It really is very hard to come up with decent proposals to contend with our highly integrated, international, essential, and not-so-well functioning financial system. While some have developed general guidelines that sound attractive, figuring out how to implement them is quite another matter.
For instance, in a recent Financial Times comment, former Treasury secretary Larry Summers set forth “Six principles for a new regulatory order.” Number one was:
… there should be a strong presumption against having regulators competing to supervise particular institutions or activities. Experience suggests that even when firms do not have the option of switching, there are substantial risks that regulators will be co-opted. Adding “forum shopping” exacerbates the problem.
Well, yes, eliminating regulatory arbitrage is a very nice idea. but short of having a world government and a single financial regulator that manages everything from teeny credit unions and payday lenders though uber-banks, there isn’t a simple prescription for how to make this happen. And having a single regulatory framework has its own drawbacks. Henry Kaufman has argued for the formation of a high powered regulator to be aligned with the Fed to supervise the biggest, most complex institutions. But having horses for courses regulators is at odds with Summer’s idea of more integration.
From an interview in the Financial Times:
Mr Kaufman said a distinctive feature of the financial crisis was “much greater lapses in official supervision and regulation than in earlier periods”.He said there should be a new federal regulator appointed who would work with the Federal Reserve but who would have responsibility for “intensively” regulating the 30 or 40 biggest financial firms. Failure to do so could lead to a “crisis that’s bigger than the one which we have today”.
“The supervision of major financial institutions requires deep skills in credit, deep skills in risk analysis techniques and it requires within that organisation, very skilled, trained professional people,” Mr Kaufman said. “That is lacking in the supervisory area in the United States.”
So while it is important to get agreement on the general thrust of new approaches, it’s also key not to let good ideas, particularly ones that are practical, go by the wayside. The Financial Times featured one today in a comment by Charles Goodhart and Avinash Persaud, “A party pooper’s guide to financial stability“:
Much attention has been paid to the fraught task of aligning bankers’ bonuses to longer-term outcomes. But it will be easier to amend supervisors’ pay, to similar macro prudential effect. If supervisors received large annual bonuses that were withheld for five years and paid conditionally on successful supervision during this period, they might be more willing to remove the punch in time – thereby limiting bankers’ bonuses in the first place. To avoid excessive regulatory zeal we would need independent assessment of supervisory success, with some input from the industry.It would need to consider such issues as widening access to finance as well as minimum cost to the taxpayer.
Because America, unlike much of the rest of the world, lacks a tradition of elite, career bureaucrats (they exist in a few places like the Department of State but aren’t part of the national psyche), we have trouble with the idea of paying them at anything approaching private sector pay scales (although the folks at the World Bank are pretty well compensated by virtue of tax breaks and very generous pensions). In Europe and Japan, the formulas vary, but one factor that is unlikely to operate in the US (at least for some time) is that the mandarins are held in high esteem.
But there is a more basic issue. If you want to prevent corruption in government and get good people you need to pay them. Singapore provides a casebook example. In the late 1950s, it has a diseased bureaucracy it had inherited from the British. Lee Kwan Yew undertook a multi-pronged effort to transform the government, which included instilling ideas that no doubt sound alien to Americans, such as having government officials, including politicians, be part of a meritocratic system. Compensation played an important role in this transformation. Top officials were very highly paid. The transformation was radical and successful. Lee Kwan Yew was attentive to the role of compensation:
On 22 March 1985, the then Prime Minister, Lee Kuan Yew, provided an eloquent justification for his government’s approach in combatting corruption when he explained in Parliament why the salaries of his cabinet ministers had to be raised. According to him, the choice was a simple one: ‘Pay political leaders the top salaries that they deserve and get honest, clean government or underpay them and risk the Third World disease of corruption.’
The Goodhart/Persaud sketch has merit. Warren Buffett has for many years used a long-term incentive scheme in his insurance business (my information is no doubt dated, but the top executives got moderate salaries and shared a bonus pool of 15% of the profits, determined and paid out 5 years in arrears when the loss experience of policies written could be determined with certainty).
Given the more ambiguous nature of the regulators’ goals, coming up with the right formula would be tricky, and it would probably need to be reviewed and tweaked. Coming up with a good oversight body is also not trivial, and making sure the regulated firms can provide information without using the oversight group as a lobbying platform is not trivial. Sadly, finance savvy and public-minded citizens like Paul Volcker are in short supply to begin with and are a dying breed. I know contemporaries who have the right skills and mindset to play such a role, but they are not high profile. That sort of highly competent, disinterested person in many cases would lose out to someone more visible. But in America, the well known are typically well-connected, which also means more susceptible to influence.
Despite the complexities in making an idea along these lines work out, it has high payoff and comparatively low cost relative to other options. I hope it gets some traction.
Anonymous 
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I am very supportive of Kaufman’s proposal that regulatory body for top tier financials be _independent_ of the Fed. There are just too many internal conflicts of interest in the way the Fed operates now with regard to multiple mandates.
I have no problem at all with paying top tier regulators and bureaucrats big money: they have real responsibilities with long term costs. A larger problem, though, is that there is no real career track for folks performing such functions. It’s hard to see entry level staffers rising to mission leadership, so that most key public administrators are likely to be recruited from the industries they will supervise; that’s a problem, and hard to get around.
Something mentioned in neither of these proposals is that said top tier financial regulator needs both a highly skilled research staff and access to information at other regulatory bodies. For example, the lead financial regulator has to have SEC and CFTC data to really get a handle on capital flows. It is easier to see the research pool attracting signficant talent, and also serving as a corrective for ‘from the industry’ recruits who may be too close to the mindset of the markets upon arrival.