Thursday, August 13, 2009

Regulatory Capture

Moving on from my little bit of banker bashing, I thought I'd write something a little more serious on the subject of regulatory capture. The idea is that regulatory agency will become "captured" by special interests, pressure groups, lobyists etc. Further to this, it is argued that since the interests being regulated are usually the best organised and most able to arrange collective action, they are likely to gain the most sway over the regulatory agency.

Consider as an example a television regulator, a number of interest groups will have an interest in how it regulates television; viewers, advertisers, numerous special interests and of course the TV companies themselves. Of those groups, it is likely that the most coherent, well resourced group is the TV companies who all share a degree of common interest. This group is therefore likely to gain a good degree of sway over the regulator and the regulations it puts forward.

Deregulation, has in been proposed as an answer to this problem, if the state regulates less then there is less regulation to capture. Sounds nice in theory, but I think this particular argument seems to fall apart when you look at the finance industry.

The deregulation of finance has changed the face of the industry. One way it's done this is in the size of the industry, we've gone from a handful of financial products to volumes in their thousands. Another way deregulation has changed is in the level of financial innovation* in the industry, new markets, new tools to manage risk and new ways of speculating on assets. It's my view that actually, deregulation of finance has actually made the industry far more difficult to regulate due to the increased size and complexity.

In some ways, you could argue that the deregulation of finance was actually the ultimate form of regulatory capture. It seems that many of the people who make recommendations about how to proceed as far as regulating finance (in both the US and UK) are those with strong connections to the finance. Is it any wonder then that we have a set of financial regulations that allow financial businesses to make massive amounts of money.

Wrapping all this up, what I'll say is that following on from the Simon Johnson post I linked a few posts down, we need to seriously consider how we regulate our finance industry. We need to consider not just profitability, but also how well it directs money towards other businesses. We also need to ask whether the complexity of the industry, brought about by deregulation is necessary or whether we should at look at creating a simpler financial system.

* I'm a little uncomfortable with this term being used in finance, while I'd accept that some financial innovations (securitisation, credit cards) have been useful. I don't think they've improved our lives to the same degree as innovation in other industries.

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