On the Border*
| Craig Pirrong |
This is my inaugural post as guest blogger here at O&M. I am grateful for the opportunity.
In his very gracious introduction, Peter Klein noted that my research is at the border of finance and industrial organization. Quite true (and indeed, “borderer” is a good description of me overall.)
That border is very, very busy today. Indeed, so much is happening there that it is difficult to keep up. In the aftermath of the financial crisis, Congress and regulators are beavering away on laws and regulations that will completely reshape the organization and regulation of financial markets, and especially of the area of particular interest to me — derivatives.
I anticipate that many of my O&M blog posts will explore these issues, but I’ll start with something very topical. Senator Chris Dodd just yesterday heaved up a 1,136-page proposed financial regulation bill, and one proposal that is attracting considerable attention is his plan to consolidate banking regulators. Dodd is not alone in thinking along these lines. Even before the financial crisis, there were myriad proposals to consolidate various regulators, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission. These have only gained in popularity in light of the crisis.
In the modern financial markets, firms are big and complex, and operate in many markets (defined geographically, or by product). It is difficult to fit a big financial firm into any box. A Goldman Sachs deals in the securities markets and the derivatives markets. So it doesn’t fit comfortably in a securities box, or a derivatives box, so in the current system for regulatory purposes the firm is split into pieces, some of which are put into the securities box and others into the derivatives box (and there are many other boxes too for a big firm like Goldman).
This leads to potential for conflicting regulations, jurisdictional disputes, regulatory arbitrage, and other problems. So, the Dodd proposal — and most of the other consolidation proposals — advocate creating really big boxes, and in the extreme, one big box that regulates everything a financial firm does.
The problems of the seen are well known (though arguably exaggerated). What concerns me are the largely unexamined problems of the as-yet-unseen big-box alternative.
Economic theory can shed some light on these problems. Specifically, any government agency multitasks. The CFTC, for instance, regulates the financial health of futures brokerages and polices market manipulation. The more expansive the agency, the more tasks it will perform. Thus, regulatory consolidation exacerbates multi-tasking problems.
Moreover, any agency has multiple principals, including Congress and the White House. Moreover, even within Congress there are multiple different constituencies that view themselves as principals. The more expansive the regulatory agency, the more principals it will have; more Congressmen will perceive an interest in the activities of the agency because it will regulate a larger array of firms operating in more districts.
Agency theory tells us that multi-tasking agents working for multiple principals face serious incentive problems, and that given this, it is the interest of the principal(s) to subject the agent to very low powered incentives. Indeed, assigning the agents more tasks and subordinating the agent to more principals generally requires (in a second best arrangement) a reduction in incentive power. Weaker incentives, in fact, than those that regulators currently face.
Thus, Congress will find it in its interest to subject an uberagency that regulates everything that breathes (financially speaking) to very low-powered incentives. This translates into an agency that is highly bureaucratic, sluggish, unresponsive, (fill in additional pejoratives here).
Regulators hardly covered themselves with glory in the lead up to the crisis. Does anyone really believe that a single, even less incentivized super-regulator is likely to do any better? Has anyone who matters even asked the question?
* With apologies to the Eagles. And Taco Bell.