November 22, 2017

Decentralize Financial Regulation

Alexander Salter

Assistant Professor of Economics, Texas Tech University

Vlad Tarko

Assistant Professor of Economics, Dickinson College

The 2007–2008 financial crisis upended conventional wisdom for financial companies, government regulatory bodies, and economists. We are still feeling the effects a decade later, as post-recession growth has been meager by historical standards. Moreover, as our new research shows, many assumptions about what caused the financial crisis are mistaken — making a repeat more likely.

Both sides of the political aisle are responsible for the inaccurate narrative. The Left tends to highlight lenders’ alleged greed in exploiting “subprime” borrowers, while the Right has focused on the “moral hazard” created by government bailouts and the bad investment caused by government subsidies. Such explanations are at best incomplete. The truth is more complex — and more disturbing — than these morality tales let on.

A well-functioning financial sector requires firms to assess and manage the risk of their actions accurately and carefully. In reality, these companies’ worst-case scenarios have turned out to be naively optimistic. The truth is that just about everyone was taken by surprise in 2008, not only by the crash, but also by its sheer magnitude. No one — including financial firms — anticipated that things could get as bad as they did.

In fact, the financial system is too complex for anyone to understand all its intricacies and dangers. Thus securing financial stability requires acknowledging this complexity as a starting point. Admitting what we don’t know is more productive than pretending to understand more than we do know.

Economists have paid too little attention to the problem of fragmented and incomplete knowledge, especially on the part of regulators trying to engineer stability. As a consequence, economists and regulators rally around technocratic solutions to financial instability that are ill-equipped to accommodate unanticipated change.

Take the current fascination with “macroprudential” regulation. This approach focuses on systemic risk within the entire financial system. In practice, it’s the same old regulatory dance to a slightly jazzed-up tune: Economists and regulators claim they can keep the financial system safe by keeping an eye on system-wide variables such as asset structures and credit ratios. The problem is that, at best, these variables provide a bird’s-eye view of an incredibly complex process. Ultimately, macroprudential regulation amounts to increased regulatory discretion by would-be financial czars who — despite their expertise — will inevitably make some human errors.

Good intentions aside, such policies threaten to make an already brittle system even less resilient. A system is fragile if it works well only when the people in charge are benevolent and have all the information they could possibly need.

That describes our current, highly regulated financial system precisely. To work properly, it requires too much knowledge, generosity, and rationality on the part of everyone involved — whether in the private or public sectors. Even fairly small departures from the assumptions of omniscience and benevolence can create large-scale problems. 

A more promising way to achieve financial stability lies in the concept of “institutional resilience,” developed by 2009 Nobel Laureate Elinor Ostrom. In Ostrom’s system, an institution is robust if it continues to perform well even when powerful players are selfish and ignorant. A resilient system of this sort punishes or offers corrections for errors of judgment, gaps in knowledge, and irresponsible behavior before they unfold into a full-blown financial crisis. 

Is this type of analysis useful beyond diagnosing institutional problems? That is, how can we correct our current institutions or even design better ones? 

One of Ostrom’s other insights is the concept of “polycentricity.” She points outthat because institutional design is so difficult and rife with uncertainties, systems must be allowed to evolve by embracing market-like features with numerous players and independent rule-making authorities. This is the opposite of what currently prevails in our financial system, which is regulated in a top-down fashion.

Because they are decentralized and allow solutions to emerge and spread organically, polycentric systems have some important advantages. First, problems generally remain relatively contained at small scales. Second, when problems occur, one part of the system is able to absorb some of the turbulence occurring in others. Third, experimentation can discover “best practices” that can be shared or even generalized. 

Historically, the financial-banking system that comes closest to being polycentric is what is known as “free banking.” This is a bit of a misnomer, as free banking does not mean that the system is unregulated. Rather, such systems eschew top-down federal regulation, relying instead on a combination of formal and informal rules that promote resilience, many of which are enforced by bankers themselves. 

The backbone of a free-banking regime is a system of private clubs. Historically, the most important clubs were the private clearinghouses created by banks for the purpose of settling liabilities. As they evolved, the clearinghouses created safety-promoting rules, such as minimum reserve requirements, and monitored banking activities to ensure members were not behaving irresponsibly. Unfortunately, this system was gradually eliminated by the creation of modern central banks and government financial regulators.

Polycentricity suggests a solution to our own fragile financial system: Governmental authorities should make some room for financial institutions to self-govern. Doing so would require a judicious repeal of much existing regulation, in a manner that allows private networks of exchange and regulation among banks to emerge once again.

The need for stability in the financial system remains one of the most significant public policy challenges today. Worryingly, policymakers and regulators appear to be doubling down on the same tried-and-failed strategies of centralization and micromanagement by government regulators. A better approach would be to embrace a genuinely polycentric financial system, which could more readily absorb the shock — and perhaps even reduce the likelihood — of future financial crises.