Three Guiding Principles for Reforming Wall Street

In the wake of the massive bank bailouts, nearly everyone is calling for some kind of financial regulatory system overhaul. The Obama administration has outlined what it would like to see and Congress is currently holding hearings on how to best reform the regulatory structure. But the lobbying began long ago.

Big banks are squaring off against smaller banks in the debate over consolidating national banking regulatory powers. All banks are lining up against financial institutions like hedge funds on the regulation of products like derivatives. Even the regulating agencies are competing against each other in hopes of garnering more power.

Unfortunately, if Congress makes choices on political criteria alone, reforms are likely to damage the country’s economic recovery.

Instead, there are three guiding principles that lawmakers should bear in mind when writing new regulations for Wall Street.

Principle #1: Facilitate competition; don’t stifle innovation

The foremost goal of financial services regulation is to establish a framework for competition by providing a common set of standards—the rules of the game—that offer accountability and enforce the law. Those standards need to promote market discipline, provide incentives for good banking practices, prevent information asymmetry where a few people have significantly better information than the average investor, and discourage harmful business practices.  The rules must not impede the wealth creation process or give certain firms special advantages.

“We don’t want to stifle innovation. But I’m convinced that by setting out clear rules of the road and ensuring transparency and fair dealing, we will actually promote a more vibrant market,” President Obama said when he released his plan to overhaul rules for Wall Street.

The current reforms in Congress aim to avoid future problems by limiting the risk that financial institutions can take when investing. But if facilitating competition is the principle, why not limit new rules and increase the consequences for failure?

Financial institutions should be allowed to limit or expand their own risk, knowing that reformed bankruptcy rules allow for the government to rapidly take them over and break them up if they become insolvent.

This would result in firms competing over safety and soundness, leading to the healthy vibrant marketplace the president wants.

Principle #2: Build resilience into risk management

There is a tension between regulations that anticipate risks and regulations that establish resilience during economic downturns.  Anticipation seeks to preserve stability by planning for and avoiding foreseeable risks. Resilience takes a flexible approach to risk management, accommodating variability, preparing to take acceptable losses in a downturn while making modest gains in strong economies. The best regulations, like the recently updated mark-to-market accounting rules, contain a healthy mix of both approaches.

Regulators themselves are fallible, with plenty of knowledge about the past, but no crystal ball for the future. It is impossible to know every risk and predict every danger. There is value in designing regulations that accept the reality of some financial risks. There will be economic downturns. Some companies will go out of business. And some investors will lose money. You can’t regulate away those realities. Simple, common-sense regulations can provide basic protections and then the market will absorb blows as they come.

Principle #3: Beware of creating perverse incentives

Regulations always have the potential to create perverse incentives that distort decision-making and restrict wealth creation. Bailouts have sent the signal that the bigger a financial institution becomes, taking on increased risk, the less likely it is to fail.

In July, bankruptcy-bound small business lender CIT Group was refused a bailout. Some experts said it was because the company didn’t take on enough risk or grow quite large enough to get a bailout. Even though CIT was ultimately rescued by the market, it wasn’t considered “too big to fail” by the government.

When CEOs see Citigroup or AIG bailed out, but CIT left to the market, the signal is clear: make sure you are too big to fail.

The biggest mistake in President Obama’s proposed Wall Street regulation overhaul makes is that it formalizes “too big to fail.”  Yes, it requires more oversight and regulation, but it actually encourages firms like CIT to unnecessarily take bigger risks so they are eligible for bailouts.

Wall Street reforms should make the consequences of failure uncomfortable. If failure means going out of business, Congress won’t need to set executive pay restrictions and micro-manage capital requirements. Companies will be forced to be more prudent if they are told that there will be no more bailouts and “too big to fail” is a thing of the past.

Getting regulation right is hard work,. Even with their good intentions, regulators too often skew market activity and create perverse incentives for investment. Although many financial sector regulations are out of date and problematic, the restructuring process could cause even more damage if it is not done properly.

This article first appeared at Reason.org.