Tuesday, January 17, 2012

Why Theories of Regulation Are Inadequate

. Tuesday, January 17, 2012

Here are some assumptions shared by the most prominent theories of regulatory politics*:

1.a. Strict regulations in one country will generally hurt the competitiveness of firms in that country.  
1.b. Unless those regulations confer rents to domestic firms. 
2. Because banks are a concentrated, influential interest group, this means that states will generally not unilaterally regulate. Therefore, new regulations must come in the form of a credible international standard -- generally originated by a powerful state with agenda-setting power -- that ensures that foreign competitors will have to abide by the same restrictions. 
3. States attempt to use their power and influence to affect the parameters of regulations in ways that benefit their firms. This may involve an international redistribution of rents, from firms in a less-powerful country to firms in a more-powerful country. Such a redistribution may, but does not have to, fall along the Pareto frontier.
Now let's look at some news from the past month:

-- Philipp Hildebrand, head of the Swiss central bank, is enforcing stricter capital standards for Swiss firms than those required in the international Basel III agreement.

-- Japan and Canada are asking U.S. regulators to not regulate U.S. firms more strictly.

-- Joe Nocera -- no lackey for the financial sector -- joins JP MorganChase CEO Jamie Dimon in protesting that the number of new regulations is potentially destabilizing and will lead to arbitrage opportunities for the type of large firms they are supposed to curtail, while agreeing with Dimon that simple rules like capital standards should be strengthened.

None of these would be expected by the dominant theories in the literature, despite the fact that none of these dynamics are especially new. In 2006, more than 40% of the governments surveyed by World Bank researchers reported that their capital regulations were stricter than the Basel requirements. There were similar responses in two previous surveys, conducted in 1999 and 2003. Only a handful (I believe it was three or four) of countries reported that their regulations were weaker than the Basel minima, despite the fact that accession to the Basel accords has not been mandatory outside of the G-10 (and later the EU). That means that, if existing theory is to be believed, 40% of the world's governments were putting their firms at a competitive disadvantage by having stronger regulations than the international standard. That means that, if existing theory is to be believed, nearly 100% of governments responding to the World Bank survey were refusing to take an opportunity to give their firms a competitive advantage by staying out of Basel**.

These empirical patterns suggest that we need to do more hard thinking about what regulations actually do and how they impact markets. Once we have a better understanding of these, we might be able to get a better sense of how interest groups form preferences over regulatory policy and how comparative and international political processes work.

I have some ideas along these lines, but this is getting long enough already. If you're interested stay tuned; I'll be posting somewhat regularly on this topic over the next year.

*I'm most familiar with theories specifically applied to financial regulation, but I believe these hold true more generally. The two main categories of regulatory theory in the political science and economic literatures are joint-gains functionalism and rent-seeking public choice. Despite having different conclusions about the outcomes of regulatory policies, they share many fundamental assumptions about the ways that regulations work and different interest groups' attitudes over regulations.

**There is certainly some "mock" compliance, where states claim to be in compliance but are not. Since Basel has no monitoring or enforcement mechanism other than market discipline, this may happen quite a bit. Indeed, Andrew Walter extensively documented some examples in East Asia. Still, the World Bank surveys have been public for years, and the researchers actively encourage people to report discrepancies between de facto and de jure policies. To my knowledge few revisions have been necessary.


Why Theories of Regulation Are Inadequate
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