Thursday, February 12, 2015

Regulation and competition

From taxis to banks, regulation is quickly captured to stifle competition. Only it's usually polite not to say it out loud. Today's WSJ has a lovely little piece, Regulation is Good for Goldman confirming the former and violating the latter pattern.
the Goldman Sachs CEO explained how higher regulatory costs are crushing the competition.
“More intense regulatory and technology requirements have raised the barriers to entry higher than at any other time in modern history,” said Mr. Blankfein. “This is an expensive business to be in, if you don’t have the market share in scale...
he said his bank is “prepared to have this relationship with our regulators”—and the regulators are prepared to have a deep relationship with Goldman—“for a long time.”
.. it is unusual to see a financial CEO like Mr. Blankfein state the effect so candidly. Goldman can afford to hire battalions of lawyers and lobbyists to commune with regulators... As ever, powerful government mainly helps the powerful.
I have met several people who started financial companies in the pre-Dodd-Frank era. They all say there is no way they could start their businesses now. Working out of the garage, you can't afford a multi-million dollar compliance department.

15 comments:

  1. This stuff is scary. Is there any systematic effort to identify harmful regulations, figure out which are worst (the most utility reducing), and get rid of them?

    -Ken

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    1. The answer is “yes”: full reserve banking involves no complex regulations. It’s simplicity itself. The basic rule is to get rid of what John Cochrane calls “run prone liabilities” on bank balance sheets. See Prof Cochrane’s article here:

      http://www.hoover.org/news/daily-report/150171

      To be more accurate, under FR, entities / banks which lend are funded just by shares, while entities / banks which accept deposits (and thus DO HAVE run prone liabilities) do nothing the least risky with that money: possibly the money is put into short term government debt. But that’s it.

      In fact the rules of FR are being imposed on money market mutual funds. That is, MMFs which invest just in short term government debt can promise not to break the buck. Other MMFs can’t. And that’s it. If that’s not simplicity, I don’t know what is. Far as I know the MMF industry is not collapsing. See:

      http://www.prestwoodfinancial.com/SEC-Decides-to-Break-the-Buck.c6145.htm

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  2. Yes you can Mr. Cochrane. It's called "Honesty". Do the right thing and you won't need a huge Compliance division.

    Ganesh

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    1. Ganesh, that is wishful thinking.

      I'm an officer of a publicly traded tech company, and let me tell you, the regulation we're subjected to is mind-numbing. Just doing the right thing is not enough to comply with SEC Rule 144, Form 4 filing requirements, SEC regulation FD, and my company's insider trading policy. And I saw what my company had to go through to file its IPO. You can say that we can afford millions of dollars in legal costs to comply with all of this stuff --- fair enough --- but you can't say it's as simple as just being honest and doing the right thing. It's just not. And my sense (from working on networking projects involving financial services companies) is that they are even more heavily regulated than we are. My wife is a doctor, and let me tell you, the barrel of laughs called "HIPPA" imposes roadblocks at every turn. Thinking of using gmail to communicate with a patient? Leaving a message on an answering machine? Hahaha.

      What line of work are you in where honest behavior is sufficient to avoid offending the regulators?

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    2. It's not even *offending* the regulators that is the issue, it's keeping track of everything you're required to keep track of, irrespective of whether you're committing malfeasance or not.

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    3. I work in a publicly traded health care company and compliance issues require far more than just honesty. HIPAA compliance requires annual training all employees who will have access to any of 18 identifiers of protected health information. Compliance requires that no employee, contractor, or outside entity be given greater access to the PHI than is minimally necessary to do their jobs. A process must be designed to secure the data, identify compliance failures, and report these failures as required by law. A compliance department must be maintained to audit all use of PHI and to receive reports from any employees who might question if a violation has occurred.

      Setting this up as a mom and pop organization will not work.

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  3. Wow. It's almost as if the financial industry isn't an example of unregulated laissez-faire capitalism after all...but that can't be right.

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    1. I remember in 2002 when FASB updated reg 133 for changes in accounting for derivative hedges. No one understood it. I was in meetings all day, every day over how to implement the damn change. Cost a small fortune to do. I could say to 99.99% of accountants out there that I was selling futures, on a down move, to hedge my negative gamma, and how many do you think would understand the nonsense that just came out of my mouth?

      How to regulate something that there are few people adequately trained to understand?

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  4. Interesting coincidence, Dr Cochrane, I recently read a paper that looks at the evidence for federal regulations and start-ups, and finds that it does not affect entrepreneurial activity.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2559803

    Of course, this is just one study, and I have some issues with methodology and how far you can take their results, but I'd be very curious to hear your thoughts.

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    1. I wonder if one of the reasons that a lot of entrepreneurial activity occurs in certain sectors (technology) and not others (finance and banking) is due to the amount of regulations involved ...

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    2. I read the paper. It's interesting. The main regression is on p.12, a regression of a dynamism index on a regulatory stringency index, across industries and years, with industry and year fixed effects. So, the fact is that an increase in the regulatory stringency index in one industry vs. another is not associated with a decrease in the dynamism index of that industry vs. another. Watch those words. It's not that increase in regulation has no effect on decrease in dynamism, because there are time dummies. It's not that more regulated industries are no less dynamic because there are firm dummies. The "fact" is the cross-industry difference in time trends, as i stated.

      OK, that's a fact. Obviously, it takes quite a jump to infer from this difference in difference that the increase over time in regulation for the economy as a whole has no effect on dynamism for the economy as a whole (the increase of the former and decrease of the latter are nicely documented in the paper).

      It's a very nice paper, with one criticism. The fact says "we fail to find a difference in difference association between a regulation index and a dynamism index". The abstract says "We find that Federal regulation has had little to no effect on declining dynamism." Finding zero is a lot different than failing to find something.

      A minor note. The paper shows that airlines are the most "stringently" regulated, because there are a lot more words like "shall" in the relevant regulations. As a pilot, I've actually read many Federal Aviation Regulations. The FARs are models of pretty darn good regulations, in that the user can, without lawyers, be pretty sure of reading them and knowing what they mean. If the FAA says you did something wrong and you didn't, you have a good chance of winning your case on the facts. There is little witch-hunting for billion dollar settlements. Yes, the regulation is misguided in many ways, and has killed a lot of innovation in light aircraft (and driven all glider production overseas, the one I know something about). But at least it's not the kind of arbitrary and capricious tool that financial, environmental, consumer protection, and labor regulation is becoming. So, one may complain that the index is really measuring the wrong thing. The "shalls" are pretty clear. It's the vague regulations that cause trouble!

      All of which is to say, it's a nice, well-written and interesting cross-sectional regression, marred only by mixing up "fail to find" with "show it's not there."

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    3. Sorry, "industry dummies," not "firm dummies"

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    4. I can remember when the financial industry fought tooth and nail to protect regulation Q and then also stock broker commissions.
      can we delicense the law profession? And how about eliminating the USDA?

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    5. Thanks for the careful reply, Dr Cochrane. I agree with you that one has to be careful about how to interpret results when there's both time and state dummies, and that, much like in your previous discussion on Unemployment insurance and unemployment, there might be 'macro effects' that we're not capturing effectively.

      And that's an excellent methodological note, that the index they use isn't, unfortunately, the best way of measuring how good or bad a piece of regulation is, the FAA rules being a good example of that. Perhaps the authors should consider using some natural language processing methods to explore their database in a more fine tuned way? They might be able to find that certain words or phrases are more closely associated with 'bad' regulation vs 'good' regulation, a distinction that could make a significant difference.

      Still, I have to say that results surprised me, as I would have expected for them to find at least some negative effects (although perhaps not overtly strong ones), which does suggest that it might be worthwhile exploring whether their suggestions for alternative causes for the drop in dynamism*, or perhaps even trying to do some cross-country analysis/regressions, which could better capture 'macro' effects as you suggest.

      *I'm particularly sympathetic to the idea that the restructuring of big firms might be mismeasured and may be 'hiding' some of the lost dynamism, in light of the growth of the google and other tech firms.

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  5. The meaning and merit of regulation is in the details. "Good" regulation should be simple, clear, direct, and effective, and thus not likely to be a significant barrier to entry. "Bad" regulation is bureaucratic, complex, overly verbose, time consuming, and not entirely effective, so these will certainly be a significant barrier to entry.

    It is clear from the Goldman CEO's comments that he fears competition and favors "bad" regulation as a barrier to entry to protect his firm. Very sad state of affairs.

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