with overlapping authorities – seemingly designed to generate conflict – we also have state regulators for banking and for insurance (which still lacks a federal regulator). Even state attorneys general occasionally use their legal powers to seek changes in the nation’s financial industry. The result is well over a hundred regulators with competing jurisdictions, mandates and objectives.
Faced with this obscure Rube Goldberg regulatory apparatus that played a significant part in bringing on the crisis, the Dodd-Frank Act – the biggest financial reform since the Great Depression – eliminated exactly one federal regulatory entity: the hapless Office of Thrift Supervision (OTS). The OTS’s failures had become so obvious – they had “supervised” AIG, Countrywide, IndyMac, and Washington Mutual, among others – that they were widely viewed as the slowest of a slow pack and were summarily fed to the wolves.
In sharp contrast to the United States, the most unified regulatory structure we know of is that of the United Kingdom, home to the world’s first or second largest financial center. The U.K. apparatus has a 21st century logic (see description here). It cleanly separates the regulation of fair conduct in financial markets (including anti-fraud efforts) from the regulation of systemic risks (including macroprudential oversight), recognizing that the expertise and talents needed for these different objectives are also very different. Aside from fair conduct regulation, the bulk of the U.K.’s regulatory apparatus is now housed within the Bank of England, with the Prudential Regulatory Authority (PRA) supervising key banks and nonbanks. Evidently, making the regulatory apparatus simple and transparent has not undermined London’s attractiveness as a global financial center.
Along with a number of other academics, we think it makes sense to have only one systemic regulator and that it should probably be the central bank. (See, for example, this Squam Lake Group working paper and a recent presentation by one of us.) The central bank has the expertise to judge the potential tradeoffs between conventional monetary policy and financial stability goals. As the lender of last resort, it is also obliged to know its customers before lending. At the same time, we think the central bank should not be in the business of implementing fair conduct rules or ensuring consumer protection in financial markets. It makes sense to have someone different (and preferably only one agency!) enforcing these rules.
The FSOC was designed by Dodd-Frank in part to bring order of out of the U.S. regulatory chaos; to promote cooperation among regulators where conflict and turf battles have reigned for decades. We admire the FSOC’s broad efforts (even if we may disagree with particular analyses or decisions). But, as the SEC Commissioner’s open letter shows, the FSOC’s task of securing effective cooperation among regulators with different mandates, staffs, training, cultures, clientele, funding sources, and even different pockets of legislative support, has already become highly politicized.
To get the right policies you need the right governance. Dodd-Frank just didn’t get this right. So we may have to wait for the next financial crisis to get a 21st century regulatory structure in the United States. For now, the public should call on the parties involved to behave cooperatively, to stop worrying about who does the job, and to focus on making sure that whoever does it, does it right.