FAA-Style Regulation for the Financial Sector?

January 26, 2012

A post by Paul Romer

I suggested in a recent paper that regulation of financial institutions could look less like the legalistic regulation at OSHA and more like the regulation at the FAA.  Dave Backus asked what it would look like in practice.  John Cochrane, the Chicago Booth financial economist and accomplished glider pilot, expressed doubt based on his own experience with the FAA.

 One answer to Dave’s question is to look North, to Canada.  Its system of financial regulation is closer to what I have in mind when I speak of FAA-style regulation.  Canada has a single financial regulator who can, in effect, say to a bank, “This practice is not safe.  Stop taking any new business until you change how you operate.”  This is the kind of power that the FAA has.  It can withhold an airworthiness certificate for a newly designed aircraft until its employees are satisfied that the plane is safe.  The agency can also ground any model of aircraft if new information emerges about a threat to flight safety. It can mandate expensive modifications that must be made to the plane before it is deemed airworthy and hence legal to fly again.

Michael Bordo, Hugh Rockoff, and Angela Redish have a recent article (gated, unfortunately) that describes the history of the Canadian system of financial regulation.  They show that this system has consistently avoided the financial crises that emerged in the United States.  They also observe that there are structural features of the Canadian system that make it easier to implement something like the FAA system.  For example, Canada has a very small number of very large financial organizations and a single regulator, the Office of the Superintendent of Financial Institutions, (OFSI).  According to Bordo et al, “Canadian regulation under OSFI proved tougher than in the United States, mandating higher capital requirements, lower leverage, less securitization, the curtailment of off balance sheet vehicles, and restricting the assets that banks could purchase.”

The Canadian experience shows that having a large number of institutions, each of which is small enough to fail, is not necessary for stability.  The US experience with the S&L crisis in the 1980s also shows that large numbers of small institutions is not sufficient for stability either.  See, for example, my paper with George Akerlof.

More generally, it is hard to point to a successful regulatory model that achieves financial sector stability by designing in good ex post mechanisms for unwinding the consequences of unlimited risk taking.  (Good luck with those living wills.)  The demonstrated path to stability is to give a single hierarchical organization the ex ante power to prevent a levels of risk-taking that are inefficient.

But how would a regulatory system decide whether a specific financial practice is safe? Perhaps in the same way that one decides whether a plane is safe.  Grant responsibility for making a judgment to someone who is objective; and hold this person accountable based on how things turn out.

Others have noted that the regulation of flight safety offers an interesting case for financial regulators to consider. For example, Andrew Lo and co-authors (link) have called for an analog of the National Transportation Safety Board.  This independent agency has no regulatory responsibility.  Its job is exclusively to establish the facts following any major transportation accident.  It is part of how the government as whole establishes how well the decisions at the FAA are indeed turning out.

Cochrane points out that any system of regulation like the one implemented by the FAA entails some social cost.  There can be no doubt on this point.  Giving responsibility to regulators does not guarantee that they will always hit the right balance in making tradeoffs about risk and benefit.  Moreover, good regulators should get high salaries.

I may lose some readers, but let me indulge in some casual economic theory.  Let S denote the idealized social optimum. Let X and Y represent the outcome for society under two different regulatory regimes. Let’s stipulate that both are less than ideal in the sense that S > X and S > Y.

Let N denote the value for society with no regulation. The interesting question is whether S is close to N. In many parts of the economy, this should be true. Economists successfully made this case, for example, with respect to price regulation for trucking and air travel. In such cases, there is no reason to worry about the relative merits of the alternative regulatory regimes X and Y. Just get rid of the regulation.

But if a worldwide crisis suggests that S is substantially bigger than N, it is possible to have inequalities of the form  S > X > Y > N. In this case, Y is better than no regulation, but X would be even better than Y. The fact that X and Y are both less than S is not decision relevant.

It could even be that S > X > N > Y. Then deregulation that moves the economy from Y to N is an improvement, but moving instead to system X would be even better.  The danger in this case lies in assuming that all regulation has to look like Y and neglecting a possibility like X.

What I tried to do in my paper, with comparisons that run from the FAA, to the Army, to OSHA, was to suggest that there are many different ways to implement regulations and that we should consider the costs and benefits of the various alternatives with an open mind.  Economists can all give the familiar theoretical arguments about why unregulated air traffic combined with the right kind of legal liability could achieve the desired level of flight safety. In fact, the experience in the US with legal liability rules for aircraft manufacturers was horrific. The rules that prevailed in the 1970s nearly killed the US light aircraft industry. Moreover, for passenger travel, the revealed preference of policy makers has been to opt for something like the FAA system of regulation over less regulated solutions.

In one notable recent example, in the lead up to the Beijing Olympics, the Chinese government adopted the FAA regulations wholesale, and flight safety improved dramatically. For more detail see Brandon Fuller’s post on China’s air safety overhaul (link).  This episode shows that government officials made a conscious decision to adopt regulation.  It also shows that the regulations do make a difference.  Chinese pilots flying essentially the same planes under different rules now have far fewer fatal crashes.

Posted by Dave Backus for Paul Romer


3 Responses to “FAA-Style Regulation for the Financial Sector?”

  1. […] « FAA-Style Regulation for the Financial Sector? […]

  2. Paul Romer Says:

    From Heski Bar-Isaac: Stark implications of reliance on process instead of principle in criminal justice:


    (gated except for first page)

  3. […] Romer’s post about the differences between the FAA and financial regulators got me thinking.  Are the latter […]

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