Friday, May 11, 2012

Rules vs. Principles in Regulation

. Friday, May 11, 2012

This gets to the heart of the difference between rules-based and principles-based regulation. You could have a version of the Volcker Rule that functions by empowering a set of bank regulators to implement the principle behind the rule. Sloan agrees that "the principle sounds wonderful and simple -- don't let banks use federally insured deposits for risky trades" so you could tell the regulators just that, with no further details or clarification. A college dorm that has a rule against loud noise or music after 10PM on weeknights isn't going to follow that up with a detailed regulatory definitions of "loud", "noise", and "music" that you can then try to find loopholes in. The issue is that if the RA decides you're being too noisy, he tells you to quiet down. 
The problem with principles-based regulation in this context is that you might fear that banks will use their political influence to get regulators to engage in a lot of forebearance. The problem with rules-based regulation in this context is that it's really hard to turn a principle into a rule.
That's not "the" problem. That's "a" problem. Another problem is that regulators will never be given one task. They'll be given multiple tasks. One might be "don't let banks use federally insured deposits for risky trades" and another might be "don't restrict our financial sector so much that foreign firms take market share". Or maybe "force banks to make safe investments" but also "lend to certain interest groups -- e.g. governments -- at privileged rates". Or maybe "regulate the banking sector" and also "manage the macroeconomy". Many of these tasks are contradictory at some margin, and that margin is precisely what is being exposed by the time we get to crisis.

Another question is "what's a risky trade"? I've been watching the Frontline documentary on the financial crisis, and one thing is clear: everybody thought that securitization was reducing risk, not concentrating it. At least at first. When I say "everybody" I mean it. Other than Brooksley Born the regulators, firm managers, journalists, academics... everybody thought this stuff was making the financial system more stable. Some people started calling this into question by the mid-2000s but at that point it was already too late. So a discretionary principle of "reduce risk" -- which is more or less what we had during the 1990s and 2000s, combined with pretty lax capital requirements -- would likely not have led to a reduction in the activity that culminated in crisis and may even have exacerbated it.

This isn't as simple as a dorm RA telling people to turn down their music after 10 pm.


Nick Gogerty said...

This is important point, in the philosophy of risk mitigation. My own bias is for principal based risk mitigation. The principals are fuzzy and there fore inefficient, but may be more resilient over the long run, assuming the roots behind the principals are remembered. Rules often become the precipice upon which participants rush towards assuming it to be an advantaged position rather than a precipice. Capital ratios are often like that.

Kindred Winecoff said...

Thanks for the appreciation.

"assuming the roots behind the principals are remembered"

Well that's the trick isn't it? I'd add "and knowing which innovations increase risk and which reduce it."

These aren't immediately obvious.

I agree that rules are, in a sense, meant to be broken... in that you can always make a lot of money by finding ways around them. So what, then? My attitude is that financial crises don't just happen. They are the result of other macro factors, and so it might make more sense to deal with those rather than endlessly try to tweak the micro.

Rules vs. Principles in Regulation




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