David Zaring Offers a Comment on ‘Regulation by Deal’

In my earlier post from last night on the Dodd-Frank financial reform bill, I asked whether the highly discretionary provisions in the legislation addressing aspects of systemic risk have the effect of “returning” us to the 2008 crisis policy of “regulation by deal.”  That term comes from a paper by Steven M. Davidoff and David Zaring that was posted to SSRN in November 2008; I realize looking at some of the comments that many readers were not familiar with the term, so here is an approximate definition from the abstract to the 2008 paper (Professor Davidoff also discusses the idea in his excellent and highly readable book Gods at War, in chapter 10, beginning particularly at p. 269):

The government’s team, largely staffed by investment bankers, pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. It then decided to seek comprehensive legislation that, as it turned out, paved the way for more deals. The result has not been particularly coherent, but it has married transactional practice to administrative law. In fact, we think that regulation by deal provides an organizing principle, albeit a loose one, to the government’s response to the financial crisis. Dealmakers use contract to avoid some legal constraints, and often prefer to focus on arms-length negotiation, rather than regulatory authorization, as the source of legitimacy for their actions, though the law does provide a structure to their deals. They also do not always take the long view or place value on consistency, instead preferring to complete the latest deal at hand and move to the next transaction.

The marriage of “transactional practice” to “administrative law” – yes; Davidoff and Zaring’s description of it was shrewd in 2008 and it remains a shrewd way to characterize it now.  My question today was whether the embrace of discretionary authority in the Dodd-Frank bill effectively enshrined this statutory authority, with further questions about the effects on future moral hazard.  Professor Zaring has been kind enough to email me something to post.  David’s comment emphasizes not so much the question of a return to regulation by deal as the question of whether anything in the financial reform bill replaces it, e.g., through the new resolution authority.  To which his comment is (and my thanks to David for weighing in with this; you can read more of David’s comments at The Conglomerate, where he is much more sanguine that I about the overall bill):

Have we replaced regulation by deal?  The answer is probably not – because governments have been bailing out banks, often by deal, so many times over the course of the twentieth century that one would have to conclude that it is a very hard habit to break.  And I think that is an implicit part of the message of Kenneth Rogoff’s and Carmen Reinhardt’s This Time Is Different, which goes even deeper into that not-so-enviable history.

The way that Congress hopes to end the emergency dealmaking lies in the new grant of resolution authority, summarized here, which would continue to try to force the government to swing into action before desperation sets in, and extend the ability to seize and bankrupt insolvent institutions to financial holding companies, as well as to banks and thrifts (thereby reaching the Lehmans – an investment, rather than FDIC insured bank – and AIGs – an insurer – of the future).  The superquick bankruptcies would be paid for by an assessment on large banks.  It’s an important grant of authority, but will it be exercised in a pinch?  The banking regulators have had a hard time pulling the trigger on resolution authority – hence the dealmaking that ensues when times get really bad.  And, of course, the fact that the government had the power to “resolve” Fannie Mae and Freddie Mac (which it did) has not prevented either precipitous action or a big bailout.

So I’m not sure that the bill ends regulation by deal, but that is very hard to do.  And the bill will probably change the way that big banks operate, depending on the way it is enforced by the regulators, and not in altogether bad ways.

The reference to This Time Is Different is apt – it makes for (what would be the right adjective?) rueful reading late at night.  As I say, I am much less sanguine that David about this bill (see his Conglomerate post linked above); my view is approximately that of Nicole “After the Fall” Gelinas, in a quick summary for a popular audience in the New York Post today.  But I also think David is quite right about resolution authority and regulation by deal, whether before this bill or after it.  And thanks to him for the comment.

Update:  I’m happy to see that the WSJ today has more or less the same view that I’ve put out here:

The Treasury, which bailed out institutions willy-nilly without consistent rules, will now lead the Financial Stability Oversight Council that will have the arbitrary power to define which financial companies pose a “systemic risk” and which can be shut down without recourse to bankruptcy. Willy-nilly will now be the law.