Based on a post on NYU Stern Economics blog. Read the full post

In a recent paper, I suggested that regulation of financial institutions could look less like the legalistic regulation at OSHA and more like the system of regulation with responsibility at the FAA.

The system of financial regulation in Canada illustrates what this could look like.

Canada has a single financial regulator who can, in effect, say to a bank, “This practice is not safe. Stop taking any new business until you change how you operate.” This is the kind of power that the FAA has. It can withhold an airworthiness certificate for a newly designed aircraft until its employees are satisfied that the plane is safe. The agency can also ground any model of aircraft if new information emerges about a threat to flight safety. It can mandate expensive modifications that must be made to the plane before it is deemed airworthy and hence legal to fly again. One of the keys to the success of this system is that the decisions by the FAA are not subject to judicial review. Employees in the FAA are responsible in the sense that they make decisions about what is right and they are held accountable for the results of their decisions, not on the basis of whether they adhered to some process, checking all the boxes.

Michael Bordo, Hugh Rockoff, and Angela Redish have a recent article (gated, unfortunately) that describes the history of the Canadian system of financial regulation. They show that this system has consistently avoided the financial crises that emerged in the United States. They also observe that there are structural features of the Canadian system that make it easier to implement something like the FAA system. For example, Canada has a very small number of very large financial organizations and a single regulator, the Office of the Superintendent of Financial Institutions, (OFSI). According to Bordo et al, “Canadian regulation under OSFI proved tougher than in the United States, mandating higher capital requirements, lower leverage, less securitization, the curtailment of off balance sheet vehicles, and restricting the assets that banks could purchase.”

The Canadian experience shows that having a large number of institutions, each of which is small enough to fail, is not necessary for stability. The US experience with the S&L crisis in the 1980s also shows that large numbers of small institutions is not sufficient for stability either. See, for example, my paper with George Akerlof.

More generally, it is hard to point to a successful regulatory model that achieves financial sector stability by designing in good ex post mechanisms for unwinding the consequences of unlimited risk taking. (Good luck with those living wills.) The demonstrated path to stability is to give a single hierarchical organization the ex ante power to prevent levels of risk-taking that are inefficient.

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