UUnniivveerrssiittyy ooff CChhiiccaaggoo LLaaww SScchhooooll CChhiiccaaggoo UUnnbboouunndd Coase-Sandor Working Paper Series in Law and Coase-Sandor Institute for Law and Economics Economics 2012 RReevveerrssee RReegguullaattoorryy AArrbbiittrraaggee:: AAnn AAuuccttiioonn AApppprrooaacchh ttoo RReegguullaattoorryy AAssssiiggnnmmeennttss M. Todd Henderson [email protected] Frederick Tung [email protected] Follow this and additional works at: https://chicagounbound.uchicago.edu/law_and_economics Part of the Law Commons RReeccoommmmeennddeedd CCiittaattiioonn M. Todd Henderson & Frederick Tung, "Reverse Regulatory Arbitrage: An Auction Approach to Regulatory Assignments" (Coase-Sandor Institute for Law & Economics Working Paper No. 610, 2012). This Working Paper is brought to you for free and open access by the Coase-Sandor Institute for Law and Economics at Chicago Unbound. It has been accepted for inclusion in Coase-Sandor Working Paper Series in Law and Economics by an authorized administrator of Chicago Unbound. For more information, please contact [email protected]. C H I C A G O INSTITUTE FOR LAW AND ECONOMICS WORKING PAPER NO. 610 (2D SERIES) PUBLIC LAW AND LEGAL THEORY WORKING PAPER NO. 397 REVERSE REGULATORY ARBITRAGE: AN AUCTION APPROACH TO REGULATORY ASSIGNMENTS M. Todd Henderson and Frederick Tung THE LAW SCHOOL THE UNIVERSITY OF CHICAGO August 2012 This paper can be downloaded without charge at the Institute for Law and Economics Working Paper Series: http://www.law.uchicago.edu/Lawecon/index.html and at the Public Law and Legal Theory Working Paper Series: http://www.law.uchicago.edu/academics/publiclaw/index.html and The Social Science Research Network Electronic Paper Collection. REVERSE REGULATORY ARBITRAGE: AN AUCTION APPROACH TO REGULATORY ASSIGNMENTS M. Todd Henderson and Frederick Tung* In the years before the Financial Crisis, banks got to pick their regulators, engaging in a form of regulatory arbitrage that we now know was a race to the bottom. We propose to turn the tables on the banks by allowing regulators, specifically, bank examiners, to choose the banks they regulate. We call this “reverse regulatory arbitrage,” and we think it can help improve regulatory outcomes. Building on our prior work that proposes to pay bank examiners for performance—by giving them financial incentives to avoid bank failures—we argue that bank supervisory assignments should be set through an auction among examiners. Examiner bidding would generate information about examiners’ skills, ex- perience and preferences, as well as information about each bank. Provided examiners bear the upside and downside of their regulatory behavior, a bidding system for regulatory assignments could improve the fit be- tween examiners and the banks they supervise, thereby enhancing regulatory efficiency. * Professor of Law, University of Chicago School of Law ([email protected]); and Howard Zhang Faculty Research Scholar and Professor of Law, Boston University School of Law ([email protected]), respectively. DRAFT AUGUST 2, 2012 TABLE OF CONTENTS I. INTRODUCTION ................................................................................ 1 A. WHY FIAT? ....................................................................................................... 1 B. REVERSING REGULATORY ARBITRAGE ........................................................ 5 II. THE THEORY OF RESOURCE ALLOCATION ............... 13 A. MARKETS V. FIRMS ............................................................................... 14 B. MARKET-HIERARCHY HYBRIDS ...................................................... 20 C. RESOURCE ALLOCATION IN PRACTICE ........................................ 23 III. BIDDING FOR BANKS .............................................................. 26 A. NECESSARY CONDITION: SKIN IN THE GAME ........................... 27 B. AUCTIONING OFF SUPERVISION RIGHTS .................................... 29 C. IMPROVED MATCHING ......................................................................... 33 1. Signaling Information and Skill ............................................... 34 2. Countering Incumbent Bias ........................................................ 36 D. THE ROLE OF DISCRETION ............................................................... 37 1. Negotiated Procurement ................................................................. 38 2. Application to Examiner Assignment .................................. 40 IV. QUALIFICATIONS AND OBJECTIONS ............................ 41 A. BIASES IN BIDDING AND BEYOND ................................................. 42 B. PERVERSE BIDDING MOTIVATIONS ............................................... 45 1. Bidding for the Revolving Door ................................................ 46 2. Bidding for Inside Information ................................................. 49 3. Bidding for Other Private Values ............................................ 50 4. Collusive Bidding ................................................................................ 51 C. EXAMINATION TEAM MICROSTRUCTURE .................................... 53 D. WHY IT HAS NOT HAPPENED YET ................................................. 54 E. THINKING BEYOND THE AGENCY ................................................... 55 V. CONCLUSION .................................................................................. 57 DRAFT AUGUST 2, 2012 I. INTRODUCTION A. Why Fiat? A scarce resource, like labor, may be allocated in one of two ways: by the price mechanism or by fiat. With the price mechanism, the resource flows via mar- ket transactions to where it is valued most highly. By contrast, fiat allocation occurs through the command of a person with authority within a hierarchy. All eco- nomic activities face this choice of resource allocation mechanism, and all institutions—be they firms, fami- lies, or governments—deploy a mix of these approach- es. For example, the head of a family may want the grass cut. She has two basic choices: she can com- mand that a family member cut the grass, or she can put the work out to bid among family members or landscaping companies. The choice will be determined by the relative costs and benefits of each approach. It is simple and cheap to direct a family member to do the work, but it might be done better or more efficient- ly if put out to bid. As the costs of using market transactions fall (or rise) relative to the costs of fiat, the more (or less) work will be allocated by the price mechanism instead of fi- at. Continuing with the grass-cutting example, if the costs of finding a landscaping service, evaluating the quality of the service, and negotiating an attractive price are lowered—say, because of the inception of an online marketplace for matching grass cutters and homeowners—then at the margin, families will be more likely to use a market than the fiat approach. The accepted practice across government is that regulatory resources, such as investigators or prosecu- tors, are allocated by fiat by department or agency heads. Bank examiners are assigned to particular banks at the discretion of higher-level regulators in the agency hierarchy. Higher-ups in the agency decide DRAFT AUGUST 2, 2012 2 HENDERSON AND TUNG based on their judgment about things like skill, fit, work ethic, knowledge, and expertise. They must ad- dress complicated tradeoffs, such as the risk of cap- ture versus the benefits of experience from regulators working with the same firms year after year. One agency solution is to rotate regulators “periodically to ensure that an objective and fresh supervisory per- spective is maintained."1 But there are downsides to a fixed rotation system: knowing when one’s stake in a particular institution will end may provide opportuni- ties to hide costs in future periods.2 In addition, the assignment process for bank examiners is completely opaque to outside observers. Although a great deal de- pends on the efficient deployment of regulatory re- sources, the public knows shockingly little about the process.3 1 See, Office of the Comptroller of the Currency, Large Bank Supervisory Handbook, available at http://ithandbook.ffiec.gov/media/22019/occ- comptr_handbook_large_bank_superv.pdf . See also "At the OCC, examiners in charge for each bank have contracts to cover a bank for up to five years. After that, they are rotated to another bank or assignment, which can mean a move to another city. We want to keep them fresh and learning. It's a very healthy thing to do. It's not always convenient for them." http://www.charlotteobserver.com/2011/07/10/2442855/financ ial-crisis-lands-more-bank.html (quoting _______Brosnan, a long- time OCC official). 2 For an example of this problem in another context, see Ami- ty Shales, “China’s Katrina Shows Post-Communism No Big Easy,” BLOOMBERG, May 21, 2008 (“China intentionally rotates its governors to ensure they don't build up personal machines. Per- versely, that freed officials from living with the consequences of shoddy construction. Soon after the ribbon is cut on the new school, they move on to the next post.”). 3 Although there is no public disclosure concerning how these decisions are made or what factors inform them, we assume bank regulators—agencies like the Office of Comptroller of the Currency and the Federal Reserve—allocate regulatory resources based on assessments of fit, capability, and expertise, as well as the bank-specific information held by examiners. While we do not pooh-pooh the value of these judgments, considering alternative (continued next page) DRAFT AUGUST 2, 2012 2012] REVERSE REGULATORY ARBITRAGE 3 We are unaware of any criticism of the fiat ap- proach to regulatory resource deployment in the legal literature or elsewhere.4 This is surprising given the widespread existence of regulatory failures and the well-known pathologies of bureaucracies, particularly those relating to regulatory assignments. For example, regulatory capture is a serious concern, and assign- ment schemes may have important consequences for combating or exacerbating capture. Our auction ap- proach may make capture more difficult than under the current system of fiat assignment, where interest groups need only target the individuals responsible for assigning work in order to influence regulation. Under our approach, or in any hypothetical labor market within an agency, interest groups would have to influ- ence all potential market participants. More generally, the fiat approach is a one-sided approach to a two-sided problem. Regulatory higher- ups have information about examiner fit and capabil- ity, but so do examiners. Insofar as the examiners cannot convey information relevant to setting regulato- ry assignments, the matching of examiners to banks fails to utilize all of the information available. This problem affects all economic transactions, and auc- tions are a well-accepted mechanism for aggregating and processing information, as well as generating effi- assignment mechanisms may offer improvements in regulatory efficiency. Moreover, the lack of transparency about the process means other values, like managerial self interest, nepotism, polit- ical favoritism, and so on, may be just as likely to inform alloca- tion decisions. 4 The post-Financial Crisis reform proposals of academics, pundits, and legislators do not address regulatory assignment mechanisms, despite the fact that examiners were aware of but utterly failed to prevent enormous amounts of excessive risk in the banking system. While factors other than examiner assign- ment methods were assigned undoubtedly played a large role in the crisis, we believe that misallocation of regulatory resources is a problem that must be addressed as well. DRAFT AUGUST 2, 2012 4 HENDERSON AND TUNG cient competition by buyers and sellers of the product or service in question. Our goal is two fold. First, we attempt to fill this gap in the literature by considering the costs and ben- efits of the current approach to regulatory resource deployment. We develop a theory of regulatory re- source allocation, pointing out the shortcomings of the pure fiat approach, as well as potential strengths. In light of recent regulatory failures, it is time to subject current examiner assignment methods to rigorous scrutiny.5 Second, by using bank regulation as a sustained example, we propose a system of resource allocation pursuant to which examiners would bid for work at a particular bank. We argue that using price-based auc- tions to inform the assignment of bank examiners would help reveal valuable information held within agencies but not readily available to higher-ups mak- ing allocation decisions. Such as system would also serve as a self-correcting mechanism for the risks of the capture of individual examiners, as well as reveal valuable information about bank risk to agency man- agers. Our proposal takes a page from private sector practices that muddy the classic Coasean firm-market dichotomy.6 A number of firms, recognizing the infor- 5 Getting regulatory assignments right may be especially im- portant in light of recent work on the problems inherent in the current regulatory approach to banking. See M. Todd Henderson & James Spindler, “Why Bank Regulation Failed . . . and Will Continue to Fail,” Working Paper, on file with authors. 6 In his work on the nature of the firm, Ronald Coase distin- guished firms from markets, defining firms as loci where hierar- chical commands effect transactions. Outside of the firm, by con- trast—i.e., in markets—transactions are characterized by volun- tary exchange. Ronald H. Coase, “The Nature of the Firm,” 4 Eco- nomica 386 (1937). Coase concluded that the firm’s boundary is determined based on where the net benefits of the fiat approach (such as simplicity) are outweighed by the net benefits of the price approach (such as information generation). Coase’s work gener- (continued next page) DRAFT AUGUST 2, 2012 2012] REVERSE REGULATORY ARBITRAGE 5 mation aggregation and matching potential of markets, have incorporated market mechanisms into their or- ganizational decision making. Markets within hierar- chies have emerged, and preliminary research largely confirms the promised benefits of the internal market- based mechanisms.7 Internal prediction markets and job markets have improved forecasting and resource allocation within hierarchies. We propose bringing this private-sector learning to the government. B. Reversing Regulatory Arbitrage In the run-up to the Financial Crisis of 2007- 2008, banking regulation failed. Government post- mortem reports on bank failures demonstrate wide- spread regulatory failure.8 As we’ve show in prior work, bank examiners routinely identified fundamental weaknesses in banks many years before their collapse, yet failed to act aggressively enough to forestall prob- lems that eventually led to disaster.9 For example, ex- amination reports identified overly aggressive home mortgage origination practices at banks like Washing- ton Mutual, but regulators failed to act because of the profits banks were making.10 In Pay For Regulator Performance, we argued that one cause of this failure was the way bank exam- iners are paid: low-powered incentives delinked from ates a prediction that as the costs of market transactions fall (rise) relative to the costs of fiat, more (less) work will be allocated by the price mechanism, instead of fiat. 7 See infra Part II.B.__ 8 We recognize there were many other types of failures that contributed to the Financial Crisis, and we do not believe it was solely a government problem. Our only claim is that regulatory failure contributed to the Crisis. 9 For a discussion of the post-mortem accounts of bank fail- ures, see M. Todd Henderson & Frederick Tung, “Pay for Regula- tor Performance,” __ S. CAL. L. REV. __ (2012). 10 Notwithstanding specific instructions not to do just this. See id at __. DRAFT AUGUST 2, 2012 6 HENDERSON AND TUNG desired outcomes yield low effort and misdirected work.11 In that paper, we recommend performance pay for examiners in the form of phantom debt and equity securities of the banks they regulate, as well as a spe- cial takeover bonus tied to the timing of the decision to take over a failed bank.12 The idea is to link bank ex- aminer compensation with desired social outcomes, so as to directly reward good regulatory outcomes and de- ter bad ones.13 While beneficial for incentivizing better perfor- mance, incentive pay for examiners by itself cannot overcome allocative inefficiencies from command-and- control assignments. Consider the well-known problem of regulatory capture. Many bank examiners work in- tensely at one bank for long periods, and this can bias them. Some examiners may have been tempted to shade facts or forestall regulatory action because of a desire to avoid conflict with people the examiner knows well and works with on a daily basis. Some ex- aminers may have been more interested in currying favor with the banks they regulated in hopes of en- hancing future employment opportunities than in pur- suing the public interest in safe and sound banking. If examiners bear the costs of regulatory laxity and these costs outweigh the personal gains, then this problem is reduced. But if pay and other work-related incen- tives are insufficient to overcome this problem, then 11 See id at __. 12 See id at __. 13 The “optimal” social outcome here is a complicated thing to define in the abstract, but it involves the efficient amount of lend- ing to the most desirable sectors of the economy. The efficient lev- el of lending trades off the potential for increasing economic growth by increasing the velocity of money in the economy with the downside from losses caused by too much lending. See M. Todd Henderson & James Spindler, “Why Bank Regulation Failed . . . and Will Continue to Fail,” Working Paper (2012) (on file with author). DRAFT AUGUST 2, 2012