Dampening Financial Regulatory Cycles

Abstract

Financial regulation should be countercyclical, strengthening during speculative booms to contain excessive leverage and loosening following crises so as to not limit credit extension in hard times. And yet, financial regulation in fact tends to be procyclical, strengthening following crises and loosening during booms. This paper considers competing descriptive and normative analyses of that procyclical tendency. All of the models and arguments considered are rooted in a public choice perspective on financial regulation, i.e. rational choice ideas drawn from economics and applied to politics, but with that perspective modified to take account of behavioralist biases in rationality, particularly the availability bias. That bias helps explain the procyclical tendency in financial regulation, as both the public and regulators ignore the threat of financial crises during boom times and become very focused on that threat when crises actually occur. The normal dominance of concentrated interest groups temporarily shifts as public attention turns to financial regulation following a crisis.

The models considered here, though differ greatly in their normative conclusions, with some mainly criticizing the deregulation which occurs during booms, others mainly criticizing the regulation which occurs following crises, and yet others critical of the timing of both. The models differ in how they understand the balance of interest groups outside of crises and how likely that balance is to lead to outcomes that reflect the public interest, in how well they think the crisis-related public attention can be channeled to reflect the public interest, and in how they analyze the underlying vulnerability of financial institutions and markets and the intellectual difficulty of regulation. After analyzing these differing models, the paper considers historical evidence to try to choose among them, and then considers various administrative mechanisms which might help dampen the procyclical tendencies of financial regulation. Some of the procedures considered include bicameralism and the committee system in Congress, notice-and-comment rulemaking, hard look judicial review, independent agencies, sunset clauses, mandated agency studies, regulatory “contrarians,” and automatic triggers for various rules.

Keywords: financial regulation, regulatory cycles, banking regulation, securities regulation, financial crises

JEL Classification: E32, E58, G20, G38, K20, L51, N20, N40