Friday, November 6, 2020

Review of Guardians of Finance: Making Regulators Work for Us by James R. Barth, Gerard Caprio Jr., Ross Levine

This review was written by Eugene Kernes

Book can be found in:
Genre = Economics, Finance
Intriguing Connections = What Goes Into An Economic Crisis?

Elaborate Description

These authors do not let the regulators away without citing the consequences created by the regulators own legislature and policies. The financial regulators, deemed to be Guardians of Finance in this book, rather than doing their job and protecting society, not only facilitated greater risk taking but were idle when problems started to occur years and decades before the financial crisis of 2007-09. A main reason, although certainly not the only one, the regulators poor performance is their unaccountability to the public. For every financial crisis, the regulators are provided with more and broader power, yet that has not helped limit the severity of each crises. This book takes a deep look into why the Guardians of Finance do not help society and at times endanger it, and with these lessons the authors express what can be done to make the Guardians of Finance work for society.

The way the authors view regulation is by the bundled incentives provided, not as individual legislature. Whether a legislature is desirable or harmful, simply adding or removing the legislature is not enough to make the financial system better. Each legislature impacts the incentives of other legislature, even if in isolation the legislature should be removed or added, the impact on incentives can be harmful. The authors also stay away from the extremes of policy which are embedded in ideology such as perfect markets or perfect government, for neither is suitable for the complexity of the financial system. Simple regulations are also not suitable as they may work during ideal times but are easily overcome by financial innovations when the regulation hinders the ability of the bank to adapt to the economic environment.

Regulations are needed to prevent the financial system from taking on too much risk at the expense of society. The authors do not agree with regulations being lax, as that leads to taking too much risk, or with regulations being too strict, as that leads to less innovation. Many financial innovations helped facility economic growth, which regulators should not impede but these innovations do carry risks which regulators should limit. Innovations are required in finance, but that also means that regulators need to adapt to the new innovations, they need to continuously change their policies to prevent the innovations from being ill-used. A problem not discussed in the book is that to make regulations enforceable, they also have to be predictable while a continuous adaption of the legislature prevents predictability. Selecting, implementing, reforming, and enforcing policies which allow financial firms to do their job of allocating capital while also limiting the amount of risk that financial firms can take is a very hard task for regulators which is why they must continuously adept and innovate as well.

When the regulators tell the story of their inability to see what was coming, to claim they did not have the power to take action, or some other form of expression for proclaiming them innocent of blame, the regulators impede the ability to create reforms and policies to prevent the next crisis. This book shows that not only did the Guardians of Finance knew the risk the financial system was taking, but that time and power were not enough for the Guardians of Finance to change the destabilizing situation, for they often chose not to take action. Regulators are not voted in by the public and are not accountable to the public so do not face the consequences of their failure.

Another reason why the regulators are unaccountable to the public is that they hold a monopoly on financial legislative information. They have the ability to assess the risks of the financial system, they create policies which impact the public, while they also assess their own work as they have the expertise. Unlike the claims that the financial market is not self-regulating, the regulators claim that they can self-regulate their own work. The public does not have the information, while the regulators are often in contact with those they regulate, which means that the regulators listen more to those they regulate leading to a plethora of lobbying efforts that defeat financial regulation or at least water-down the regulation which would reduce the risks the financial system is taking on.

Potentially one of the most important parts of the book is how regulators incentivized the 2007-09 crisis. Banks are some one of the most regulated institutions and regulators can quickly see the risks which are posed by the financial system. For this crisis, the authors show that the regulators saw the damage being done by some financial innovations decades earlier while choose to stand by. What followed were claims of inability, the creation of new regulatory institutions, and granting them more power. In fact, after every crisis, the same patter applied for which the regulators became more powerful yet not doing their job and asking for more power.

Rather than looking at any particular issue within the U.S., the authors provide lessons which were seen in most countries that experiences a crisis. Some reasons why the financial crisis happened in the U.S. might not be an applicable reason for other countries, so this book provides reasons which were applicable to most, if not all, crises. Although the book provides a template for what to look for in every country, it does not provide the specifics because the specifics change based on each country. A guide rather than an answer key of how to improve the regulatory process.

The policy recommendation in this book is a Sentinel. A Sentinel would be an institution that does not wield regulatory power and is independent of both the political and economic pressures. Its purpose would be to assess the financial regulation and provide the public with the report. An institution which makes regulations transparent and the impact of the regulations known. Along with the proper incentives to prevent the Sentinel from being corrupted by political or economic pressure, the Sentinel would help spot regulations which are in need of change or should be added/removed. As the Sentinel will report to the public, it will make the Guardians of Finance accountable for the regulations and lack thereof. Just the presence of a Sentinel, as an auditor of the regulators, can make the Guardians of Finance behave in favor of the public rather than the for the powerful.

The Sentinel’s design focus is meant to correct the defective incentives of the Guardians of Finance. These corrections have much merit but they can also show a technical fault in the way the Sentinel operates and the authors own ideological bias. Part of the problem with the Guardians of Finance is the revolving door between those who regulate and those they regulate, for which this book rightly questions whether the Guardians of Finance work for the public or their next employer. To correct this, the authors propose that the pay of the Sentinel’s employees be of comparable amount to those they regulate, which will slow or close the revolving door, with the claim that the higher pay would attract the higher skill worker. This can be a problem as skill and pay are not very correlated, much like they question the compensation of the financial industry. Another Guardians of Finance oversight is that they are polarized in ideology, for which the Sentinel can raise concerns about the policies, with the problem that the Sentinel concerns raised can also be ideological. One of the key features of the Sentinel would be to hold policy makers accountable for their policies, for which the Sentinel is supposed just raise the debate on policies and provide analysis without any regulatory power. Even without regulatory power, the Sentinel can become the ultimate decider in policy debate for which the Sentinel would be able to decide the regulations created as the Guardians of Finance would try to please the Sentinel.

This is an eloquent book which expresses deep complexity of financial regulations while easily accessible to any reader. The focus of the book is on the Guardians of Finance and the U.S., they show the impacts on the financial system as a whole and the role of regulators in other counties. Financial crisis are expensive, and stifling regulations which limit innovations and technological progress are just as expense, but the Sentinel seems to be the most effective and least cost method of changing the incentives of the Guardians of Finance to work for the public.

Book Details

Edition ISBN:  9780262017398
Pages to read:   235
Publication:     2012
1st Edition:      2012
Format:            Paperback

Ratings out of 5:
Readability    5
Content          5
Overall           5