FAA and financial regulation revisited

January 31, 2012

A post by Larry White

Paul Romer’s post about the differences between the FAA and financial regulators got me thinking.  Are the latter so bogged down in detail that they miss the point?  Do they lack bottom-line responsibility?

First, there is some oversight of the financial regulatory process:  a) Congress, of course, always gets involved.  Alas, that’s usually for theatrics rather than objective fact-finding; still, it is involvement.  And b) Like many federal agencies, the FDIC does have an Inspector General that does after-the-fact reviews and audits.  So does the Federal Reserve.  So does the Federal Housing Finance Agency.  The Office of the Comptroller of the Currency (OCC) doesn’t appear to have its own IG; my guess is that the Treasury Department’s IG also covers the OCC, since the OCC is lodged in Treasury.

Second, there is another way to think about the limitations of financial regulation.  In some other areas of health-safety-environment regulation, there has been some movement away from “command and control” regulation and toward what I have called “an outputs and markets” orientation.  For example, “cap and trade” in environmental regulation; auctions in electromagnetic spectrum regulation; property rights in fisheries regulation.  But one is hard pressed to find any comparable movement toward an “outputs and markets” orientation in financial regulation.  In this respect Paul is exactly right, financial regulation, as currently practiced, is different.

Third, bank prudential regulation (i.e., safety and soundness regulation) has a combination of a massive rule book and a corps of examiners and supervisors who are responsible for enforcing the rule book through roughly annual examinations and then supervisory reviews.  In principle, this places the responsibility for a bank’s safety on a relatively small group of people.  But with 7000+ depository institutions in the U.S., the corps is large; and the failure of a bank, though nowadays perhaps as dramatic, isn’t as generally well understood by the public as the crash of an airplane.   I’m still not sure whether FAA-style would work, or whether financial markets are simply more complex than airplanes, and therefore more difficult to regulate.

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