Wednesday, June 13, 2012

University of Chicago Law Professor Todd Henderson May Have the Dumbest Bank Regulatory Idea of the Year – And Contends for the Dumbest Regulatory Idea Ever

There is a Reason Why We Don’t Let Academicians Run Things

The University of Chicago has a great economics department and a great law school.  Really they do, just ask them and they will tell you.  In fact the Nobel Prize in Economics has been awarded many times to a Chicago economist because, well, we really don’t know why and those who make the selections probably don’t know either.

The claim to fame of the University of Chicago economics department and law school is their belief in a market driven economy that needs little or no regulation.  That’s right, despite all evidence to the contrary they believe that the market will not allow things like dangerous products to be sold, or for financial institutions to take such risks with investor’s money that they fail (and have to be bailed out by taxpayers). 

Chicago-style free-market economics is an easy target for satire, but the movement that flourished at the University of Chicago’s economics department in the 1960s, ’70s, and ’80s really did change the world. Giants such as Milton Friedman, Gary Becker, Robert Lucas, and Eugene Fama provided the intellectual foundation for the political philosophy of President Ronald Reagan and British Prime Minister Margaret Thatcher. In his approach to tax cuts and deregulation, Republican presidential candidate Mitt Romney is an heir to that tradition.

Chicago has given the sheen of academic respectability to a series of misguided polices, and may play that role again in the future.

The law school in recent years has become enamored with the economics folks, and the concept of law and economics together is a force that Chicago faculty have created

Last October, Dean Michael Schill announced a major initiative to deal with the challenges, to capitalize on the school’s place in history, and to keep law and economics relevant for the 21st century. He called it, predictably, Law and Economics 2.0. “Just as Chicago was at the forefront of the first wave of law and economics, so it shall be in the future,” he wrote to alumni.

In what has to be regarded as the most ridiculous attempt ever to combine law and economics, we have this from law professor Todd Henderson.

Chicago Law professor Todd Henderson proposes paying bank examiners in part with “phantom” securities linked to the banking companies they regulate. The phantom bonds, essentially derivatives, would rise and fall in concert with a bank’s debt. If banks took too much risk, regulators would feel a hit to their own wealth. To keep regulators from getting so cautious that they ban legitimate transactions, Henderson would throw some phantom stock into their pay packages as well. “There is no reason we can think of why bank regulators should not be paid for performance,” he wrote in the spring 2012 issue of Regulation, a magazine published by the libertarian Cato Institute.

Really, he seriously (at least we think he is serious, the Cato Institute is known for many things, a sense of humor is not one of them) thinks regulators should have a economic stake in the companies they regulate!  Gosh what could go wrong there? 

Actually Professor Henderson has done the world a great favor.  He and his proposals will be the standard case history of why it is never, ever a good idea to bring theoretical professional academics into the real world.  And yes, if this was all just a joke, then yes, we were fooled.  But it probably is not, just because something sounds like a joke doesn’t make it a joke, just look at Conservative proposals for improving the U. S. economy.

As for Dean Shill, if this is Law and Economics 2.0 you really, really need to move quickly to Law and Economics 3.0.  Your beta testing of Law and Economics 2.0 flunked. 


  1. If the "Dismal Political Economist" bothered to read the paper I (along with Fred Tung of Boston University) wrote, (s)he would have learned that we proposed paying a bonus to bank regulators tied mostly to bank debt in order to give regulators incentives to act more aggressively to restrict bank risk taking. But I guess it is easier to criticize a paper we didn't write instead of the one we did.

    If anyone is reading this blog -- and I have my doubts given this kind of sloppiness -- you can read the paper for yourself here:

  2. Remarkably, Prof. Henderson criticizes the DPE for not reading his paper, and then simply repeats the content of the article quoted in this post. I suppose Bloomberg is also guilty of not reading Prof. Henderson's paper.

    The DPE is saying that tying regulator pay to bank performance is a terrible idea per se. He is right. That sort of situation is called a conflict of interest.

    I have no idea how many people read this blog. If more people did, the country would be in much better shape.

    1. Read the paper, "Rich Mahogany." Read the paper. You might learn something. You might not. You might disagree with us. Fine. But your disagreement should be based on something other than your fantasy about what we've actually proposed. For instance, if you think it is a "conflict of interest" for regulators to bear some downside risk from regulatory laxity, why isn't it a problem, say even a conflict of interest, that currently they bear no direct consequences from serving the interests of banks instead of the public? Why wasn't it a problem that salaries are fixed and regulators can't be fired, when we know that led to regulatory laxity? What think you of the $20 million in bonuses paid to bank regulators in 2007 that were tied to, well, we don't know because the government won't tell us? Surely conflict of interest is a legitimate concern, and it is one we address. We think the value of giving regulators some downside risk from bank failure is a good thing. You may prefer the current model in which they don't. We can agree to disagree. But your opinion should be informed by the content of our ideas, not who we are or what someone who hasn't read our paper thinks of our ideas or us.