Regulating Financial Institutions: The Value of Opacity

Article excerpt


I.   Financial Institution Regulation: Rationales and
     Structural Characteristics
II.  Optimizing Administrative Design
     A. Insulation
     B. Transparency and Opacity
     C. Combining Insulation and Opacity
III. Regulating Financial Institutions
IV.  Policy Implications


The global financial crisis highlighted profound difficulties in the banking sector, which in turn cast attention on differing regulatory approaches across countries. (1) Drawing on the administrative law literature, we examine the characteristics of a regulatory agency that oversees financial institutions and ask how these characteristics influence the strength of its oversight. In particular, we analyze the agency's insulation from political control and the opacity in its operations. (2) We discuss both the value of these characteristics in the regulation of financial institutions themselves and also how these characteristics interact--when are they complements and when are they substitutes?

In order to ground the theoretical discussion, we examine the regulator of Canadian financial institutions, which is called the Office of the Superintendent of Financial Institutions (OSFI). Canada's financial institutions weathered the crisis well relative to their international peers, an outcome that has been attributed at least in part to the presence of an effective regulator. (3) The academic literature points to Canada's regulatory structure as a factor that discouraged banks from taking excessive risks. Ratnovski and Huang, for example, examine the performance of the seventy-two largest commercial banks in OECD countries during the financial crisis, analyzing the factors behind Canadian banks' relative resilience at this time. (4) They identify two main causes, one of which is regulatory factors that reduced banks' incentives to take excessive risks. (5) This view of the efficacy of banking regulation permeated Canada's own government. For example, OSFI was not subject to regulatory reform following the crisis, and the government in fact relied on the structure of OSFI, and new guidelines that OSFI proposed, to stave off an international bank tax. (6)

Building on the existing literature, this article assumes that OSFI played a role in ensuring the stability of Canadian financial institutions relative to their international peers during the financial market meltdown of 2008. (7) Of course, we do not mean to exclude factors other than Canada's regulatory structure that likely contributed to the stability and performance of Canadian financial institutions, such as: Canada's oligopolistic market (consisting of rive big banks); (8) macroeconomic policies emanating from the Bank of Canada; the historical structure of the banking system; the approach to regulating the Canadian mortgage market; and, a generally conservative approach that pervades the banking sector. (9) Given the international interest in the structure and role of OSFI, however, we examine whether there are characteristics of Canada's financial institution regulator that may be worth emulating.

OSFI's efficacy may at first be surprising. It is the primary regulator of Canada's rive big banks (which account for approximately 85 percent of Canada's banking sector). (10) Its power to overcome the possibility for rent seeking or capture by these institutions depends on its rule making and enforcement processes, and forms of accountability for its actions. That is, if not sufficiently independent, regulated institutions might seek rules that favour their profitability at the expense of consumers. Yet on many important issues, including capital adequacy requirements, OSFI relies on guidelines rather than regulations. OSFI creates these guidelines through a largely opaque process in which the regulated parties have early input. Other parties (such as consumers) not only face considerable collective action problems but are limited to a stunted notice and comment process. …