# Presentation: 543059

## Focusing More on Outputs and on Markets: What Financial Regulation Can Learn from Progress in Other Policy Areas

- 	Lawrence J. White
- 	Stern School of Business
- 	New York University
- 	lwhite@stern.nyu.edu
- 	Presentation at FDIC, Arlington, VA, 	November 30, 2007

## Overview

- Background on regulation (in general)
- Examples, in other areas of regulation, of “success stories” that focused on outputs and markets
- Examples of four proposals for reforms of financial regulation that would have focused on outputs and markets (but have not been adopted), and one area of successful flexibility: bank reserve requirements and the Fed Funds market
- Conclusion

## Classifying types of regulation

- Economic regulation
- Health-safety-environment regulation
- Information regulation

## Economic regulation

- Control over prices or profits or entry or exit
- The Civil Aeronautics Board’s (CAB) former regulation of the airline industry
- Bank regulators’ former ceilings on deposit interest rates, limits on entry, branching
- The Securities and Exchange Commission’s (SEC) former restrictions on which bond rating companies can become a “nationally recognized statistical rating organization” (NRSRO)

## Health-safety-environment regulation

- Control over production processes or inputs or outputs
- The Federal Aviation Administration’s (FAA) safety requirements for airlines and pilots
- Bank regulators’ safety-and-soundness regulatory requirements for banks
- The SEC’s minimum capital requirements for broker-dealers and competency requirements for securities brokers

## Information regulation

- Control over the types and formats of information
- Department of Transportation’s (DOT) regulation of fare announcements by airlines
- Bank regulators’ interest rate disclosure requirements
- SEC’s disclosure requirements for publicly traded companies

## Where does corporate governance regulation fit in?

- The goal of corporate governance regulation – assuring investors of a fair outcome – is not all that different from the safety goals of the FAA or the Consumer Product Safety Commission (CPSC)

## Classifying regulatory implementation

- Command-and-control regulation: Centrally devised (macro) solutions imposed at the micro level; often “one-size-fits all”
- Technology standards (inputs oriented)
- All firms must adopt a specific technology
- Performance standards
- All firms must meet a specified level of performance, but can choose their technologies
- “Bubble” concept
- The firm is judged on its aggregate performance (put a plastic bubble over the entire firm), not on the performance of individual units

## Regulation of the auto industry exemplifies all three concepts

- Vehicle safety standards embody technology requirements and performance requirements
- Vehicle pollution control requirements embody performance requirements
- Vehicle fuel mileage requirements (CAFE) embody the bubble concept

## Going beyond command-and-control: embracing “outputs and markets”

- “Cap-and-trade” system for controlling SO2 emissions
- Electromagnetic spectrum auctions
- “Dedicated-access-privilege” programs for fisheries

## “Cap-and-trade” system for  SO2 emissions

- Replaces command-and-control with much greater flexibility
- National aggregate maximum amount of annual SO2 emissions has been allocated among electric utilities
- They can trade SO2 emissions permits among themselves
- This encourages greater efficiency and innovation
- The SO2 program has been highly successful

## Electromagnetic spectrum auctions

- Replaces Federal Communication Commission’s (FCC) command-and-control allocation of broadcast licenses
- Auctions have allowed greater flexibility in use, greater efficiency
- Auctions have generated tens of billions of dollars for the federal treasury
- Spectrum auctions are considered highly successful

## “Dedicated-access-privilege” (DAP) programs for fisheries

- Fisheries are a watery commons and often suffer from “the tragedy of the commons”
- Response of the National Marine Fisheries Service (NMFS) has been command-and-control regulation for overfished fisheries
- DAP programs are like “cap-and-trade”
- Set an annual “total allowable catch” TAC
- Allocate TAC among fishermen
- Allow trading of the allocations
- DAP programs in U.S. and especially abroad have been highly successful

## Financial regulation

- Financial regulation is not different from other regulation
- Financial regulation sometimes encompasses technology standards and sometimes encompasses performance standards; often “one-size-fits-all”
- Where are the programs that emphasize “outputs and markets”?
- Bank reserve requirements and the Fed Funds market
- And some proposals
- Benston/Kaufman proposal for mandatory subordinated debt for banks
- Klausner’s proposal for CRA reform
- Ronen’s proposal for financial statement insurance (FSI)
- My proposal for NRSRO reform

## Bank reserve requirements and the Fed Funds market

- Depository institutions are required to hold funds “in reserve” as vault cash or as deposits at the Federal Reserve, calculated as a fraction (e.g., 10%) of their deposits
- The Fed Funds market permits banks to buy and sell “excess reserves” and thus provides flexibility in meeting the requirement
- “Floor and trade”

## Capital requirements for banks

- Depository institutions are required to hold minimum levels of capital (net worth) as a % of assets
- Capital is a direct buffer that protects depositors (or the deposit insurer) against reductions in asset values
- Capital represents the owners’ stake in the bank; a greater stake reduces the incentive for risk-taking

## The Benston/Kaufman 1988 proposal for mandatory subordinated debt

- As part of their capital requirement, depository institutions should be required to issue a tranche of subordinated debt
- Sub debt would bring a set of stakeholders who would lose from the down side of risk-taking but not gain from the up side
- Sub debt holders might restrain risk-taking by owners (or managers on owners’ behalf)
- Regulators might use the yields on subordinated debt to help identify problem institutions
- The Benston/Kaufman proposal has never been implemented

## The Community Reinvestment Act of 1977

- The CRA requires banks to “meet the credit needs of the local communities in which they are chartered consistent with safe and sound operation of such institutions”
- The CRA is command-and-control regulation
- Technology standards from 1977-1995
- Performance standards since 1995

## Michael Klausner’s 1995 reform proposal

- A bank’s CRA annual commitment would be specifically defined as a dollar amount of loans originated and/or held
- The obligation could be transferred to other lenders; a market could develop
- Consciously modeled on the SO2 “cap-and-trade” program
- Klausner’s proposal has never been implemented

## Current accounting/auditing arrangements: the problem

- Investors and creditors rely on financial statements
- Auditors are hired (and can be fired) by corporate boards of directors, who are selected by managements
- Managements always favor rosy scenarios
- Auditors face an inherent conflict of interest
- After-the-fact liability suits are an imperfect solution
- Sarbanes-Oxley command-and-control regulation is not a satisfactory solution

## Joshua Ronen’s 2002 proposal

- Companies would purchase “financial statement insurance” (FSI) from a competitive insurance market
- The insured amount and the premium would be public information
- FSI ends the auditor’s conflict of interest: The FSI insurer would hire the auditor and would be interested in “the truth”
- Rosy scenario means premiums that are too low
- Pessimistic scenario means that the insurer would be underbid by an insurer with a more accurate auditor
- Ronen’s proposal has not been acted upon

## NRSRO regulation

- The bond rating industry was subject to protective regulation by the SEC, 1975-2006
- In 1975 the SEC created the category “nationally recognized statistical rating organization” (NRSRO) and grandfathered Moody’s, S&P, and Fitch
- The NRSRO category created an artificial barrier to entry
- The SEC never defined NRSRO
- When it proposed a definition (in 1997 and 2005), it focused on inputs
- The NRSRO designation process was opaque

## My 2002 reform proposal

- Plan A: abandon the NRSRO category and allow financial markets to form their own judgments as to reliable bond ratings and rating companies
- Plan B: retain the NRSRO category, but the SEC must cease being a barrier to entry and must certify NRSROs on the basis of “*outputs*” – efficacy in predicting bond defaults – rather than inputs
- This proposal was not acted upon; but the new (Sept. 2006) NRSRO law may reduce the barrier to entry – or not

## Conclusion (1)

- An “outputs and markets” orientation would be worthwhile for financial regulation
- There are successful examples in other regulatory areas
- Bank reserve requirements and the Fed Funds market are an example of successful application
- The mandatory sub debt proposal, Klausner’s CRA proposal, Ronen’s FSI proposal,  and my NRSRO proposal show that these ideas are more widely applicable to financial regulation
- There are surely more areas of financial regulation where these ideas could be applied

## Conclusion (2)

- My message to financial regulators and policy makers and to financial sector researchers:
- 	 Think expansively and creatively!
- 	 Think “outputs and markets”!