Lawrence J. White Stern School of Business New York University lwhite@stern.nyu

1. Focusing More on Outputs and on Markets: What Financial Regulation Can Learn from Progress in Other Policy Areas Lawrence J. White Stern School of Business New York University lwhite@stern.nyu.edu Presentation at FDIC, Arlington, VA, November 30, 2007

2. Overview • Background on regulation (in general) • Examples, in other areas of regulation, of “success stories” that focused on outputs and markets • Examples of four proposals for reforms of financial regulation that would have focused on outputs and markets (but have not been adopted), and one area of successful flexibility: bank reserve requirements and the Fed Funds market • Conclusion

3. Classifying types of regulation • Economic regulation • Health-safety-environment regulation • Information regulation

4. Economic regulation • Control over prices or profits or entry or exit • The Civil Aeronautics Board’s (CAB) former regulation of the airline industry • Bank regulators’ former ceilings on deposit interest rates, limits on entry, branching • The Securities and Exchange Commission’s (SEC) former restrictions on which bond rating companies can become a “nationally recognized statistical rating organization” (NRSRO)

5. Health-safety-environment regulation • Control over production processes or inputs or outputs • The Federal Aviation Administration’s (FAA) safety requirements for airlines and pilots • Bank regulators’ safety-and-soundness regulatory requirements for banks • The SEC’s minimum capital requirements for broker-dealers and competency requirements for securities brokers

6. Information regulation • Control over the types and formats of information • Department of Transportation’s (DOT) regulation of fare announcements by airlines • Bank regulators’ interest rate disclosure requirements • SEC’s disclosure requirements for publicly traded companies

7. Where does corporate governance regulation fit in? • The goal of corporate governance regulation – assuring investors of a fair outcome – is not all that different from the safety goals of the FAA or the Consumer Product Safety Commission (CPSC)

8. Classifying regulatory implementation • Command-and-control regulation: Centrally devised (macro) solutions imposed at the micro level; often “one-size-fits all” • Technology standards (inputs oriented) • All firms must adopt a specific technology • Performance standards • All firms must meet a specified level of performance, but can choose their technologies • “Bubble” concept • The firm is judged on its aggregate performance (put a plastic bubble over the entire firm), not on the performance of individual units

9. Regulation of the auto industry exemplifies all three concepts • Vehicle safety standards embody technology requirements and performance requirements • Vehicle pollution control requirements embody performance requirements • Vehicle fuel mileage requirements (CAFE) embody the bubble concept

10. Going beyond command-and-control: embracing “outputs and markets” • “Cap-and-trade” system for controlling SO2 emissions • Electromagnetic spectrum auctions • “Dedicated-access-privilege” programs for fisheries

11. “Cap-and-trade” system for SO2 emissions • Replaces command-and-control with much greater flexibility • National aggregate maximum amount of annual SO2 emissions has been allocated among electric utilities • They can trade SO2 emissions permits among themselves • This encourages greater efficiency and innovation • The SO2 program has been highly successful

12. Electromagnetic spectrum auctions • Replaces Federal Communication Commission’s (FCC) command-and-control allocation of broadcast licenses • Auctions have allowed greater flexibility in use, greater efficiency • Auctions have generated tens of billions of dollars for the federal treasury • Spectrum auctions are considered highly successful

13. “Dedicated-access-privilege” (DAP) programs for fisheries • Fisheries are a watery commons and often suffer from “the tragedy of the commons” • Response of the National Marine Fisheries Service (NMFS) has been command-and-control regulation for overfished fisheries • DAP programs are like “cap-and-trade” • Set an annual “total allowable catch” TAC • Allocate TAC among fishermen • Allow trading of the allocations • DAP programs in U.S. and especially abroad have been highly successful

14. Financial regulation • Financial regulation is not different from other regulation • Financial regulation sometimes encompasses technology standards and sometimes encompasses performance standards; often “one-size-fits-all” • Where are the programs that emphasize “outputs and markets”? • Bank reserve requirements and the Fed Funds market • And some proposals • Benston/Kaufman proposal for mandatory subordinated debt for banks • Klausner’s proposal for CRA reform • Ronen’s proposal for financial statement insurance (FSI) • My proposal for NRSRO reform

15. Bank reserve requirements and the Fed Funds market • Depository institutions are required to hold funds “in reserve” as vault cash or as deposits at the Federal Reserve, calculated as a fraction (e.g., 10%) of their deposits • The Fed Funds market permits banks to buy and sell “excess reserves” and thus provides flexibility in meeting the requirement • “Floor and trade”

16. Capital requirements for banks • Depository institutions are required to hold minimum levels of capital (net worth) as a % of assets • Capital is a direct buffer that protects depositors (or the deposit insurer) against reductions in asset values • Capital represents the owners’ stake in the bank; a greater stake reduces the incentive for risk-taking

17. The Benston/Kaufman 1988 proposal for mandatory subordinated debt • As part of their capital requirement, depository institutions should be required to issue a tranche of subordinated debt • Sub debt would bring a set of stakeholders who would lose from the down side of risk-taking but not gain from the up side • Sub debt holders might restrain risk-taking by owners (or managers on owners’ behalf) • Regulators might use the yields on subordinated debt to help identify problem institutions • The Benston/Kaufman proposal has never been implemented

18. The Community Reinvestment Act of 1977 • The CRA requires banks to “meet the credit needs of the local communities in which they are chartered consistent with safe and sound operation of such institutions” • The CRA is command-and-control regulation • Technology standards from 1977-1995 • Performance standards since 1995

19. Michael Klausner’s 1995 reform proposal • A bank’s CRA annual commitment would be specifically defined as a dollar amount of loans originated and/or held • The obligation could be transferred to other lenders; a market could develop • Consciously modeled on the SO2 “cap-and-trade” program • Klausner’s proposal has never been implemented

20. Current accounting/auditing arrangements: the problem • Investors and creditors rely on financial statements • Auditors are hired (and can be fired) by corporate boards of directors, who are selected by managements • Managements always favor rosy scenarios • Auditors face an inherent conflict of interest • After-the-fact liability suits are an imperfect solution • Sarbanes-Oxley command-and-control regulation is not a satisfactory solution

21. Joshua Ronen’s 2002 proposal • Companies would purchase “financial statement insurance” (FSI) from a competitive insurance market • The insured amount and the premium would be public information • FSI ends the auditor’s conflict of interest: The FSI insurer would hire the auditor and would be interested in “the truth” • Rosy scenario means premiums that are too low • Pessimistic scenario means that the insurer would be underbid by an insurer with a more accurate auditor • Ronen’s proposal has not been acted upon

22. NRSRO regulation • The bond rating industry was subject to protective regulation by the SEC, 1975-2006 • In 1975 the SEC created the category “nationally recognized statistical rating organization” (NRSRO) and grandfathered Moody’s, S&P, and Fitch • The NRSRO category created an artificial barrier to entry • The SEC never defined NRSRO • When it proposed a definition (in 1997 and 2005), it focused on inputs • The NRSRO designation process was opaque

23. My 2002 reform proposal • Plan A: abandon the NRSRO category and allow financial markets to form their own judgments as to reliable bond ratings and rating companies • Plan B: retain the NRSRO category, but the SEC must cease being a barrier to entry and must certify NRSROs on the basis of “outputs” – efficacy in predicting bond defaults – rather than inputs • This proposal was not acted upon; but the new (Sept. 2006) NRSRO law may reduce the barrier to entry – or not

24. Conclusion (1) • An “outputs and markets” orientation would be worthwhile for financial regulation • There are successful examples in other regulatory areas • Bank reserve requirements and the Fed Funds market are an example of successful application • The mandatory sub debt proposal, Klausner’s CRA proposal, Ronen’s FSI proposal, and my NRSRO proposal show that these ideas are more widely applicable to financial regulation • There are surely more areas of financial regulation where these ideas could be applied

25. Conclusion (2) • My message to financial regulators and policy makers and to financial sector researchers: Think expansively and creatively! Think “outputs and markets”!