Financial Regulation Book Review 127 Harv. L. Rev. 1991

The Politics of Financial Regulation and the Regulation of Financial Politics: A Review Essay

Reform efforts need to focus on taming politics



The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It. By Anat Admati & Martin Hellwig. Princeton, N.J.: Princeton University Press. 2013. Pp. xv, 398. $29.95.

Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself. By Sheila Bair. New York: Simon & Schuster. 2012. Pp. viii, 415. $16.00.

Bailout: How Washington Abandoned Main Street While Rescuing Wall Street. By Neil Barofsky. New York: Free Press. 2012. Pp. xxvi, 272. $16.00.

The Federal Reserve and the Financial Crisis. By Ben S. Bernanke. Princeton, N.J.: Princeton University Press. 2013. Pp. vii, 134. $19.95.

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. By Alan S. Blinder. New York: Penguin Press. 2013. Pp. xix, 476. $29.95.

The Payoff: Why Wall Street Always Wins. By Jeff Connaughton. Westport, Conn.: Prospecta Press. 2012. Pp. viii, 277. $24.95.

The financial crisis of 2008 was the first truly systemic and acute crisis to occur against the backdrop of the modern regulatory state. The panic of 2008 tested the modern financial regulatory system as it had never been tested before. How did the financial regulatory system fare? Did the regulatory system work before and during the crisis? Is the system basically sound, needing only minor reforms? Or does the crisis bespeak a more profound problem in financial regulation?

The answers to these questions have far-reaching implications. In the modern, financially intermediated economy, the regulation of financial markets impacts the economy as a whole. Financial regulation affects the aggregate amount and distribution of wealth in society. Do we trust the institutional structures and processes for ordering the financial marketplace to produce normatively acceptable distributional outcomes? Does the process have sufficient legitimacy to support its distributional effects?

The question of faith in the regulatory system as a means of economic ordering has animated American politics following the financial crisis. Both the Tea Party and Occupy Wall Street movements are sharp repudiations of the financial regulatory system as failing to produce normatively acceptable distributions of wealth in society.

The question of faith in the system also underlies and permeates virtually the entire literature about the financial crisis, as shown by titles such as In Fed We Trust and Regulatory Breakdown: The Crisis of Confidence in U.S. Regulation. In the five years since the crisis, a small literature has emerged on its causes, the government response, and potential reforms. Much of this literature has been in the form of journalistic accounts of either the run-up to the crisis or the government response to the crisis, sometimes with concluding policy proposals. More recently, we have begun to see academic examinations and insider accounts. These accounts tend to either lionize bank regulators as the expert heroes who staved off financial Armageddon or criticize them for the political priorities reflected in their decisions before and during the crisis. The former narrative extols regulatory independence, while the latter urges political accountability. These narratives also reflect a difference in priorities regarding banks and the real economy or, in shorthand, Wall Street versus Main Street. For those who see the current banking system as indispensible and inherently fragile, the rescue of the system was a triumph in the face of potential catastrophe. For those who see the banking system merely as an imperfect means to the end of facilitating the real economy, the rescue of the banking system but not of the real economy (and of the housing market in particular) reflected misplaced distributional priorities enabled by a failure of governance. These narratives of crisis and response are judgments on the modern financial regulatory state. These judgments have important implications for the design of the financial regulatory system going forward in terms of how much discretion and independence financial regulators should have and the institutional framework in which they should operate.

Part I of this Review Essay examines six recent books on the financial crisis. Some of these books are by current or former insiders, while others are by academics. Some are scholarly or wonky, while others are gossipy. None of them tell the full story of the crisis and its aftermath. Yet taken together, they help explain both the regulatory failures that enabled the financial crisis and the shape of the regulatory response to the crisis. As a group, these books provide a Rashomon-type story of the financial crisis retold from a variety of perspectives: the Central Banker, the Establishment Economist, the Bank Regulator, the Prosecutor, the Lobbyist, and the Professors. These books also underscore the dueling themes of technocratic independence and democratic accountability, of faith in or rejection of the modern financial regulatory system, and of Wall Street versus Main Street.

Part II of this Review Essay steps back and considers how these dueling principles have played out in the political and regulatory response to the crisis and the lessons that might be learned. In particular, Part II discerns two basic narratives of the crisis in the books reviewed in Part I, each with different implications for regulatory reform. One narrative is that the financial regulatory system had become outmoded and was thus vulnerable to a “perfect storm.” This narrative points to regulatory updating and narrow technocratic fixes to regulation.

The other — and more convincing, if uncomfortable — narrative is a story of regulators failing to prevent the crisis, and even enabling it through deregulation, because they were captured. This capture narrative sees financial regulation as suffering from a core governance problem that has skewed the process of choosing between Wall Street and Main Street. The critique is one of both process and results, with the implicit assumption that better process would produce different results.

Three basic, if potentially conflicting, approaches to addressing capture problems can be discerned from post-crisis regulation: moving toward more democratically responsive and less technocratically independent regulation; restructuring the regulatory agencies to increase technocratic independence and better insulate regulators from politics; and capitalizing on the rent-seeking impulses of interest groups to produce offsetting political pressures on regulators, thereby enabling space for genuinely neutral, technocratic policymaking. To the extent that we believe that there is a capture problem in financial regulation, reform efforts need to focus on taming politics, not technical regulatory questions. Future research should focus on identifying the most effective approaches to combat capture.