So How Should We Respond to Regulatory Failure?

Mark Thoma poses the question on his blog. Specifically, he notes:

I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.

Agreed. And the conservatives beating the anti-regulation drum are getting tiresome. Let's do a 30-second review of regulatory failure and the financial crisis.

There were structural reasons for the failure:

1. We have a confusing hodgepodge of regulators (OTS, OFHEO, FDIC, SEC, OCC, Fed, etc.). Is it any surprise that regulatory issues fall through the cracks between their respective walled fiefdoms? Or that their regulatees go "regulator shopping," trying to find a sympathetic ear, with such a plethora of choices? Our Balkanized regulatory system is defeating us. What if the Food and Drug Administration, an acclaimed regulator, were broken up into the Vegetable Administration, the Fruit Administration, the Meat Administration etc. Is there anyone who thinks that would be more effective?

2. What needed to be regulated wasn't regulated. The huge shadow banking system wasn't on anyone's watch list. That needs to change by, say, yesterday. By rights the Fed is the best equipped to oversee shadow banking. But the Fed, we're learning, is an academic-minded, banker-sympathetic institution that enjoys gazing at its theoretical navel. These guys have no appetite for bare-knuckles regulation. So we'll have to figure out another way to do it, unless we can graft a pair of cojones onto this gelding.

There were cultural causes of failure:

1. Regulators didn't believe in their mission. Christopher Cox. SEC. Need I say more? And that's just one example. Under Bush, too many foxes were assigned to head The Association for the Safety of Chickens.

2. Regulators who didn't believe in their mission were, not surprisingly, uninformed about the latest innovations/questionable activities going on. Why spend your afternoon learning about credit default swaps/CDOs/some other complicated thing when your boss doesn't really care anyway and some really racy porno on the office computer is only a few mouse clicks away?

The single most important part of the solution, besides fixing the above:

Disable or at least severely crimp Wall Street's loophole-diving, rule-evading capability. Wall Street will always be a step ahead of the regulators in "innovating" cool new products that avoid tax payments and arbitrage capital regulations. We can shrug and meekly accept regulatory impotence. Or we can have a deeper conversation and realize it's time we started thinking outside of the box.

What about saying to the lords of high finance: any new product, whether intended for institutional or retail consumption, is illegal unless it has been approved by a new "Financial Products Safety Commission." Sure, Wall Street would howl. And such a requirement would quash some innovation. But, as we've seen, in this Brave New World of high finance, a lot of innovation is ultimately destabilizing and incredibly complex to no good purpose.

Or what about getting radical on accounting? Currently we let Goldman, Morgan Stanley et al do the limbo in a thousand creative ways to avoid capital constraints and make themselves appear more robust than they are. What if we told them the game has changed? That they are liable for criminal/civil penalties for using any accounting treatment that later is found not to accord with the spirit of existing regulations, as judged by say a "reasonable corporate accountant" or some such? Will this be chilling and cause more conservative accounting? Sure. But isn't that what we need after the free-for-all of the last decade?

It's fun to dream, though I'm not optimistic that any of my ideas will be adopted. We need big thinkers, big thoughts, ambitious men (and women!) to pull off meaningful change. And that's not what we have right now in Washington.