19 July 2011

Korean Lessons for the US, Part 1: Credibly Committing to Bad Regulation

It's always a good day when you notice your PhD research overlapping with what's going on in the news. PhD research might actually matter!

This happened to me when I was listening to a recent Fresh Air interview with NY Times reporter Louise Story about why the United States has prosecuted so few people involved in the financial crisis. A couple points caught my attention:

  • Regulatory agencies, especially the SEC, are understaffed. (not really news to most people interested in this stuff)
  • Since 2008 the Justice Department has officially allowed financial companies to defer prosecutions if they conduct their own investigation into alleged wrongdoing. (that's more like it)
  • The combined effect of understaffing and essentially outsourcing investigations to financial companies is that regulators are:

    • Losing the capacity to do their own investigations of financial institutions
    • Not going to even be able to critically evaluate the investigations given to them by the companies they are regulating.

She lists a number of other reasons for lax regulatory enforcement, but these points caught my attention. They reminded me of the 1997 Korean situation. (I'm shovelling through the Korea-end of a comparison of financial crisis in Korea and Ireland with Mícheál O'Keefe at the LSE.) In particular it reminded me of an argument we're trying to make regarding regulator capacity and information.

Long-story-short: if the financial sector is unhealthy (lots of non-performing loans, etc), but a regulator doesn't want regulations tightened they can obscure the information they give to policymakers. Put another way, making the economy seem good makes people feel like there is no need to impose new regulations.

I guess regulators could just lie about the state of the financial sector. But this has its problems, like being called to testify at a congressional investigation about why you lied. There is also the problem of credible commitments.

Question: How can you ensure that information remains bad overtime and in a way that is credibly signalled to financial markets?

Answer: make the regulator unable to collect good information. (I'll come back to this point in the next post.)

In pre-1997 Crisis Korea the Ministry of Finance and the Economy (the ministry of finance and financial regulator wrapped up in one) was able to do this through a complex web of understaffed regulatory departments (for background see a 2002 paper by Jin Wook Choi). Louise Story's reporting indicates some ways that US regulators can credibly commit to bad information and therefore weak regulation.

I'm sure you're all wondering about two unresolved questions. Why would a financial regulator prefer weak regulation and how did Korea solve this problem?

Well, I'll give my answers to these questions in the next post.

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