An outstanding guest post by “bond girl” at Baseline Scenario.

I would argue that the fundamental flaw in financial regulation is that it is based on the assumption that regulators are not self-interested individuals like the rest of us. We think about regulation only in terms of how to engineer the incentives of the regulated and ignore the fact that regulators themselves rarely have a stake in doing their job well, which in any other occupation would limit the motivation and types of individuals a position attracts. We all know how the performance of a consistently good trader is rewarded. How is the behavior of a consistently good regulator rewarded?

Her suggested remedy:

I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the holdings of financial institutions independently and audit their records.

Sounds like rating agencies. Aware of this, she writes,

These contracts can be funded by fees charged to the industry that pass through the federal budget and are subject to public scrutiny. Although the fee income that supports these entrepreneurs would derive from industry operations, the social entrepreneurs will not have the power to establish the fees themselves, which should reduce the “shopping” behavior that already exists in financial regulation and with the rating agencies. Some degree of slack will develop as with any form of delegation, but that may be reduced to some extent by adding performance-based metrics to the terms of contracts or by giving the companies a portion of recoveries when they identify instances of fraudulent behavior

it is easy to poke holes in an idea like this, particularly since it is only sketched out in a couple of paragraphs. But keep in mind that we do not have a competing regulatory solution that is foolproof. So I would like to see something like this introduced into the policy debates as an option.

I think that the challenge is to come up with a reward system for the regulator/entrepreneurs. It isn’t just fraud that you are trying to find. What you want is a set of incentives that in 2004 and 2005 would have rewarded the social entrepreneur for identifying and measuring the exposure of key financial firms to stress in the housing market and to the misbehavior in the mortgage market. It’s even tougher than that, because there are two types of errors the regulator/entrepreneur can make. One is to fail to spot a dangerous situation. The other is to incorrectly characterize a benign situation as dangerous. Too much incentive to avoid one type of error will increase the errors of the other type.

Note: She has a link to a speech by Ben Bernanke in June of 2006, which illustrates the extent to which what Danny Kaufmann calls “cognitive capture” affected the regulators.

To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization.

In other words, all the stuff that we now think of as the cause of problems was, at the time, regarded as the solution.