Another Way to Make Finance Safer

CAMBRIDGE – Since the financial crisis erupted in 2008, policymakers have sought to make the world’s banks safer, mainly via detailed instructions: use more capital, avoid specified risky activities, provide more transparency, and punish reckless behavior. But this approach to financial regulation, while laudable, requires officials to make, or shape, banks’ most important strategic decisions: capital levels, liability structure, and the scope of their business activities. And, while regulators often target bank executives’ incentives, they often leave intact the organization’s incentives to take risks – but then command them, via regulation, not to take those risks.

This command-and-control approach has shortcomings: regulators may mistake which activities to regulate and how; banks resist; and bankers and their advisers – some of the smartest businesspeople around – innovate to free themselves from many of the imposed constraints. High-quality economic talent could be better used elsewhere.

Worse, many command-and-control efforts have become too complex to implement well. In the United States, the Dodd-Frank Act’s famous “Volcker rule,” which seeks to limit banks’ proprietary trading, has swollen to hundreds of pages, and its introduction has been repeatedly delayed.

There is a simpler, mostly untried approach to financial regulation. Instead of relying primarily on command-and-control rules, regulators should focus on what motivates the organization as a whole and align those incentives with financial safety. Doing so could both change banks for the better and increase the effectiveness of ongoing command-and-control regulation.