Ep49 “Making Regulation Work” with Jay Clayton

Introduction and Challenges of Regulation

• The topic of regulation is being discussed, specifically whether there's too much regulation in the economy, a question being debated by political candidates (43s).
• When regulators intervene in a market, measuring the success of the regulation is challenging, similar to how medicine affects the human body, with potential side effects and unforeseen consequences (1m17s).
• Unlike medicine, the side effects of regulation are not random, but rather a result of people changing their behavior in response to the regulation, often with different incentives than the regulators (2m25s).
• Measuring the effectiveness of regulation is difficult due to the lack of a clear control group and experiment group, making it impossible to know the counterfactual outcome had the regulation not been implemented (2m59s).
• Given the challenges of measuring regulation's effectiveness, it's recommended to tread lightly and avoid making big changes (3m16s).
• Regulation not only qualifies people to do a job but also dictates how they do it, leading to fewer people doing the job and increased returns for those who can navigate the regulations effectively (3m24s).
• The hosts, Jules van Binsbergen and Jonathan Berra, have a paper related to the topic of regulation and are discussing it in the context of their expertise as finance professors at the Wharton School and Stanford University, respectively .

Costs and Consequences of Overregulation

• One of the real costs of regulation is that it incentivizes people to spend effort looking for ways to get around the regulation rather than doing things to help consumers (3m55s).
• The banking sector became heavily regulated after the financial crisis, causing smart people to leave the sector and move into the unregulated "shadow banking sector" where they can do the same activities in a smarter way (4m22s).
• As a result, banks are losing market share to alternative parties like private equity funds that are much less regulated and are now starting to do private credit and other financial products (4m52s).
• Heavily regulating an industry can limit competition, innovation, and profits, causing the very smart people to look for other places to provide value and get rewarded (5m21s).
• The best students used to go to investment banks, but now they go to private equity firms, which have grown out of the regulation from the financial crisis (5m57s).
• Private equity firms have become what used to be the investment bankers, with very talented people doing innovative things and greasing the financial system (6m12s).
• The effects of regulation are large, with about half of the corporations that used to be publicly traded now being privately traded, and a significant shift in the way financial markets operate (6m52s).
• The effects of regulation and laws passed over time cannot be underestimated, causing people to shift to different places to avoid regulation and making significant changes to the US economy (7m12s).

Discussion with Jay Clayton and Unintended Consequences

• Jay Clayton, former Chairman of the SEC from 2017 to 2020, currently serves on the board of Apollo Asset Management as the independent chair and chair of the executive committee, and is also a policy advisor to the firm (7m36s).
• The concept of "all else equal mistakes" refers to the idea that decision-makers often assume that changing one aspect of the world will not affect other aspects, when in reality, interventions can have unintended consequences (8m15s).
• In the context of regulation, unintended consequences are often more costly and profound than estimated, and are more likely to occur in complex systems (9m9s).
• Unintended consequences can be seen as equilibrium effects that should have been anticipated, and regulation can enhance the return to skill by requiring smart people to find ways around it, while reducing competition (9m31s).
• Regulation can reduce competition, increase returns to skill, and lead to regulatory arbitrage, where smart people create value by exploiting loopholes rather than creating real value (9m57s).

Benefits and Positive Effects of Regulation

• However, there are areas where regulation can achieve good, such as breaking down information asymmetries and allowing competition, as seen in retail investment advice and products (10m27s).
• Good disclosure and transparency can lead to lower prices, better competition, and consumer benefits, as seen in areas where total costs are clearly disclosed (10m54s).
• The Dodd-Frank Act, while having unintended consequences, also had positive effects, such as shrinking the banking system, increasing capital requirements, and promoting stability (11m32s).

Shift in Credit Markets and Private Equity

• In a credit-based economy, taking instruments off the books of banks can result in a shrinking economy or credit being created elsewhere, and in the US, the amount of credit being created elsewhere has increased significantly over the last 15 years, making the credit markets more competitive and diversified (11m43s).
• Over 50% of the world's non-sovereign credit is now created in the US, and a majority of it is created outside the banking system, with a significant portion moving into the shadow banking sector due to high regulation of banks (12m15s).
• The number of publicly traded firms has decreased, with many moving into private equity markets, and bank activity has shifted into private credit markets, which can be seen as a result of overregulation of public markets and banks (12m42s).
• The unintended consequences of regulation can sometimes lead to competition and a response, but it is acknowledged that equity and debt markets are overregulated, with equity markets being "ridiculously overregulated" (13m17s).
• The credit markets have become more stable, with specialty credit and other forms of credit being created or held outside the banking system, but the risk depends on how the other side of the balance sheet is financed (13m45s).
• The new private credit is not financed by deposits with guarantees from the government, which is seen as an improvement, but it is also acknowledged that regulatory arbitrage is a long-standing issue (14m19s).

Limitations and Outdated Regulation

• The limitations of regulation are highlighted, as regulators are not all-knowing and cannot anticipate all the consequences of their actions, leaving them at a disadvantage against smart individuals who can find ways to work around the regulations (14m43s).
• Regulation can become outdated as new financial instruments emerge, such as swaps, which can provide similar economic exposure to traditional methods but with different capital charges, allowing users and providers to make more money than expected under existing regulations (15m32s).
• When regulation becomes outdated, it's essential to think carefully about the incentives of the players involved and consider using regulation as a "very sparing stick" (16m14s).
• Instead of simply banning certain practices, such as insider trading, regulators should consider the potential consequences and whether allowing such practices could lead to more efficient markets (16m27s).
• Allowing insider trading could potentially lead to information being released quickly, reducing the cost of insider trading, and creating a more incentive-compatible system (16m50s).

Rethinking Regulation and the Role of Competition

• When crafting regulation, it's essential to consider the possibility of not having any regulation at all and to think about how competition can lead to better outcomes (17m19s).
• The debate around regulation is often characterized as a battle between "good people" who want regulation and "bad people" who don't, but this oversimplifies the issue and ignores the potential for competition to drive good behavior (17m32s).
• Regulators themselves can be part of a principal-agent problem, and their objectives may not always align with the stated goals, such as protecting consumers (18m3s).
• The SEC's stated goal of protecting consumers raises questions about whether the focus should be on maximizing total surplus rather than just consumer surplus (18m11s).
• Different heads of the SEC have interpreted their role in different ways, highlighting the potential for inconsistent objectives (18m27s).
• Recent Supreme Court cases have reacted to regulatory bodies overstepping their power or expertise, highlighting the need for regulatory agencies to stay within their narrow areas of expertise (18m42s).
• Crafting a set of rules that allows for real competition in a marketplace can lead to the best results, particularly in financial services markets, by reducing opacity, information advantages, and capital advantages (19m10s).
• The US large-cap equity markets are incredibly competitive, allowing for easy entry and exit with good liquidity, which is a great result, and more of this competitiveness in different places would be beneficial (19m40s).

The SEC's Role and Effectiveness

• The official role of the SEC is to protect individual investors, and it has a three-part mission: to protect investors, facilitate capital formation, and provide for efficient exchange (20m1s).
• Institutions are generally good at taking care of themselves, but the SEC's focus should be on protecting the $10 trillion of middle-class money in the marketplace, and reducing costs for retail investors (20m31s).
• The SEC has done well in reducing costs for retail investors, with a 50 basis point reduction in costs translating to a $50 billion annual benefit, but it has not done well in growing the economy through regulation (20m42s).
• The SEC has gotten in the way of capital formation with regulations, such as the climate rule, which is an example of misguided regulation with no expertise or demonstrated value (21m7s).
• The trend of overreach and desire to go outside the narrow mandate of the SEC is driven by Congress's abdication of its responsibility, leaving thorny issues like climate change and social justice to be handled by regulators (21m53s).
• Congress's abdication of responsibility is due to political expediency, with politicians calling on regulators to take action on issues they should be handling themselves, rather than pushing back and saying it's not their responsibility (22m7s).
• Regulators should push back and say that certain issues, like climate change, are matters of national security, energy policy, trade, and economic policy that belong with Congress, rather than trying to handle them themselves (22m38s).
• The problems of political gridlock and partisanship in US legislatures, due to redistricting, have contributed to the trend of regulators taking on more responsibility and overreaching their mandate (23m24s).

Political Influence and Overreach

• The US has districts that are heavily left or right, and social media's instant gratification can lead to regulators being pushed to act quickly, sometimes without proper understanding of the issue, as seen in the SEC being asked to deal with campaign finance despite having no expertise in the area (23m34s).
• The SEC's votes often follow political lines, making it difficult to make dispassionate decisions, and the commission's makeup over the last 30 years has had few members with meaningful experience in financial markets (24m20s).
• Most SEC commissioners come from a political background, which can lead them to gravitate towards political issues rather than market-related ones (24m50s).

Fixing the System and Retrospective Review

• To fix the system, a retrospective review of major rules with significant unintended consequences is necessary, to understand what went right and wrong, and to address the asymmetry between implementing and abolishing rules (25m38s).
• The total amount of regulation in financial markets today is incomparable to when the SEC started, with some regulations being good, some inconsequential, and some bad (26m17s).
• The SEC's willingness to take on issues outside its expertise, such as campaign finance, can lead to inaction and a lack of progress, as seen in the 20-year-old request from Congress (24m1s).
• The podcast aims to ask provocative and direct questions to understand problems and find solutions, and the conversation with Jay highlights the need for a nuanced approach to regulation (25m19s).