“The major impulses to successful financial innovations over the past twenty years have come, I am saddened to have to say, from regulations and taxes…[Through tax changes} The government is virtually subsidizing the progress of financial innovation just as it subsidizes the development of new seeds and fertilizers but with the important difference that in financial innovation the government’s contribution is typically inadvertent…the role of government in producing the pearls of financial innovation over the past twenty years has been essentially that of grain of sand in the oyster…the same process can be seen at work in any financial area subject to government regulation…The pressures to innovate around prohibited types of profitable transactions, or around newly imposed or newly-become-effective interest-rate ceilings, are particularly strong but, as we have come to see lately, even what purports to be deregulation can sometimes trigger changes that go far beyond the intentions of the original sponsors….The process of adaptation and selective survival in response to tax and regulatory changes has been going on throughout recorded history.” ((Merton Miller, (1991) Financial Innovations and Market Volatility, Cambridge: Blackwell, pages 5, 6, and 19.))
Writing in 1991, the Nobel Laureate in Economics, Merton Miller, pointed toward taxes and regulations as major drivers of financial innovation. Merton’s message complements other drivers we studied in the two previous weeks, profit-seeking, risk management, market incompleteness and market inefficiency. The point of our exploration in week five was to lay more groundwork for a critical appraisal of financial innovations in the weeks ahead: innovations in markets, institutions, instruments, and services.
Why regulate? A detailed answer could fill entire libraries. But in the abstract, regulation seeks to promote societal values, such as stability (e.g., capital requirements for banks), honesty (e.g., anti-fraud regulations), transparency (e.g., requirements about disclosing financial performance) and fairness (e.g., laws against insider trading). Such intentions may be found in the preamble to laws, the hearings on which those laws were based, court decisions about those laws, and in statements by public officials. The article by Campbell et al. explained that regulations aim to correct market failures that “impede efficiency or create unacceptable distributional outcomes”—such failures include externalities, search costs, market power, information asymmetries, and complexity.
Evidently, it’s a nasty world out there. In fiscal year 2016, the SEC filed 868 enforcement actions dealing with fraud, issuer disclosure, management accountability, fairness among market participants, insider trading schemes, misconduct by investment advisers, market manipulation, and foreign corrupt practices. In fiscal year 2015, the Comptroller of the Currency issued 302 enforcement actions against institutions and affiliated parties and reviewed 22, 468 consumer complaints that dealt with unfair billing practices and unfair marketing practices—the revelation in September 2016 that Wells Fargo opened some two million bank accounts without customers’ permission is the most prominent recent case. In fiscal year 2015, the Federal Reserve completed 51 formal enforcement actions and assessed $2.2 billion in penalties; and it completed another 91 informal enforcement actions that resulted in memoranda of understanding, commitments, and resolutions by bank boards. One could review the enforcement activity of all of the regulatory agencies, but you get the picture: bad stuff can happen.
Regulation creates incentives. These incentives might prompt businesses to do some things or stop doing others. For instance,
· Usury laws set maximum interest rates for loans. Typically, the intent of such laws is to stop extortion or predatory lending.
· Charters, granted by governments to financial institutions create protected franchises. By screening entrants, governments seek to promote prudence, safety, and soundness in the financial system.
· The Community Reinvestment Act of 1977 sought to stop discriminatory lending practices (called “redlining”) and to promote the availability of credit in low-income neighborhoods.
· Unit banking laws prohibited branch-banking. Popular in the 19th Century and in agricultural regions of the U.S., such laws were motivated by a belief that the unavailability of credit was due to the aggregation of savings into the money centers from bank branches in rural areas and that unit banks would help to retain capital in credit-starved regions.
· During the Panic of 2008, the Securities and Exchange Commission (SEC) used its regulatory powers to suspend short-selling in an effort to quell the cycle of panicked selling.
· The Dodd-Frank Act of 2010 introduced the most significant changes in financial regulation in 77 years. In one of its provisions, the Act mandated that credit default swaps, which are traded over-the-counter, should be cleared through exchanges. The intent was to promote standardization and transparency.
Side-effects. The reading by Acharya et al. stated that “Regulation is a tricky business; the law of unintended consequences always applies” and pointed to the mispricing of government guarantees, acceptance of opacity of firms and markets, and a narrow focus on individual, rather than systemic risk of financial firms as creating incentives for excessive risk-taking. Regulations may create unintended incentives that stem from the two big drivers we studied in weeks three and four: market incompleteness and inefficiency. Consider that:
· Usury laws (like the prohibition of drugs and alcohol) may drive transactions into the grey and black markets. Desperate borrowers may turn to the Mafia, a clear sign of market incompleteness.
· Charter provisions and unit banking may have led to local banking monopolies or oligopolies, and therefore higher prices for consumers. Restrictions on market entry can limit arbitrage and therefore efficiency. As the reading by Acharya et al. reported, the collapse of Continental Illinois Bank (a unit bank) in 1984 was due to the fact that its lending business outgrew its deposit base, causing the bank to rely heavily on wholesale funding.
· Critics accused the Community Reinvestment Act of stimulating overinvestment in housing and lending practices that produced subprime loans—this remains a fraught contention. But in general, government mandates to invest tend to distort market prices and liquidity.
· Bans on short-selling interfere with price-discovery, and thus market efficiency.
· Efforts to standardize credit default swaps and other financial instruments will tend to discourage customization and may promote incompleteness.
Many of these cases illustrate the creation of moral hazard through regulation. The clarity of rules, the backstop of a lender of last resort, and the creation of safe franchises may stimulate aggressive behavior to earn high returns while the regulator bears the risks.
Ways in which financial entrepreneurs might respond. They see the violations of completeness and efficiency and are attracted to exploit those market imperfections to their advantage. The readings and our classroom discussion suggest at least four kinds of response:
· Regulatory observance could be profitable if regulation bestows valuable privileges on a few players. Consider an entrepreneur who gains a coveted charter to operate a financial institution: like government licenses everywhere, bank charters carry their own franchise value derived in part from scarcity. A current manifestation of this is the “rent-a-charter” phenomenon, in which an online lender who has no charter and cannot take deposits from the public, strikes a partnership with a small chartered bank in which the online lender finds the customer and structures the loan, while the bank partner actually makes and holds the loan.
· Alternatively, the financial entrepreneur could simply ignore the laws and regulations. But let’s be clear that regulatory violation is illegal and plainly inconsistent with the Honor Code that UVA students should carry with them through life.
· Co-opting regulators. Critics have argued that the regulatory apparatus can get hijacked by special interests looking to use government power for private benefit. Charges of “crony capitalism” have risen to some prominence in the current election season and earlier in the protests by Occupy Wall Street and the Tea Party. Hijacking can occur when the regulations are formed (through intensive lobbying or even bribes), or later, if regulators get co-opted by the people they regulate. Research suggests that material self-interest (e.g., through political donations or an interest in maintaining government funding) and cultural embrace (e.g., through “revolving door” personnel policies) can result in regulatory capture. The Fed, SEC, and CFTC have been criticized as regulators captured by their wards—the accuracy of such allegations is disputable. The Office of Thrift Supervision was dismantled in 2011 after several of its wards failed in the financial crisis of 2007-2009, owing in part to its lax regulation. Regulatory capture is ethically suspect if it seeks to place private interests ahead of the public interest—though ill-considered laws and regulations could prompt co-option in the public interest.
· Regulatory arbitrage was discussed by several authors of our readings this week. Financial entrepreneurs will seek to carry their activities to jurisdictions where regulation is light and from jurisdictions where it is relatively heavy. Merton Miller cited the rise of the Eurodollar bond market in the 1970s as a way for U.S. firms and individuals to invest their funds overseas without incurring the costs of repatriating funds and investing in the U.S. Why has there been a thriving estate and trust custody business in Grand Cayman and Panama? There, low tax rates and strong privacy laws help customers to avoid (or evade?) taxes, hide wealth from grasping relatives and the media, and launder money. Under the Basel Accords, international treaties that aimed to harmonize regulations of bank capital, banks need to hold capital in relation to the risk of the financial assets they hold. Simon Johnson and James Kwak argue that the advent of securitization and use of off-balance sheet entities made it possible for banks to circumvent the Basel Accord capital requirements, leading up to the Panic of 2008. In a reading for this week, Charles Calomiris wrote, “There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage.”
Regulatory discretion. Regulators retain discretion about enforcement of laws and regulations and may be reticent to sanction every infraction. Alan Greenspan, as Chairman of the Fed was more interested in monetary policy and less interested in regulatory enforcement. He believed that the private sector would police itself. Therefore, he tended to discount reports of predatory lending in the housing bubble of the mid-2000s. Charles Calomiris wrote that “The main story of the subprime crisis…is one of government ‘errors of commission’” such as the conscious under-estimation of risk, a lax Fed interest rate policy, ineffective prudential regulation, and rules that limited bank takeovers. We want regulators to exercise some discretion since laws and regulations cannot anticipate every possible circumstance. Yet inconsistent enforcement may prompt aggressive action by market participants.
Regulations might reflect popular sentiment rather than economic wisdom. For instance, the concept of free trade has attracted some lively opposition during the current election cycle. Yet, protectionism is a tax on consumers and almost unanimously opposed by experts in the economics of foreign trade. The infamous Smoot-Hawley Tariff of 1930 contributed to the severity of the Great Depression. The adoption of anti-usury laws and bans on short-selling typically reflect episodes of social stress (such as financial crises). Speculators are easy targets for an angry public. Speculation is often condemned as an immoral activity, like gambling, and often in contrast with investing, which seems to take the high ground. Yet the boundaries between speculation, gambling, and investing are fuzzy. In the best overview of this, Professor Reuven Brenner assessed the history of enmity toward speculators and concluded: “Behind the apparent misunderstanding lurked suspicion, envy, and resistance to providing a channel for social mobility through which a new class of people were becoming rich.”
Principles-based regulation vs. rules-based regulation. Bright-line rules have the advantage of clarity and transparency. One knows exactly what is illegal. But such rules may invite aggressive behavior: financial entrepreneurs might manage right up to the bright line, and even test its robustness. Principles-based regulation is constructively ambiguous and often dependent on court decisions to lend illumination. This may motivate the financial entrepreneur to behave well within the ambiguous boundary out of aversion to risk. Simplicity (in the form of principles) can be a virtue: detailed rules can be gamed.
Regulation is hard. The regulator must stay abreast of innovations in new markets, new institutions, new instruments, and new services or practices. Complexity makes it increasingly difficult to draft simple and straightforward regulations. To regulate blockchain, derivatives, OTC trading, new technology (such as HFT) requires technological sophistication. The complexity generates information asymmetry, which frustrates transparency and accountability. And ultimately, measuring risk and welfare outcomes is difficult.
Cycle of innovation and regulation. The readings suggested that regulation is both a cause and consequence of financial innovation—our focus this week was on the former, how regulation might cause financial innovation. Later, in week 13, we’ll revisit regulation to consider how it becomes a consequence. But it is worth mentioning here because regulation and financial innovation form a cycle of activity: one stimulates the other, and then the other stimulates the one. Merton Miller wrote,
For a variety of reasons—including especially [the] desire to blunt the force of previous successful innovations by taxpayers—governments (or more properly, the shifting coalition of interest groups, that vehicle for protection and advantage) prefer to keep changing the structure, thereby altering the internal rate differentials and creating new opportunities for financial innovation. This endless sequence of action and reaction has been aptly dubbed the “regulatory dialectic.” ((Merton Miller, ibid. pages 5-6.))
The process of action and reaction between regulation and financial innovation has at least two big implications:
· Stasis is unlikely. The desire of incumbents and regulators for stability and equilibrium has been dashed repeatedly throughout history. Innovation in a capitalist economy is relentless—this is the gist of Joseph Schumpeter’s notion of “creative destruction”: capitalism is an engine of constant change. Therefore, the innovation-regulation cycle seems likely to continue indefinitely.
· It seems unlikely that regulation will gain control over the cycle. Regulation is basically reactive. Regulators respond to news of illegal activities, to prominent failures of financial innovations, and to civic sentiments in legislatures, the media, and the population at large. The curbs put in place tend to respond to known regulatory gaps—in that sense, regulation is backward-looking. Like generals who are prepared to fight the last war, governments strive to ensure that the last known problem won’t reoccur. But such preparations won’t necessarily win the next war.
Isn’t self-regulation possible? One alternative to government intervention in the private sector would be for the private sector to regulate itself. This month, a group of online lenders agreed to form the Innovative Lending Platform Association that would promote a standardized presentation of credit costs for greater transparency to consumers. Examples of successful regulations in the past would include member rules at securities exchanges and bank clearinghouse surveillance, started in the mid-19th Century. But critics allege that self-regulation amounts to inmates running the asylum. They point to the failures of private-sector debt-rating of subprime mortgages in the mid-2000s and of self-policing of public auditing in the late 1990s. Though the tendency of federal policy has been to experiment with private-sector self-regulation as a first step, recent criticisms by populists at both ends of the political spectrum seem likely to push for a greater role for government-based regulation.
So…is regulation pointless? The insights this week may seem downbeat. Regulation is reactive and never quite gets control over the disruptive attributes of financial innovation. Regulation can be a blunt instrument with plenty of unintended side-effects. Measuring risk and the effectiveness of regulations is difficult. Some regulations have been prompted by popular sentiment rather than economic wisdom. Regulation can get corrupted by regulatory capture. And regulations are skirted through arbitrage. As regulation of financial services has grown, government has assumed a greater role in the management of risk—but how much of this do we want or need? David Moss, in his book, When All Else Fails, documents the dramatic socialization of risk that accompanies the democratization of credit. This creates a free rider problem: costs of regulation are spread widely (taxes to support the regulatory establishment), while benefits may accrue more narrowly. Advocates of laissez-faire would argue that regulation is expensive and ineffective and that free markets offer the best corrective mechanism.
Even so, one recoils from the regular exposure of venality, mendacity, and incompetence in finance and business. Does that behavior make one proud to be a financial entrepreneur? Would one be willing to accept the risks and consequences of such behavior in a laissez-faire world? We want regulators to inspect our restaurants for cleanliness and our airplanes for safety. It seems that people are sufficiently risk-averse to want governments to manage risks associated with financial innovations. The big question is how much risk are we willing to accept?
Perhaps we expect too much of regulations. For instance, is zero the maximum amount of fraud we are willing to accept? It seems likely that the costs of surveillance, enforcement, and other market interventions would be enormous and would violate civil liberties and norms of privacy. Maybe “pretty good” regulation is better than perfect.
Some implications for the financial entrepreneur:
1. Laws and regulations are complex, ambiguous, and variously enforced. Hire excellent legal advice.
2. Regulations will change. Pay very careful attention to the timing and direction of regulatory change.
3. Regulation is an adaptive system: participate in the adaptive process. Have a voice. Consider the possibility that your regulator could be an ally in pursuit of higher aims for your product, your firm, and your market. Work with regulators to improve regulation—and if you cannot honorably fight to improve bad regulations you might face, then leave the field.
In your response to regulatory change, take the long view: do what is consistent with the kind of society you would like to bequeath to future generations. Don’t skate to the edge of the ice.