Obama's Wall Street Regulations as Behavioral Control

As Congress prepares to move forward on financial services regulation, it’s worth taking a step back to look at the proposals for what they really are: behavioral control mechanisms. This is not to say that regulation is inherently bad. A free market can only exist within a framework of rules for competition. And there are certainly some good aspects of the White House plan to reform Wall Street’s rules. But the core measures the president wants passed before the end of the year are simply the expansion of government to dictate terms of action to financial institutions and consumers.

First, the Consumer Financial Protection Agency (CFPA) is an attempt to control the behavior of financial institutions, and what they can or cannot offer. It is an attempt to govern the behavior of individuals who are apparently no longer capable of bearing responsibility for their own actions in choosing financial products. Wright and Zywicki write for FinReg21 that there is a “high likelihood of unintended consequences that will result from [CFPA] actions, including reducing competition and valuable consumer choice.”

Second, derivative regulation reform proposals would make it very expensive and complicated to write unique derivative contracts between firms, with rules designed to push the market towards using more standardized products. Why? Because standard contracts are easier to monitor, easier to control.

Third, the tiered structure for regulating financial institutions will create categories that allow the government to vary its regulatory rules based on the arbitrary perception of risk in the market by the regulators. Washington is looking to control how much risk firms can take, and what kinds of risks.

And fourth, the executive pay rules that passed the House and are now before the Senate Banking Committee, grant the government authority to restrict compensation packages it deems “threatening” to the financial sector. Not only is a grab at more control, this power would allow regulators to intimidate companies into setting pay by its terms without ever having to exercise the power.

Here’s the rub: supporters of these new controls fail to realize regulatory failure and misaligned incentives in the marketplace from government policy were significant causes of the housing bubble and the financial crisis. Ramping up the breadth of regulation as a response is going to be problematic.

The really unfortunate part of this is that the attempts at controlling behavior–forcing firms to operate within the arbitrary limits of Congressional committee members–is putting off the opportunity to actually make helpful changes to the regulatory structure.

After all, consumer protection isn’t perfect right now. But instead of a Consumer Financial Protection Agency, we could bolster the current consumer protection laws by empowering the current regulators to resolve disputes more easily and collect restitution when necessary. We could let consumers make choices for themselves and emphasize personal responsibility. We could recognize that people will make financial mistakes, even when contracts are clear, but this isn’t the fault of businesses. The role of the government is not to parent consumers or businesses, which is a leading reason the U.S. Chamber of Commerce is viscerally opposed to a CFPA.

On the issue of derivatives, it’s true that the market could benefit from more transparency. But new exchanges and any necessary standardization should develop naturally (as is already happening). The demand for “safer,” more standardized contracts should drive prices. A regulatory gun forcing this to happen would mean arbitrary and distorted prices for these products, and for unique, over-the-counter products that might carry more risk. In a market with more standardized trades, over-the-counter contracts may naturally be more costly, but that pricing should be market based, not Washington based.

And when it comes to the “Tier 1” financial institutions that dominate the market, we should be looking to eliminate the too big to fail system, not codify it. The current proposal from the White House will create many unintended consequences. For instance, more explicitly defined firms that are too big to fail will have access to cheaper credit, given that their credit risk would be as good as the U.S. government. They would enjoy protection from Washington just like government-sponsored enterprises. And these benefits may encourage smaller financial institutions to take on more risk than they otherwise would to achieve the special Tier 1 status. (Just think about CIT, a big lender, but not quite too big to fail; should we have a system that would have encouraged it to take on more risk just to get Tier 1 protections?)

Financial services regulation should be focused on facilitating competition and avoiding perverse incentives in the market from government favoritism. Washington doesn’t have to control the behavior the financial industry in order to protect the market, it simply needs to ensure the consequences are clear and sufficient that financial institutions can take responsibility for their own prudent risk management.