Reverse Regulatory Arbitrage: An Auction Approach to Regulatory Assignments

AuthorM. Todd Henderson - Frederick Tung
PositionProfessor of Law and Aaron Director Teaching Scholar, University of Chicago School of Law - Howard Zhang Faculty Research Scholar and Professor of Law, Boston University School of Law
Pages1895-1934
1895
Reverse Regulatory Arbitrage:
An Auction Approach to
Regulatory Assignments
M. Todd Henderson & Frederick Tung
ABSTRACT: In the years before the Financial Crisis, banks got to pick their
regulators, engaging in a form of regulatory arbitrage that we now know
was a race to the bottom. We propose to turn the tables on the banks by
allowing regulators—specifically, bank examiners—to choose the banks they
regulate. We call this “reverse regulatory arbitrage,” and we think it can
help improve regulatory outcomes. Building on our prior work that proposes
to pay bank examiners for performance—by giving them financial
incentives to avoid bank failures—we argue that bank supervisory
assignments should be set through an auction among examiners. Examiner
bidding would generate information about examiners’ skills, experience and
preferences, as well as information about each bank. Provided examiners
bear the upside and downside of their regulatory behavior, a bidding system
for regulatory assignments could improve the fit between examiners and the
banks they supervise, thereby enhancing regulatory efficiency.
I. INTRODUCTION .................................................................................... 1897
A. WHY FIAT? .................................................................................... 1897
B. REVERSING REGULATORY ARBITRAGE .............................................. 1899
II. THE THEORY OF RESOURCE ALLOCATION ........................................... 1904
A. MARKETS VS. FIRMS........................................................................ 1905
B. MARKET–HIERARCHY HYBRIDS ...................................................... 1909
C. RESOURCE ALLOCATION IN PRACTICE .............................................. 1911
III. BIDDING FOR BANKS ............................................................................. 1913
A. NECESSARY CONDITION: SKIN IN THE GAME .................................... 1914
B. AUCTIONING OFF SUPERVISION RIGHTS ........................................... 1915
Professor of Law and Aaron Director Teaching Scholar, University of Chicago School
of Law (toddh@uchicago.edu).
 Howard Zhang Faculty Research Scholar and Professor of Law, Boston University
School of Law (fredtung@bu.edu).
1896 IOWA LAW REVIEW [Vol. 98:1895
C. IMPROVED MATCHING .................................................................... 1918
1. Signaling Information and Skill .......................................... 1918
2. Countering Incumbent Bias ................................................ 1919
D. THE ROLE OF DISCRETION .............................................................. 1920
1. Negotiated Procurement ..................................................... 1920
2. Application to Examiner Assignment ................................. 1922
IV. QUALIFICATIONS AND OBJECTIONS ...................................................... 1923
A. BIASES IN BIDDING AND BEYOND ..................................................... 1923
B. PERVERSE BIDDING MOTIVATIONS ................................................... 1925
1. Bidding for the Revolving Door .......................................... 1926
2. Bidding for Inside Information .......................................... 1928
3. Bidding for Other Private Values ........................................ 1929
4. Collusive Bidding ................................................................. 1929
C. EXAMINATION TEAM MICROSTRUCTURE ......................................... 1930
D. WHY IT HAS NOT HAPPENED YET ................................................... 1931
E. THINKING BEYOND THE AGENCY ..................................................... 1932
V. CONCLUSION ....................................................................................... 1933
2013] REVERSE REGULATORY ARBITRAGE 1897
I. INTRODUCTION
A. WHY FIAT?
A scarce resource, like labor, may be allocated in one of two ways: by the
price mechanism or by fiat. With the price mechanism, the resource flows
via market transactions to where it is valued most highly. By contrast, fiat
allocation occurs through the command of a person with authority within a
hierarchy. All economic activities face this choice of resource-allocation
mechanism, and all institutions—be they firms, families, or governments—
deploy a mix of these approaches. For example, the head of a family may
want the grass cut. She has two basic choices: (1) she can command that a
family member cut the grass; (2) or she can put the work out to bid among
family members or landscaping companies. Her choice will depend on the
relative costs and benefits of each approach. It is simple and cheap to direct
a family member to do the work, but it might be done better or more
efficiently if put out to bid.
As the costs of using market transactions fall (or rise) relative to the
costs of fiat, the more (or less) work will be allocated by the price
mechanism instead of fiat. Continuing with the grass-cutting example, if the
costs of finding a landscaping service, evaluating the quality of the service,
and negotiating an attractive price are lowered—say, because of the
inception of an online marketplace for matching grass cutters and
homeowners—then at the margin, families will be more likely to use a
market than the fiat approach.
The accepted practice across government is that regulatory resources,
such as investigators or prosecutors, are allocated by fiat by department or
agency heads. Bank examiners are assigned to particular banks at the
discretion of higher-level regulators in the agency hierarchy. Higher-ups in
the agency decide based on their judgment about things like skill, fit, work
ethic, knowledge, and expertise. They must address complicated tradeoffs,
such as the risk of interest-group capture versus the benefits of experience
from regulators working with the same firms year after year. One agency
solution is to rotate regulators “periodically to ensure that an objective and
fresh supervisory perspective is maintained.”1 But there are downsides to a
1. See OFFICE OF THE COMPTROLLER OF THE CURRENCY, LARGE BANK SUPERVISION 2
(2011), available at http://ithandbook.ffiec.gov/media/22019/occ-comptr_handbook_large_
bank_superv.pdf. “At the OCC, examiners in charge for each bank have contracts t o cover a
bank for up to five years. After that, they are rotated to another bank or assignment, which can
mean a move to another city. ‘We want to keep them fresh and learning’ . . . . ‘It’s a very healthy
thing to do. It’s not always convenient for them.’” Rick Rothacker, Financial Crisis Lands More
Bank Examiners on Job, CHARLOTTE OBSERVER (July 10, 2011), http://www.google.com/
url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=1&ved=0CDEQFjAA&url=http%3A%2F%2
Fdigest.stjohns.edu%2Fdownload.axd%2F248784d32caa4f20ad9e3448cd5e7bb6.pdf%3Fd%3
D110713_CHARLOTTEOBSERVER&ei=wHJ9Ub2rGfk2wXG84H4Dw&usg=AFQjCNFcTJcJqEt
30Nl1Zd-B7X30KZwe5A&sig2=D9BrnWOYD1BfJ2hLFyZrUw&bvm=bv.45645796,d.b2I

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