Jared Bernstein’s excellent blog post on the political barriers to banking regulation | Blog#42

Kudos to Jared Bernstein for a very thoughtful blog post on the political barriers to banking regulation.  My thoughts below his:

Why is it so hard to regulate the banks? It’s less the complexity than the political power. | Jared Bernstein | On the Economy

May 31st, 2015

Give a read to this incisive analysis by Adam Davidson on the challenge of regulating banks. It’s deceptively hard to write about this world as clearly as Davidson does here (I tried to do so in Chapter 7 of The Reconnection Agenda; not sure how well I succeeded). I think his conclusion is unduly pessimistic, or, more precisely, pessimistic for the wrong reason. The problem in regulating banks is less complexity–though that’s a real challenge–and more their political power.

(Also, as I stress below, in passing he gives us a great working definition of the concept of economic “rents,” one that confuses many readers.)

Davidson worries that we can’t effectively regulate the banking sector because if we try to do so with a light touch, they’ll easily evade the regulations. But if we then try to write complex regulations that get into nuanced corners of modern finance, the resulting intricacy will render the rules unenforceable. For example, under Dodd-Frank’s Volcker rule, we’re asking regulators to figure out if a deal made by an insured bank is legitimate “market making” on behalf of a client (e.g., finding buyers for a stock that the market isn’t moving on its own), and thus exempt from Volcker, or a risky bet that exposes taxpayers.

He points out that banks have the resources—deep pockets, bevies of lawyers—to tie up the regulatory process ad infinitum arguing cases like that. Moreover, they’re quick to point out that imposing such rules gums up the credit system and thus costs us growth and jobs. And they’ve got powerful politicians on their payrolls, as it were, to back them up.

That’s all true, of course, but my argument in The RA is that if we can get the four corners of Dodd-Frank firmly in place, we’ve got a good chance of busting, or at least dampening, the “shampoo cycles”—bubble, bust, repeat—that have repeatedly laid waste to economic recoveries both here and abroad. The idea behind the structure I advocate is that if you get some of the big stuff right, the parts you get wrong won’t create as much external damage.

Briefly, the four corners are (see chap 7 for details):

–When a bank gets kicked in its assets, it needs an adequate capital buffer. Significantly raising the amount of equity that banks must hold against losses will diminish their profitability but it is by far the first line of defense against the shampoo cycle.

–The Consumer Financial Protection Bureau must vigilantly protect against shoddy underwriting. If underpriced risk is the evil genius of financial bubbles, than bad underwriting is the work of her minions. As I stress in the book, this is not that complex an endeavor, and the CFPB is actually off to a good start, despite outside pressures pushing against their efforts.

–A Federal Reserve that trolls the waters for systemic risk. Former Fed chairs argued that the Fed couldn’t really spot bubbles and even if they could, they didn’t have the tools to do much about them without hurting growth. Chair Yellen disagrees, and Dodd-Frank creates a mechanism for the Fed to oversee this process. Importantly, she distinguishes between “macro-prudential” policies and macro-management ones.

–A strong Volker rule. As noted, this one is tricky, and the “market maker” exemption has already had to be tightened a bit. I’m less confident about this corner of the architecture but if the other three are in place it may be less consequential.

I’m not saying any of these are simple—no one knows the optimal capital buffer ratio and spotting systemic risk is not obvious (though neither is it so obscure, as Dean Baker stresses re the housing bubble). But where I depart from Davidson is that the challenge is not substantive details. It’s politics.

Take capital buffers. Erring on the side of caution would suggest taking what the experts recommend—something around 10-15% of assets as a buffer zone—and adding another 5%. But remember that part above about the finance sector’s influence on politics?

That, not complexity, is what drives my pessimism in this space. Same with spotting and deflating bubbles before they explode and prohibiting glaringly obvious forms of underwriting that under-prices risk (“no-doc loans”; “exploding ARMs”; do those sound like prudent products to you?). None of this is beyond the scope of oversight; none is so complex that it couldn’t be accomplished.

The problem is less creating the switches; it’s blocking political power from paying people to fall asleep at them.


Here at OTE, I often point to the market failure of rent-seeking, a serious problem in advanced economies that’s closely associated with high levels of economic inequality and particularly pernicious in finance. It’s not an intuitive or particularly well-named concept, and people often ask me what it really means. I thought Davidson’s description was clear and resonant:

Generally speaking, businesses earn profits in one of two basic ways. The first is by providing goods and services more productively than others and selling them at a price people are willing to pay. The second is by seeking rents. “Rent,” in the economic sense, refers broadly to any excess benefits that people and businesses receive simply because they have power over something that others need. Patents are a form of rent, as are cable TV monopolies.

For economists, rent­-seeking is everywhere, and is a common way that economies go awry. Crudely speaking, productivity enhancement is good, because it makes society richer over all. Equally crudely, rent­-seeking is bad, because it makes the people who are already rich even richer. Rent-­seeking tends to be a force against innovation and for stagnancy, in large part because its focus is on the past — on maintaining power and influence gained long ago, often at the expense of innovation. Businesses built around rent­-seeking don’t try to increase the size of the pie; they just want to make sure they get a bigger slice. (If a company doesn’t seem to care about your opinion of it as a customer, there’s a good chance that it is seeking rents.)

I’m not sure about that last part. It’s certainly true at the company level. The fact that Comcast can tell you that they’ll come fix your internet connection sometime between 10 and 5 suggest a level of monopolistic market power that reeks of rent-seeking. But there’s another reason we all have lots of customer interactions where it seems like the firm doesn’t care about our business: the principal-agent problem. It’s not rents, but it’s another form of market failure.

Blogger’s Note:

I would like to add a few thoughts… An aspect we must not lose sight of is the influence of neoliberal policies and thought that have been absorbed by the public at large in just the last two decades, amid an increasingly loud barrage of neoconservative ideas that, in spite of vigorous debunking, just don’t seem to go away. That last piece is rather well-addressed by Professor Paul W. Kahn in his must-read piece in Al-Jazeera America:

“It makes sense that a thorough rejection by the voters of the liberal agenda would lead to political paralysis, for the left really believes that it has hold of the truth in its critique of the right. There is not an alternative truth it can find to take the place of these policies. When American voters reject theories of evolution, it is not time for the biologists to reconsider. This is how the left feels about their policies on redistribution, regulation, environmentalism and foreign policy. At most, they can think of repackaging. If that is not enough, they are immobilized.”

A great companion read is “Neoliberalism has brought out the worst in us,” by Paul Verhaeghe”

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