Tag Archives: regulatory reform

Reinventing Regulation

by Larry Grant

If one could remove oneself from the panic of the financial crisis, it could be instructive—even amusing—to see if this crisis does, in fact, take the course described by its antecedents:  Crisis, regulation, co-option.  Let’s hope not, but, cynical me, I expect the worst.

The worst in this case would be a rush to regulation that, in typical bureaucratic fashion, will create a new regulatory body based on legislation that will require a one-size-fits-all Procrustean bed.  This will be especially worrisome if the push for regulation of the financial institutions and the markets they play in goes beyond to other institutions/companies the Treasury decides to invest in where the player is too big to fail.  Also, I worry that market forces and public investments will result in further mergers and acquisitions in the banking industry creating even more concentration that we can’t afford to bail out.  (See “Both Sides of the Aisle Say More Regulation, and Not Just of Banks,” Jackie Calmes,  New York Times.)

What we need is regulation that is focused on the specific situation of the institution or product being regulated—e.g., not all banks, this bank; or insurance products by any other name (like “credit default swaps” maybe?).  I found it encouraging that Gary Stein, President of the Minneapolis Federal Reserve Bank appears to support an approach that uses specific data from financial institutions that would indicate existing or future problems so that regulators could act before it is too late.  (Gretchen Morgenson, “Regulators In Need Of Rehab,”  by Gretchen Morgenson, New York Times)  Put another way, Floyd Norris writes in the New York Times that “[o]ne principle of the new regulatory system must be that regulations are based on what people do, not on who they are.”

If you are a reinventor faced with designing a regulatory or control functions, we have a basic approach that, over the last two decades has been continually refined.  This approach has three conceptual dimensions focused on the “situation” of the complier (the institution or individuals to be regulated):  Willingness to comply, Ability to comply, and Risk associated with non-compliance.  (Note:  this approach began with the thinking of Hersey and Blanchard  and their concept of “situational leadership.”)

Taking each of these dimensions independently, the concepts are that differences in willingness to comply, ability to comply, and the risk of non-compliance should have different regulatory responses or demands.  For example, if someone is willing to comply, it doesn’t make sense to treat them as a target for criminal enforcement.  Maybe all they need is the best information about how to comply or the social consequences of non-compliance, or just feedback on the degree to which they are complying.  Why bear the cost of stationing a traffic cop on a stretch of road when a simple radar-enabled sign provides feedback on speed?  In some communities this latter approach is much more cost effective to bring down the speed of traffic.  However, where those to be regulated are not willing to comply, information won’t work—enforcement is necessary.

This is similar to an assessment of a complier’s ability to comply.  For example, some states have found that their tax forms had become so complicated that people had great difficulty paying the correct amount.  By simplifying the forms much higher levels of compliance were achieved without the great additional expense of more auditors and tax enforcement personnel.

In the case of risk, the reinventor needs to keep in mind the risk or cost involved in non-compliance, and the relative cost of regulation.  One needs to take a different approach to regulation if the risk is high, than if the risk is low, or if the cost of regulation outweighs the cost of non-compliance.  A common example is where it costs several hundred dollars to process a procurement form for a product or service that only costs a few dollars, and the risk is very low if the “wrong” product or service is, in fact, procured.  Or take Russian roulette.  As Norris says, “even a low probability event may represent an unacceptable risk.  Few of us would play Russian roulette, even if the odds were wildly in our favor, because it is a game no one can lose twice.”

The challenges in making this approach to regulation work are the issues of resources and metrics.  In other words, the regulator needs to have the tools and ability to assess the relative willingness, ability, and risk involved.  Otherwise, the path of least resistance (for the bureaucrat and the elected official) is one-size-fits-all.  And we know where that path leads.

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A Bailout Badly in Need of Reinvention

by Larry Grant

Frankly, I didn’t want to think much more about government regulation, but it is clear that somebody better.

In an earlier post on this blog, I said that the regulatory cycle went something like:  crisis, creation of a regulatory agency, quiescence, and capture of the regulators by the regulated.  This seems to be playing out right now in the current financial crisis.  There are, to be sure, some added wrinkles: a massive bailout of the financial industry and the adoption of dictatorial powers by the executive branch to dispense these financial favors – excuse me, a “clean” grant of authority.  Still, in reaction to the administration’s “solution,” a new regulatory agency is being proposed.

What can we expect to happen, and how might a reinventor think about it?  I expect that should such an agency be created, it will most likely contract out the actual work of designing and effecting regulation to the experts – yes, the same “experts” who created the mess in the first place.  So we will have bureaucrats, well meaning I’m sure, trying to deal with the flim-flam artists of our age.  Guess into whose pockets the money will flow?

There is an alternative – certainly not the only one, but something a little different.  It reminds me a little bit of the issues surrounding public financing of professional sports stadiums.  It has always seemed bizarre that the public should subsidize rich men’s jock sniffing without getting any of the reward.  If the public invests, why shouldn’t the public own?

As Paul Krugman says, “… if government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership …”  If it is true that the actual percentage of bad loans is in the neighborhood of 3 percent, and the real problem is that we don’t know where they are in these mixed packages of mortgage-backed securities, then once it gets untangled, the people (read “taxpayers”) could get the potential profits.

What reinventors need to do is design ways that government can become savvy investors in the firms that solve the problems.  Then it will be clear who the customer is.

The Attack of the Killer Tomatoes: Part II

by Larry Grant

Who are the customers of compliance or regulatory functions? Usually elected officials. To reinventors the customer is the primary intended beneficiary of a specific service (or product). In the case of regulatory functions the primary intended beneficiaries of the process are the citizens (or the “people,” as in “we the people”). In a representative democracy such as in the United States, the interests of the people are presumed to be held by the officials we elect.

This idea resonates with some and confuses others. We need to say a lot more about the idea of “customer” and “complier,” but since this started with “killer tomatoes” and government regulation, let’s start at the beginning.

The history of regulation (or, if you will, “government interference”) is pretty interesting. It certainly goes back to Roman times with the regulation of grain and slave markets. But “modern” regulatory practices come just after the dawn of the industrial revolution when the British government began to take an interest in factory and working conditions—especially in the mines. In the United States it was certain of the states (like Massachusetts) that established regulations around factory working conditions. It was only after the turn of the 19th century that the federal government got involved. The irony being that the greatest pressure for regulation of industrial practices came from big business as a means to increase the costs of smaller businesses and thus drive out competition.

As regulation (and regulatory government agencies) became more common a certain regulatory rhythm began. A crisis (real or imagined) creates a public outcry, a set of laws are passed, a new (or old) regulatory agency is obligated to interpret and enforce the laws by creating regulatory processes, which, if followed, will end the crisis and ensure that it will never happen again. Of course, like a river, which you can’t step into the same place twice, the same crisis in need of regulation rarely occurs. In this way there is both opportunity for new crises—begetting new laws, agencies, and rules, and, as true of any good bureaucracy, processes beget even more processes, interpretations, rules, and the experts who know them. Over time the only people who really know the rules—because it becomes part of their life-blood of profit, the real engine in the whole thing—are those who work in the regulated industries or markets. The regulatory agency and its agents are now long out of the crisis-driven public eye, and dependent on the regulated to understand the regulations and the processes they are intended to regulate. A former professor of mine viewed this as a classic example of the “symbolic uses of politics” where crisis begets action, action begets, quiescence, and quiescence begets in its turn cooption. In effect, the regulatory agency gets “captured” by those whom they are supposed to regulate.

One fundamental reason why this happens is confusion about who is the customer. At the most obvious level, it doesn’t make sense to say that the individuals and businesses are the primary intended beneficiaries of the regulation. Sure, they do benefit by being regulated, but it is we the citizens who are the primary intended beneficiaries. And most government workers know this in their bones.

Look at the Federal Aviation Administration mission and vision http://www.faa.gov/about/mission/:

Our mission is to provide the safest, most efficient aerospace system in the world. Our vision is to improve the safety and efficiency of aviation, while being responsive to our customers and accountable to the public.

Who do you think they believe to be their “customers?”

Attack of the killer tomatoes: Regulatory policy comes home

by Larry Grant

My daughter would not use ketchup on her hamburger this weekend because she saw that it was “tomato ketchup.”

I can’t help but notice how often the governmental regulatory process has come up recently—from toys, to food, to drugs, to financial markets, to accounting practices, to the airways, to just about anything and everything in our lives. It’s hard for a “reinventor” to ignore regulatory processes and practices, but our clients are extremely reluctant to take them on—until there is a crisis, and even then the wheels turn slowly (witness 9/11 and containerized cargo) and only down well-traveled bureaucratic roads.

How is a reinventor of government to approach this? That is the question. The stakes and incentives for both the regulator and the regulated are high. Agencies in a bureaucracy don’t like to solve problems that are their very reason for being, and the regulated, even though they rail against the regulatory paper storm are quite comfortable with the status quo. Who know what evil lurks in the shadows of change?

Paul Krugman, in his NYTimes column last Friday the 13th, highlights how some of our most, apparently, mundane regulatory functions of U.S. government affect everything from my household, to our foreign policy, to the stability of foreign governments (witness the demonstrations in Korea related to American beef). So even though the regulatory functions seem mundane, the stakes can be high – as I found out when my bypass surgery depended to a great extent on a drug that was found to be adulterated.

What is a reinventor to do with regulatory functions that don’t work – or don’t work the way we think they should?

As with just about any question concerning reinvention we begin with “who’s the customer?” That is, who is the primary intended beneficiary of any product or service – or regulatory function? The idea of “customer” makes many public servants uncomfortable – particularly when regulatory or other kinds of “control” functions are concerned. I find that this discomfort goes away when we point out that the “customer” is not always the person or group that you interact with regularly – like in a retail transaction.

It doesn’t make sense to call the recipient of a speeding ticket the customer of the “arresting” officer. This is because the primary intended beneficiary of the speeding ticket is not the speeder, it is the “public.” This is to say that it is in the public interest that we regulate traffic. The officer in this case delivers an obligation (in the form of a ticket) to the speeder.

This is quite common in government agencies. Sometimes the agency is delivering a service (such as welfare benefits), and sometime the agency is delivering an obligation (ensuring eligibility for the benefit). A reinventor makes a strong distinction between service functions and compliance functions, because their customers are very different. Service functions are generally delivering services (or benefits) directly to their customers. Compliance functions generally deliver obligations to the people they regularly deal with – we call them “compliers” so they are not confused with “customers.”

So what do you think? Who are the customers of these regulatory functions?