Timothy Taylor excerpts from a book on macroprudential regulation.
Paul Tucker: “Legislators have typically favoured rules-based regulation. That is for good reason: it
helps to guard against the exercise of arbitrary power by unelected officials. But a static rulebook is the meat and drink of regulatory arbitrage, which is endemic in finance. Finance is a ‘shape-shifter’.
Rules do not work, because banks figure out a way to manipulate the rules. Tucker gets this. So does Wolf Wagner, also quoted by Taylor.
Also, discretion does not work, in my opinion, because discretion tends to be procyclical, doing exactly the wrong thing at the wrong time. In good times, regulators ease up, and in bad times, they tighten up. Just look at how regulators behaved before and after the housing crash. Or compare Ben Bernanke’s discussion of bank supervision before and after he knew about the crisis.
I think that principles-based regulation might work better. That is, pass a law saying that managers and directors of financial institutions are responsible for prudent management. Require auditors to flag questionable practices.
Also, I think that incentives are important. Casual observation suggests that investment banking was more cautious when investment banks were partnerships rather than limited-liability corporations. We should look for ways to give bank executives more skin in the game in their institutions. Suppose you have a bank that goes bust in 2025. All of its top executives over the preceding 10 years would be held personally liable those losses, in proportion to the compensation that they received over that period.
(For each year, take the five most heavily compensated executives, and put their total compensation into a hypothetical pool. Add these to get a company total for fifteen years. Then divide each executive’s total compensation over the 10 years by the company total to get the fraction of losses for which that executive is liable.)
Actually, I don’t think that the formula needs to be perfectly “just.” The point of any such system is to make executives manage banks as if they were risking their own money, because they would be.