Rare and Effective: The Appropriate Role of Regulation in the Economy

Since the advent of the financial crisis, many observers have argued that it is the result of excessive trust in the ability of markets to regulate themselves. Occasionally, these critiques go as far as to claim that deregulation of financial markets has been the favored trend of the last thirty years and that this deregulatory approach has now been debunked by the financial crisis.

This formulation misstates the history of financial regulation. The prevailing sentiment over the past three decades that private markets and private financial institutions could largely be trusted to regulate themselves is no passing theory. Rather, this idea--that there is no sound policy reason for the federal government to protect the safety and soundness of any financial institution that is not backed in some way by the government--has dominated U.S. government policy on financial regulation for the last two hundred years. The notion that the federal government has in some sense withdrawn its regulation of financial institutions over the last thirty years--or that a different theory about financial regulation prevailed in the past--is entirely fallacious.

The Failure of Regulation

Indeed, the overwhelming fact about traditional safety-and-soundness regulation--in which a government agency oversees the operations of individual companies--is that it has been a consistent failure. After the savings and loan (S&L) debacle of less than twenty years ago led to the failure of both the S&L industry as well as almost 1600 commercial banks, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) significantly tightened bank and S&L regulation. Despite this much more stringent regulatory structure, depository institutions, including S&Ls and commercial banks, are the principal sources of today's mammoth crisis. Many have already failed, others will fail, and dozens have been saved from failure only by the infusion of taxpayer funds. In other words, we have strong evidence that the current regulatory system has been not been effective in preventing financial breakdowns.

With the limited exception of the five largest investment banks, the only financial institutions that have ever been regulated for safety and soundness at the federal level are federally-backed commercial banks, savings and loans, and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. However, in 2004, in response to a demand by the European Union that securities firms operating in the EU have a consolidated home country safety-and-soundness regulator, the SEC assumed this oversight role for the five largest investment banks then doing business in the EU. This proved disastrous, as all five banks took advantage of the appearance of government regulation to overleverage themselves.

There are some things that can be done to improve regulation in the cases that regulation is actually needed.

To suggest, as many have, that the current financial problems of unregulated entities are in any sense or degree different from the current financial problems of regulated entities is obviously wrong. Assuming that we treat the investment banks as unregulated, there has been only one total failure among these institutions--Lehman Brothers--while four others have either been rescued (Bear Stearns and Merrill Lynch) or sought shelter against the consequences of a profound loss of market confidence in their stability or solvency by becoming regulated bank holding companies. Meanwhile, many heavily regulated banks and S&Ls have failed thus far, and the government has overseen a costly, multi-billion dollar rescue of at least one bank--Citibank--that was closely regulated for years by the Comptroller of the Currency. The argument that the failure of unregulated financial institutions was the result of their lack of regulation is thus clearly unsustainable; it completely ignores the fact that many more fully regulated entities have suffered the same fate. If regulation does not produce a better result than non-regulation, there is no reason to pursue it.

When and When Not to Regulate

While there is little evidence that regulation produces salutary results, there are many sound reasons for the government to stay its hand. Although such deficiencies are difficult to quantify, economists and financial experts often cite them as reasons for skepticism about regulation:

  • While they are painful when they occur, business failures can be a good thing for the economy as a whole. Bad managements or bad business models are eliminated from the economy, making room for good managements and better business models. Regulation that prevents this is only aiding the survival of bad managements and business models. Moreover, related losses by investors and creditors will make them cautious about future investments and loans, which will ultimately enhance market discipline.
  • The existence of regulation--especially safety-and-soundness regulation--creates moral hazard. Market participants believe that the government is looking over the shoulders of the regulated industry, and lenders are thus less wary that regulated entities are assuming unusual or excessive risks.
  • Regulation creates anti-competitive economies of scale. The costs of regulation are more easily borne by large companies than by small ones. Moreover, large companies have the ability to influence regulators to adopt regulations that favor their operations over those of smaller competitors, particularly when regulations add costs that smaller companies cannot bear.
  • Regulation impairs innovation. Regulatory approvals necessary for new products or services delay implementation, give competitors an opportunity to imitate, and add costs to the process of developing new ways of doing business or new services.
  • Regulation adds costs to consumer products. These costs are frequently not worth the additional amount that consumers are required to pay.

Going forward, these deficiencies--together with the consistent failure of regulation to protect taxpayers or the economy--suggest that regulation should be a last resort, employed only when absolutely required. The market situations in which regulation could be necessary are limited to a few circumstances:

  • When a company or an industry has the backing--implicit or explicit--of the government. In these cases, the wariness of creditors is impaired and market discipline is reduced, allowing more risk-taking than would normally occur. Additionally, government backing adversely affects competition and tends to create taxpayer liabilities.
  • When the failure of a particular company or financial institution will have systemic effects. However, if we try to designate companies as "systemically significant," we will certainly allow them to become so because the designation itself reduces or eliminates market discipline and creates competitive advantages. In normal markets, it is very difficult for companies without government backing to become systemically significant, and currently the only companies that can be so considered are already regulated as banks.
  • When there is a significant asymmetry of knowledge between a supplier of services and its customers. Personal insurance lines such as homeowners, auto, or life are examples of this. The complex contracts required for these services are beyond ability of most consumers to understand.

Better Regulation

Assuming, then, that regulation of safety and soundness (in other words, risk-taking) is appropriate for one of these reasons, we should be looking for methods of implementation that are more effective than the failed systems of the past.

The most effective way to control risk-taking is to enhance market discipline. In general, creditors--unlike equity investors--get no benefit from risk-taking behavior. When they have the necessary information, creditors can limit risk-taking by withholding funds or seeking higher interest rates on loans in order to compensate themselves for additional risk. This is the essence of market discipline. Good policy, then, would focus regulation on helping creditors exercise market discipline.

It's also important for regulation to be countercyclical. An element of human nature with which we are all familiar is the tendency to believe that when prices are going up they will continue to go up, and when they are going down that trend will also continue. In other words, as many have noted, we are subject to both irrational exuberance (manias) and panics. The current financial crisis is the result of both--a huge real estate bubble that drove housing prices well beyond the level that people could reasonably afford, and then a collapse in prices--driven by panic--which is still continuing. So the second thing we ought to be looking for in regulation is counter-cyclicality--the incentive and the ability to act against, or encourage others to act against, the development of either bubbles or panics.

With these thoughts in mind, there are some things that can be done to improve regulation in the cases that regulation is actually needed. Such measures include fostering market discipline through metrics or indicators of risk-taking that are published regularly, reducing government's distortion of markets through implicit backing of certain financial institutions, revising and reforming mark-to-market (fair value) accounting to create an accounting system that is counter cyclical rather than pro cyclical as it is today, requiring regulators to use market indicators, like spreads in the credit default swap market, to strengthen prompt corrective action, instituting counter cyclical capital requirements that mandate increases in capital during flush times so that regulated companies put away reserves for leaner periods, and protecting the counter cyclical activities of short-selling and hedging, which tend to moderate the rise of bubbles and the deflation of busts.

In addition to fostering market discipline and counter cyclical behavior, there are a few other policies that would help to prevent a recurrence of the current housing meltdown. First, the prevalence of non-recourse mortgages has encouraged the phenomenon of people walking away from their mortgage obligations when the mortgage on their home is higher than the home's value. If people understood when they signed up for a mortgage that they are personally liable for the note, they might be less inclined to take on mortgages that they may not be able to afford.

Second, several policies permit--and even encourage--the depletion of home equity. Mortgages can be refinanced without penalty at any time, so that when the value of the home has risen, homeowners are able to refinance and take some of that price appreciation out in cash. Additionally, tax laws permit the interest on home equity loans to be tax deductible, which encourages homeowners to borrow against the equity in their homes to pay off credit card or other debt--the interest on which is not tax deductible. When prices decline--as they inevitably do--minimal home equity coupled with non-recourse loans exacerbate the tendency of people to walk away from their mortgage obligations.


Despite the frequent calls in the wake of the financial crisis for wider regulation of financial institutions that are not regulated today, there is no sound policy for following this course. Banks must be regulated for safety and soundness because they are perceived as backed by the federal government. But beyond banks and GSEs, which are similarly backed, there is no policy reason to prevent financial institutions from failing--indeed, it is debatable that regulation is even capable of achieving this lofty goal.

In the event that regulation is deemed necessary because companies or financial institutions enjoy government backing, its focus should be on two objectives: (i) enhancing market discipline by requiring regulated entities to publish metrics and indicators of risk-taking that will alert creditors to excessive risk-taking, and (ii) structuring regulation so that it is counter cyclical in its operation. Using this hierarchy, it is difficult to see that extending regulation beyond GSEs, commercial banks, and S&Ls would be productive or useful. It would impair competition and innovation, raise consumer costs, and interfere with the market discipline that is instrumental in holding risk-taking in check.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI

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