By Steven K. Beckner
JACKSON HOLE, Wyo. (MNI) – The benefits of more government
regulation and higher capital standards have frequently been extolled in
wake of the financial crisis, but those benefits are not automatic and
could be offset by adverse effects, according to a paper presented to
top Federal Reserve officials and economists here Saturday.
Brown University Professor Ross Levine, a research associate with
the National Bureau of Economic Research, contends that increased
regulation and ostensibly more restrictive capital standards can
actually be detrimental to the financial system and the economy if not
done properly.
The Dodd-Frank Wall Street Reform and Consumer Protection Act,
enacted last July in wake of the financial crisis, is less than perfect,
in the view of Levine, who suggests the legislation contains blind
spots. New international risk-based capital standards also pose
problems, he warns.
While regulation can enhance the functioning of the financial
system and facilitate economic growth, it can backfire in a big way,
Levine finds in a paper presented to the Kansas City Federal Reserve
Bank’s annual Jackson Hole symposium. This year’s theme is “Achieving
Maximum Long-run Growth.”
“Granting greater power to official supervisory and regulatory
agencies tends to damage the operation of financial systems unless there
are extraordinarily effective institutional mechanisms for compelling
these agencies to use their powers in the best interests of the public,”
writes Levine. Yet, “most countries lack such institutional mechanisms.”
“Consequently, empowering official agencies often goes badly awry,
curtailing financial development, increasing corruption, and stymieing
economic prosperity,” he adds.
That is the prevailing reality throughout the industrialized world,
according to Levine.
“Empowering official regulators tends to have adverse effects,” he
writes. “Very few countries effectively govern and oversee their
regulators. In the vast majority of countries, increasing official
regulatory power hurts the functioning of the financial system, with
clear ramifications on economic growth, the distribution of income, and
poverty.”
Levine says that in 65% to 85% of countries, “greater regulatory
power is associated with bad outcomes, suggesting that national
institutions do not effectively induce financial regulatory authorities
to improve the operation of financial systems.”
“It is unclear whether any country has an independent institution
— independent of the financial services industry and short-run
political machinations — that has the information and expertise to
assess financial regulation from the perspective of the public and the
prominence to communicate its concerns to regulators, legislatures, and
the public,” he writes.
Part of the problem is that the regulators tend to be captured by
the regulated, he suggests.
“Simply relying on the moral compass of regulators does not
represent a sound governance system,” Levine writes. “An enormous body
of evidence suggests that the financial services industry exerts undue
influence on the setting of financial policies by governments and the
interpretation and implementation of those policies by financial
regulatory agencies through an assortment of mechanisms, suggesting that
the good intentions of officials are insufficient.”
Levine goes on to argue that the potential for the financial
industry to exercise “undue influence” on the regulatory agencies make
its vital to improve the governance of those agencies. But he maintains
that’s not happening, and he singles out the United States.
“As the U.S. Dodd-Frank Act grants greater and greater authority to
regulatory agencies with close ties to the financial services industry,
there has not been a commensurate improvement in the governance of the
agencies themselves,” he writes. “If the regulatory authorities
themselves are not properly incentivized to interpret and implement
policies in the public interest, the particular statutory rules will be
ineffective at creating a well-functioning financial system.”
The Dodd-Frank Act gives a Financial Stability Oversight Council
(FSOC) dominated by the Federal Reserve responsibility for making
“macroprudential” rules for “systemically important” financial
institutions. But Levine says “this does not obviate concerns about the
potentially adverse effects of empowering regulatory agencies.”
In fact, he notes that concerns have been raised about the
governance of the Fed itself.
“Banks play a role in choosing some of the Fed’s executives,”
Levine writes. “People flow between the Fed and the financial services
industry, raising concerns that this ‘revolving door’ threatens the
Fed’s independence and its ability to represent the broad interests of
the public.”
“And, the daily interactions between regulator and regulated can
influence the perspectives of regulators, such that regulators take a
narrow, skewed view of regulatory policies,” he adds.
It is generally recognized that the growth of financial
institutions deemed by the government to be “too big to fail” played an
important role in the financial crisis. But TBTF — itself a government
policy — lives on, says Levine, echoing warnings made frequently by
Kansas City Fed President Thomas Hoenig and others.
“TBTF reduces the incentives of debt holders to monitor large
financial institutions, which impedes market discipline and hence
hinders the efficiency of capital allocation,” Levine writes. “Only
the regulatory authorities seem capable, on paper, of constraining
executives. But … the executives of large banks often successfully
influence those very regulatory agencies.”
Levine asserts that “undoing TBTF is crucial for enhancing market
discipline to improve the incentives governing the capital allocation
choices of major banks.”
Levine also faults the Dodd-Frank Act also failed to alter what he
perceives as a perniciously cozy relationship between the government and
a handful of credit rating agencies. Standard & Poor’s 500 and others
have long been federally empowered to rate securities. Their triple-A
ratings of mortgage backed security products, which were perceived as
government approved, encouraged the sale and purchase of instruments
that proved unsound when the housing bubble collapsed in 2007-08.
Credit rating agencies (CRAs) play an important role, says Levine,
because they “affect the allocation of capital by rating securities. If
they raise concerns about a firm, the prices of its securities fall —
the most basic form of market discipline — and investors alter their
asset allocation decisions. If CRAs make poor assessments, this hurts
the efficiency of capital allocation, slowing growth.”
Yet, “current regulations both increase the influence of CRAs on
investment decisions and reduce the quality of their assessments,” he
writes. “For example, many regulators of banks, investment banks,
insurance companies, and pension funds set capital requirements and
portfolio guidelines based on credit ratings, compelling these
institutions to use CRA assessments in making investments regardless of
the accuracy of the CRAs.”
“At the same time, regulations protect CRAs from bearing full
responsibility for their assessments since CRAs face little financial or
legal liability for their assessments,” Levine continues. “Thus, while
these regulations insure that CRAs play a central role in credit
allocation, they simultaneously insure that the CRAs are insulated from
the consequences of doing a lousy job.”
“Although Dodd-Frank Act attempted to reform CRA regulation, these
reforms have been postponed — indefinitely,” he writes.
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