Can We Trust Regulators to Regulate?

In an op-ed column for the New York Times today, economist Paul Krugman argues that financial reform must be made "fool-resistant" by providing it with less reliance on regulators. In particular, he worries the systemic risk council could be too lax in creating strict enough rules to govern banks. Instead, he thinks the legislation should be more aggressive to create more specific, immutable rules.

Krugman begins by explaining that one of the major reasons for the financial crisis was too much leverage building up in the shadow banking system. He then writes:

The Dodd bill tries to fill this gaping hole in the system by letting federal regulators impose "strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity." It also gives regulators the power to seize troubled financial firms -- and it requires that large, complex firms submit "funeral plans" that make it relatively easy to shut them down.

That's all good. In effect, it gives shadow banking something like the regulatory regime we already have for conventional banking.

But what will actually be in those "strict rules" for capital, liquidity, and so on? The bill doesn't say. Instead, everything is left at the discretion of the Financial Stability Oversight Council, a sort of interagency task force including the chairman of the Federal Reserve, the Treasury secretary, the comptroller of the currency and the heads of five other federal agencies.

He worries that the council simply won't do the trick. He bases this on the fact that those who would have been on the council in 2005, including Federal Reserve Chairman Alan Greenspan, Secretary of Treasury John Snow and Comptroller of Currency John Dugan wouldn't have changed a thing. It's plausible that he's right.

So why have a council of regulators responsible for these tasks? Because that's what regulators are for. Think about the FDA. The "Nutrition Labeling and Education Act of 1990" had some specific requirements in place, but also:

Authorizes the Secretary of Health and Human Services to: (1) require certain information to be highlighted; (2) require additional nutrients to be included in the labeling; or (3) exempt nutrients from the labeling requirement.

What happens if a new medical study provides overwhelming evidence that some common mineral is highly beneficial to health? The regulator has discretionary power to highlight that nutrient on food labels. And the FDA is supposed to be a subject matter expert when it comes to nutrition, so its regulators would be able to use this authority properly.

Congress is the alternative. Krugman wants the House and Senate to legislate more details of financial reform, such as capital and liquidity requirements. This could be problematic for two reasons.

First, regulators have far more flexibility than Congress. Legislation takes time; politics can be difficult. Regulators, on the other hand, can change rules very quickly. In a sector as fast-paced as finance, speed is an important benefit.

Second, regulators understand their industry better than Congress does. If you had an economics question, who would you ask: the Senate Banking Committee or the proposed Financial Stability Oversight Council? I'd rather rely on the latter group, even if it's imperfect. So when it comes to implementing the specifics of financial reform, I would trust a group of experts to get them right, not a group of politicians.

Of course, Krugman's particular example does have some merit. It's definitely possible that the specific group of regulators who would have sat on the Council in 2005 would not have acted. Indeed, they clearly didn't do so on an individual basis, or we wouldn't have had as deep a financial crisis on our hands a few years later.

But these regulators also didn't have the benefit of a systemic risk council in place. Perhaps if they did, the input of other experts would have helped to lead them all to a different conclusion about the state of the financial system. While it's tempting to believe that regulators would be political partisans blind to any and all logic, that's a pretty cynical view. And there's little reason to believe that Congress is any better.