Attracting Brilliant Regulators

Earlier today, I wrote a post suggesting that failure plans and associated fees to cover resolution costs should be required from systemically risky firms. In response to that, one commenter "Diversity" explained the worry that firms will likely try to devise plans to look less risky. I responded that savvy regulators will need to be able to pick apart these plans and see through such attempts. Another commenter, Kenneth Parker, responded:

I also think the industry's employee compensation should get a surtax, and that tax used to fund the regulators. SEC pay should be better than AIG and Goldman's pay.

I'm not sure whether such a surtax makes sense, but this comment definitely raises an important question: how does the government attract brilliant minds up to the arduous task of effective regulation?

Clearly, regulators haven't done very well recently. Even if you believe no one was smart enough to predict or regulate our way out of the catastrophic failure in the financial markets last year, surely someone should have at least caught Madoff sooner. The reality is that regulators are too thinly staffed. They are also almost certainly not as talented as the bankers they regulate -- if they were, why would they be making measly government paychecks while bankers make millions? The result is that some tricky bankers might be able to "innovate" themselves out of regulatory measures more effectively than regulators can keep them honest.

The regulatory challenges going forward are significant -- pretty much no one questions that. So government regulators not only need to ramp up, but also attract real talent. The only way to do that is with money. So how do you pay for it?

The Entire Financial Industry?

The obvious solution is that the financial industry should pay. After all, that's where such regulation and oversight is aimed. If there was no fraud, excessive risk-taking or regulatory avoidance in that sector, then there would be little need for regulation. Yet, I don't particularly like the idea that the entire industry should pay for the actions of a few, so sweeping measures like this don't jive well with my logic. So let's consider a few different scenarios, as I think different situations require different parties to pay.

The Rogue Trader

I think firms should have an incentive to promote high ethical standards. Thus, if an employee of a firm is found to commit fraud, then that firm should pay a lofty fine. The would also enhance the firm's desire to perform thorough internal audits. This one is easy.

Additionally, I really like the idea of fraud-finder commissions. If a regulator finds $1 million worth of fraud, she gets, say, 5% of that, in addition to her regular base pay.

Hedge (and other) Funds

But what about other Ponzi schemes -- such as the Madoff debacle? In that case, it was an entire firm that was fraudulent. Yet, most hedge funds weren't. Why should those other firms without sin be forced to pay for supervision that they don't need? This doesn't seem very fair.

How about this idea: let the investors in hedge funds, or other funds requiring oversight, pay for supervision based on taxes on their profits or fees on their investment. When a hedge fund, or something similar, fails it does not pose a systemic risk. As a result, taxpayers really shouldn't be nearly as interested in its supervision as the investors. After all, it's the investors who stand to lose if fraud takes place. As a result, it's those investors who should pay for this supervision.

Financial Firm Resolution Authority

What about the resolution authority? In this case, I think that the regulators who work on resolution plans should be treated like independent auditors. They should be paid by the hour, with the kinds of fees big audit firms charge. As a result, the authority's employees' pay could be comparable to what those auditors at the Big 4 make.

This would serve two ends. First, banks would want to develop as complete and rigorous plans as possible, so to minimize the fees it would have to pay for regulators to validate them. Second, it would only impose those fees on the banks that chose to become systemically complex and risky.