Rules versus Discretion

2013 Financial Markets Conference

April 2013

An interview with Willem Buiter, chief economist, Citigroup

Dave Altig: I'm Dave Altig, research director at the Atlanta Fed, and I'm here at the Atlanta Fed's Financial Markets Conference. My guest is Willem Buiter, who is the chief economist at Citigroup, although he has a long and distinguished résumé, including past stints as a professor of political economy at the London School of Economics and an external member of the Bank of England's Monetary Policy Committee. Dr. Buiter, welcome.

Willem Buiter: It's a pleasure to be here.

Altig: So you were during our conference here moderating a panel on "rules versus discretion in regulatory approach." I gather that you don't think that the rules versus discretion distinction is the most useful one.

Buiter: No, it really tries to make a distinction which is relevant between commitment and flexibility, and clearly in the real world when we're dealing with problems that can not be foreseen, no matter how hard we try, you need both. You need to be informed by general rules and principles, but the application cannot be outlined in minute detail for each possible contingency, things will always happen; there are no known unknowns. And so you have to have flexibility to respond to things that you simply never thought of.

Altig: So if you think about, sort of, this preserving flexibility while giving enough transparency or direction to those to whom the rules are imposed, are there some principles or guidelines or some general characteristics that you think a good regulatory structure would have?

Buiter: We have to get back to something much simpler, much more relying on the incentives that motivate people in the organizations whose behavior you're trying to influence, rather than being a box-taking prescriptive framework of which Dodd-Frank, Basel III, and all the other modern manifestations of discontent, understandable discontent, which is the way the financial sector performed during the run-ups of the last crisis and since the last crisis, and you want to do it in the way that it is not going to be done, because Dodd-Frank, Basel III are what the next 10 years are going to be about for the U.S. and for the rest of the world. It will be costly.

Altig: Well, what about those costs? What do you see as the likely cost of these?

Buiter: Well, the costs of implementation or attempting to comply with the rules are, I think, astronomical by themselves—the simple time and human resource course.

But more important [than] the direct measurable costs, the thousands of lawyers and other box-takers that run around financial institutions, is the cost which is very hard to measure of the innovation not undertaken, of the initiative not grasped, of the risk not taken because of fear of falling foul of the regulatory framework. So it's a "holding back" on entrepreneurship, on legitimate risk taking and innovation. That's going to be the most costly aspect of this inevitable period of overregulation and pointed regulation that we are entering now.

Altig: You kind of mentioned something there, which sort of has the flavor of thinking that we're fighting the last war, in many ways, on these regulatory approaches and that we really aren't protecting against where the risks are going forward. Do you think that's an inevitable part of regulation in general?

Buiter: Politically, yes. There is populist demand for retribution, and that's what they're facing now, and also, I think, well-intentioned attempts to lock the stable door after the horse has bolted. What we should instead be doing is make sure that banks and other systemically important financial institutions hold much more capital, that we have significant additional resolution capacity for systems, banks that nevertheless go bust, and that allows them to be resolved at the speed of light or at the speed of crisis without closing the intermediation activity where they're essential. More capital, no reliance on information that's private to the regulated entity, and efficient resolution of complex institutions, those are the three things that we all should focus on.

Altig: So of course, Dodd-Frank and Basel have provisions for capital. Dodd-Frank, in particular, has a resolution mechanism written into it. I presume...

Buiter: I'm in favor of that. I mean not all of it is wrong. The capital requirements are, in my view, pointless because they rely on risk ratings that depend on internal models, which is private information to the banks or entities that use it and that's useless.

Altig: So there was an interesting remark you made that had to do with "cognitive regulatory capture." Can you describe what you mean by that?

Buiter: This is a concept I introduced in the competition here, the Fed of Kansas City at a conference in 2008. Cognitive capture is where the regulator absorbs, through direct social work and other contact with the entities he or she is regulating, the views, the fears, the opinions, the approach to what should be done, what can be done, of the entity they're regulating. You become culturally absorbed, so to speak, and you lose the capacity for independent judgment, or at least the capacity for independent judgment gets impaired.

Altig: Do you think there's any way to resolve that conflict?

Buiter: Very, very difficult, and I think very important not to monopolize the regulatory faction. In other words, I used to be critical of the many overlapping supervisory bodies of the financial sector in the U.S. You have the FDIC, the Fed, the SEC, and the Office of the Comptroller of the Currency, all regulating partly the same entities, markets. I now actually think that in the best of all possible worlds where everybody was omniscient and omnipotent, this would not be an efficient arrangement. It certainly limits the risk of wholesale capture, there's always likely to be at least one regulator who sees that the emperor has no clothes, and that I think is helpful. I think that competition evolved, overlap, redundancy in regulatory frameworks is actually a good thing. It's quite a departure of what I used to think.

Altig: And we think of the Kansas City Fed as our colleagues, not our competition.

Buiter: For conferences.

Altig: Dr. Buiter, thank you. And thank you for watching.