The video features a conversation on the complexities and challenges of regulation within the financial markets. Jules van Binsbergen and Jonathan Burke, finance professors from the University of Pennsylvania and Stanford University respectively, explore regulation's impacts, using a medicine analogy to describe how intricate regulatory changes can have widespread effects, often leading to what they term an "over-regulated system." They discuss how regulation may inadvertently incentivize smart individuals to divert efforts away from consumer benefits and toward sidestepping regulations instead, emphasizing the difficulty in measuring a regulation's success due to the lack of visible counterfactuals.

The discussion incorporates insights from Jay Clayton, former chairman of the SEC, focusing on unintended consequences of regulation. They highlight how increased regulation in the banking industry has led to the growth of shadow banking and private equity markets. Clayton acknowledges both the benefits and drawbacks of regulation, particularly in banking and financial markets, explaining how competition and diversified credit markets have evolved from unintended regulatory consequences. The conversation moves toward politics, questioning if regulatory actions are often more about responding to political pressures than achieving financial efficiencies.

Main takeaways from the video:

Please remember to turn on the CC button to view the subtitles.

Key Vocabularies and Common Phrases:

1. regulation [ˌrɛɡjəˈleɪʃən] - (noun) - Rules or directives made and maintained by an authority to regulate conduct. - Synonyms: (rules, directives, controls)

We actually have a paper related to this topic, which is regulation.

2. counterfactual [ˌkaʊntərˈfæktʃuəl] - (noun) - A statement or hypothesis about what could have happened, comparing real events with what might have been. - Synonyms: (hypothetical scenario, alternative history, what-if analysis)

We will never know what the counterfactual would have been had the regulation not been implemented.

3. shadow banking [ˈʃædoʊ ˈbæŋkɪŋ] - (noun) - Financial intermediaries involved in facilitating credit flows but are not subject to regulatory oversight like traditional banks. - Synonyms: (non-bank financial intermediaries, parallel banking, alternative finance)

They move into what we call the shadow banking sector, and they essentially start doing the same activities that the banking sector was doing before.

4. regulatory arbitrage [ˈrɛɡjəˌleɪtəri ˈɑrbɪˌtrɑːʒ] - (noun) - The practice of exploiting differences in regulations between markets to gain an advantage. - Synonyms: (regulatory loophole, jurisdictional advantage, compliance loophole)

A lot of very smart people instead of creating real value or creating regulatory arbitrage.

5. information asymmetries [ˌɪnfərˈmeɪʃən ˌæsɪˈmɛtriz] - (noun) - Situations where one party has more or better information than the other in a transaction. - Synonyms: (knowledge gap, informational imbalance, unequal information)

One of the most notable is when there are information asymmetries and you are rewarding people who have better access to information.

6. dispassionate [dɪˈspæʃənɪt] - (adjective) - Not influenced by strong emotion, able to be rational and impartial. - Synonyms: (impartial, objective, detached)

It really makes you wonder if we can make dispassionate, value maximizing decision.

7. principal-agent problem [ˈprɪnsəpəl-ˈeɪdʒənt ˈprɑbləm] - (noun) - Challenges that arise when one party (the agent) is able to make decisions on behalf of another (the principal) and where their interests may not align. - Synonyms: (agency dilemma, conflicts of interest, delegation issue)

That the regulator itself is part of a principal agent problem.

8. tectonic shifts [tɛkˈtɑːnɪk ʃɪfts] - (noun) - Major changes or transformations that occur in a significant area, often profound and far-reaching. - Synonyms: (seismic changes, fundamental transformations, major upheavals)

So these are really tectonic shifts in the way that financial markets are operating.

9. gridlock [ˈɡrɪdlɒk] - (noun) - A situation where there is difficulty in decision making due to evenly divided interests or factions. - Synonyms: (stalemate, deadlock, impasse)

Why is it happening now? It's because of a number of factors. First, more political gridlock due to more partisanship.

10. overreach [ˈoʊvərˌriːtʃ] - (noun) - The act of exceeding one's grasp, often in terms of authority or control. - Synonyms: (excessive extension, overstepping, stretching too far)

Avoiding overreach and unnecessary complexity.

Ep49 “Making Regulation Work” with Jay Clayton

Welcome to the Lauder Institute at the University of Pennsylvania. I'm Jules van Binsbergen, director of the institute and a finance professor at the Wharton School. And I'm Jonathan Burke, a finance professor at the Graduate School of Business at Stanford University. This is the All Else Equal podcast.

Welcome back, everybody. Today we're going to talk about a topic that Jules and I are close to our heart. We actually have a paper related to this topic, which is regulation. And I think the question really comes up because one of the big questions that the political candidates are debating right now is whether or not there's too much regulation in the economy. And so we thought it'd be worthwhile just talking about whose interest regulations in and how it works.

Absolutely. But before we go there, Jonathan, the first question that I have is, suppose you and I were regulators, and we saw that there was an issue in a market that we didn't like, and then we wanted to intervene in that market. How are we going to measure success? In other words, how do we know that the regulation is working? The analogy that I always like to make is the analogy to medicine and the human body, right? You have an incredibly complicated, dynamic system. You start messing around with one component of it, and the immediate side effect is that all kinds of other things in the human body start doing different things in response to the medicine that you just applied. And because of these so-called side effects, we generally want to make sure that the side effects are not too intense.

But it's even really hard to measure all of the side effects. And then to the extent that there are side effects, people start prescribing more drugs to start to fight the side effects. So that in the end, you get accumulation of medicine being applied to try to address all these issues. And I think that that happens with regulation, too. You implement regulation, something happens that you didn't like or didn't foresee, the so-called unforeseen effects. And then you just implement new regulation and more regulation to start to fight that. And before you know it, you have a very over-regulated system.

Jules, I think it's much worse than what you just said. With medicine, I would assume the side effects are pure chance. It happens to affect something, and there's a pure chance with regulation. It's not pure chance. When you put regulation in place, this is a classic all else equal mistake. You put regulation in place, people will look at the regulation and change their behavior based on the regulation, and they won't necessarily change the behavior to what you want because they have different incentives than what the regulator has. And so it's a much worse problem than the medical problem.

And then the question is, how do you measure it? And indeed, in the medicine case, you do have a very clear control group and an experiment group. You apply the medicine, you compare the outcomes between the two. For the vast majority of policies that we implement, we never get to see that when, say, the SEC implements a new rule in financial markets, we will never know what the counterfactual would have been had the regulation not been implemented. I think the bottom line is, since you know you'll never be able to do the counterfactual, you should tread lightly, don't make big changes. That's at least my view.

Now, regulation, I think, takes it even a step further, because with regulation, you're not only qualifying people to do a job as you would for licensing, you're telling them how they're going to do that job. And so that inevitably leads to less people doing the job. And more importantly, it also increases the returns to being really smart, because if you can figure out a way of doing the job the way you want and staying within the regulation, you get a very big competitive advantage. So one of the real costs of regulation is, I think, it incentivizes people to spend effort looking to get around the regulation, rather than doing stuff to help consumers.

And so let's look at one very specific example of this that's particularly relevant for the discussion we're going to have with our guest today, which is that we had a banking sector. The banking sector had very smart people in it. The financial crisis happened. The consequence of it was that the sector became much more heavily regulated. And in response to lots of regulation, both on the banking side as well as in public financial markets, such as public equity markets, we're just seeing that this additional regulation means that the smart people try to start to do something else. They're leaving the banking sector. They move into what we call the shadow banking sector, and they essentially start doing the same activities that the banking sector was doing before.

But just the smarter people do it in a smarter, unregulated way, through the shadow banking system. And so I think that banks are losing market share all over the place in all kinds of different product provisions, whether it's on the insurance market, or whether it's on the mortgage market or whether it's in the direct lending market. It doesn't really matter where they're losing market share to alternative parties like private equity funds that are much less regulated and that are now even starting to do private credit and all kinds of other financial products like insurance. It's a really nice example of what we were talking about.

Think about it. You heavily regulate an industry, so it becomes an industry where there isn't much competition. But of course, the regulation limits the extent to which people can innovate and limits the profits in the industry. I mean, you have to be bright, but you don't have to be the very, very top person because it's not a very competitive place. Very smart people go, wait, I can do much better than this, but I can't do it within the regulation. So I'm going to find another place to do it where I can really provide value and get rewarded immeasurably with that. And that's exactly what happened. So, you know, there was a time when the best students in Stanford went to investment banks. Those days are gone. Today, the best students at Stanford go to private equity and the sector that grew out of the regulation from the financial crisis.

And I would say today the private equity firms essentially are what used to be the investment bankers. What do I mean by that? Investment bankers were places of very, very, very talented people doing incredibly innovative things and really greasing the financial system. And I would say that where that talent is today is in the private equity sector, and the effects are really, really large. And I don't just mean that by the extent to which people go to different places to work, as well as what the assets under management of these big private equity firms is. But also, let's just think about the amount of equity that's currently traded in public markets versus private markets. I think that probably about half of the corporations that used to be publicly traded are no longer publicly traded and moved into the private space.

So these are really tectonic shifts in the way that financial markets are operating. And so I think that the effect on the US economy and how it's developed itself, I think the effects of regulation and laws that have been passed over time cannot be underestimated. This is not a little bit on the margin. This is really making people shift to different places just to avoid the regulation.

So I think this is a good time to introduce our guest. Yeah, so our guest today is Jay Clayton, who was chairman of the Securities Trades Commission from 2017 to 2020. Today he serves on the board of Apollo Asset Management, where he's the independent chair and chair of the executive committee. And he's also a policy advisor to the firm he worked for before he went to the SEC, Sullivan and Cromwell.

Jay, welcome to the show. Well, it's nice to be with you both. I look forward to an engaged and lively discussion. As you know, the podcast is called All Else Equal, and what we often discuss on the podcast are so-called all else equal mistakes, which is that decision makers think that if they try to change something in the world, in economics or elsewhere, that the rest of the world will stay constant. But of course, in reality, as soon as you make a decision or you try to intervene with regulation, you have an effect on the people that you're trying to regulate.

And so the question is, if we look at regulation also, in your experience as the head of the SEC, in what fraction of regulatory intervention in markets does the regulation actually achieve the stated goals? And are unintended consequences inevitable, or are there things that can be done about them?

First of all, congratulations on that name for your podcast, because it is the issue that regulators grapple with the most when they're being serious about regulation. In almost all cases, there are unanticipated or even anticipated secondary effects. They're often more costly than estimated, they're often more profound than estimated. Then the more complex the system, the more likely they are to occur. That's just the reality of regulation. In modern markets, where I think I have some expertise, it's almost always the fact that there are unintended consequences.

Let me follow up on that, because my own view is that what people call unintended consequences are just the equilibrium effects that we should have anticipated. And taking that argument a stage further, since people are always going to react to the regulation, when you regulate, in my view, you actually enhance the return to skill, because you need really smart people to figure out a way around the regulation, and at the same time, the regulations reducing competition, which in the end means that the regulation itself could very easily make the world worse off. You've reduced competition, you've increased the returns to skill. You have a lot of very smart people instead of creating real value or creating regulatory arbitrage. So the question is, how often does regulation actually achieve good as opposed to these ultimately not achieving good?

Well, Jonathan, let me be positive, and then I'll come back to your comment. There are areas where regulation achieves good. One of the most notable is when there are information asymmetries and you are rewarding people who have better access to information, sometimes even created by other regulations. Breaking down information asymmetries and allowing competition is one way to have, I think, very effective regulation. And you can see this in retail investment advice and retail investment products in every area where there's transparency of total cost. Said another way, how much of my money is actually going to work for me and how much of it is going to frictions and intermediaries? When you have good disclosure around that prices come down, the consumer wins, you have good competition.

There are a lot of other areas where regulation does create some of those very asymmetries and information you're looking to get rid of, and I can think of a number of those. But coming back to rewarding skill and what it means for the long run, it'll be shocking for you to hear me say there was a lot of good that came out of Dodd Frank and a lot of the good came out of unintended consequences. Dodd Frank basically said, hey, we're going to shrink the banking system. We're going to require more capital, we're going to take some instruments off the books of banks. But in a credit-based economy, that's either going to result in a shrinking of the economy or credit being created elsewhere. And in the US, the amount of credit being created elsewhere over the last 15 years ballooned. Now it's remarkably competitive in that area. So we have, I think, more competitive credit markets, more diversified credit markets.

As a result of people entering the non-bank credit provision markets, basically more than 50% of the world's non-sovereign credit is now created in the US and a majority of is created outside the banking system. But Jay, to put a different spin on that same point, right, if we really regulate banks, but the consequence of that high regulation for banks is that removing this activity into the shadow banking sector where it's not as regulated. If we, for example, think about private equity and private debt markets, the number of firms publicly traded has gone down by a lot. It's all moved into private equity markets. A lot of the bank activity that we've seen before has gone into private credit markets. Can that also not be interpreted as just that both public markets and banks are just over regulated? I understand that you call that unintended consequences, but is this a good thing? Wouldn't have been better to not regulate this much to begin with?

The answer to your question quickly is yes. But what I'm saying is sometimes the unintended consequences do result in competition and a response, oh yes, and look to your point. Equity and debt markets are differently. Our equity markets are ridiculously over regulating the fact that we have less than half the public companies we used to, and that we use the public equity regulatory system for things that go way beyond what I would say is financial efficiency, transparency, and investor protection, but go to social engineering is an absurd result, and that's why we have fewer public companies.

The credit markets are a little bit different. What we've done in the credit markets is we've said we're going to have a very stable banking system, particularly at the core of the banking system, and that what I would say is specialty credit and other forms of credit will be created or held outside the banking system. The question of whether that's risky or not depends on what the other side of the balance sheet looks like. How do you finance the provision of that credit? If you finance it without leverage and you finance it with equal duration, no problem. If you add a lot of leverage and you have duration mismatch, big problem indeed. And of course, this new private credit is nothing. Finance by deposits, this super short term deposit thing with guarantees from the government. So that certainly seems like an improvement to me.

William Jay, let me push back a bit on this and let me give you my perspective, okay? If there was an all-knowing central planner, the world would be better off, okay? We wouldn't need markets. We would just have this all-knowing person correctly assign value and everybody would be very happy. But the problem is there isn't an all-knowing person. And so in that world, a regulator is coming in and deciding, look, the world could be better, and I'm going to then put in a set of laws to make the world better.

At the same time, though, there are very, very smart people on the other side who get affected by those laws. And those very smart people are going to think, well, given the new environment I'm in, how do I make a lot of money for myself? And it seems like that asymmetry of the really smart person against the regulator leaves the regulator at a tremendous disadvantage, so that in the end, those smart people will find a way around the regulation. No, well, regulatory arbitrage is as old as regulation.

For years you had limitations on leverage in equity markets, and then somebody invented swapshe. And it's the same type of economic exposure, borrowing to take a long or a short position as it is to put a swap on, one has a different capital charge to the purchaser than the other. And of course, the users and providers of swaps basically were able to make more money than was expected when you had regulation based purely on the margin rules. So these types of, I'll call them regulatory testing, go on all the time. The question is, Jonathan, to push back on you, when regulation becomes outdated, how do you test it?

Well, I would say we should really think much more carefully about regulation, and we should use it a very sparing stick, and that we should think much more about incentives of the players involved. So it's easy to say, okay, let's ban insider trading, and so you can rile all their bans, insider trading, and somebody else will come around with a form of insider trading which doesn't exactly follow the law. And then you have to then plug that hole, and before you know it, you're just plugging holes. Another possibility is we could say, well, wait a minute. What if we allowed insider trading and allowed markets to work so that the information comes out very quickly and so the cost to the insider trading isn't that high? I mean, those are two different ways of solving the same problem. And I don't think we give enough thoughts to having an incentive compatible way of doing it.

Mike, I agree with you. And I do think that we often, when we're crafting regulation, compare regulation A to regulation B, and don't start with the idea of what if we don't have any regulation? Yeah, it's a very good lens through which to view a problem.

Where the debate often is politically, which I find very frustrating, is it's often characterized as well, it's the bad people who don't want regulation. And so, therefore, for the good people, we need the regulation to put it very simply. But really, nobody's thinking, no, no, no, if we set the world up with enough competition, the so-called bad people might actually act in a way that is good for the so-called good people, and we don't think carefully enough about those situations.

So, to add to that, Jonathan, I think that we also need to think about the possibility that the regulator itself is part of a principal agent problem. For example, the purpose of the SEC, at least its stated goal, is to protect consumers. But that whole objective already raises one question, which is, wouldn't we generally want to maximize total surplus rather than just consumer surplus? That's the first question that raises.

But secondly, if we look at how different heads of the SEC have interpreted their role, I think Gary Gensler, for example, interprets his role very differently than you did. Jay, correct me if I'm wrong, but that just makes you wonder to what extent the objectives are even really the same.

I think the recent Supreme Court cases you have seen are a reaction to regulatory bodies looking to solve problems that are outside of their power or expertise. Yes. And that the promise of the new deal and the promise of separate independent regulatory agencies was that they would apply their expertise in a narrow area. And we've gotten way beyond that. That is a fact. I do agree with both of you that if you can craft a set of rules, a marketplace, or massage it, where you have real competition, that is the best result, by far the best result, particularly in financial services markets, getting rid of opacity, getting rid of information advantages, getting rid of advantages for people who have more capital versus less capital, those types of things. You have incredibly efficient markets, our large captain, not across the spectrum, but our large-cap equity markets now are incredibly competitive. You can get in and out of exposure to our top 100 stocks for fractions of a penny with pretty good liquidity. That is a great result. More of that in different places would be good.

But while we're on the SEC, the official role of the SEC is to protect individual investors. What do you think? Do you think DC is doing a good job of that at the moment, not even at the moment for the last 20-30 years? Ed? I think that it has a three-part mission, Jonathan. It is to protect investors. It's also to facilitate capital formation, to grow the capital markets, which enhances returns, and to provide for efficient exchange. That's the three-part mission.

I can tell you the way I looked at it, which is generally institutions are pretty good at taking care of themselves and fighting the regulators. There's probably ten to 20 trillion, let's just say it's 10 trillion of middle-class money in the marketplace. If you get the costs of going in and out of the market over a year, down by 50 basis points, that's $50 billion a year, that goes into the pocket of retail investors. I think in that area, the SEC has done very well over the last two decades. Have we done overall well for growing the economy through SEC regulation? No. We have gotten in the way of capital formation with SEC regulations in a lot of ways.

The climate rule that's now on hold is probably one of the best examples of incredibly misguided regulation. No expertise, no demonstrated value in the data, other than a general desire to have some client data coming back. Then to this point and the previous point that you made, which is that there's this overreach and this desire to go outside of what the narrow mandate is and where the expertise is. What do you think explains that trend? Why do we see so much more of that today, not just, I think, at the SEC, but broadly at institutions? What do you think drives that?

I think one overriding driver is Congress's abdication of its responsibility. So thorny issues like climate change, social justice, education, these are right in the heart of what Congress should be doing. But instead, it is very politically expedient to call in the head of the SEC, for example, pound the table and say, what are you doing about climate change? The member of Congress tweets that out with a picture of them being all agitated and says, look what I'm doing to respond to the risks of climate change. And the silly regulator sits there with no expertise whatsoever in how to handle issues like climate change and says, oh, sure, I'll go try and do something about it, instead of pushing back and saying, look, climate change is a matter of national security, it's a matter of energy policy, it's a matter of trade, and it's a matter of economic policy that belongs with you. You tell me what the transition for our energy sector is and I'll figure out how to help companies disclose it. But don't put it on me to be the architect of what our climate transition looks like. That's what the regulator should say. But they don't. They kowtow to the politicians and they say, I'll take care of it.

Has that always been the case? No. So what's so new about, is it that the problems are harder and Congress doesn't have good solutions for it that we see it more now, or the political gridlock? Why is it happening now?

It's because of a number of factors. First, more political gridlock due to more partisanship in US legislatures because of redistricting. And you have a vast majority of the districts that are either heavy left or heavy right. But then you also add to that the, I would say, the instant gratification of social media and the desire to put something out, that you're doing something about this. And the regulators were an easy third party. Think about the fact that the SEC was asked by many members of Congress to deal with campaign finance reform. Now, what does the Securities and Exchange Commission know about campaign finance? Nothing. But the SEC willingly said, you know what? We'll look at it. We'll see what we can do. Well, of course, that was 20 years ago and nothing has happened because Congress was able to push its responsibility to a regulatory agency.

Yeah, I mean, one of the issues with the SEC that I find really worrying is the fact that the votes of the commission are so down political lines it really makes you wonder if we can make dispassionate, value-maximizing decisions. It seems like every single thing has to be cast in the light of whatever political debate is going on at the time.

Well, I think you're right, Jonathan. If you look at the makeup of the commission over the last 30 years, it has very few people who have meaningful experience in our financial markets. Most of them come from the political area, and they're not bad people. But you're just going to gravitate toward the issues, you know, and if you come from the political area, not the markets area, you'll gravitate toward political position.

Well, Jay, it's been an interesting conversation. Unfortunately, like many things today, solutions do not jump out at us. Put it that way. I want to compliment you guys, the fact that you asked these provocative and direct questions. You don't get solutions until you understand the problem. And we certainly don't shy away from the hard topics on this podcast. Indeed.

But if you thought about suppose you wanted to go and fix the system, where would you start? I think that is a hard one because at least if you knew where the first step was, that would be helpful. I do think the first step is a retrospective review, to your point, which is, what are the major rules that had significant unintended consequences, negative ones? And how can we review them? Instead of just continuing to say, what's the next problem over the transom, go back and look at what you've done over the last decade and say, what did we get right? What did we get wrong in that sense? I think there's this huge asymmetry between implementing a rule and abolishing one. Right? I mean, I think that there's such an asymmetry and that adopting yet another one to fix all the problems that the previous ones caused is so much easier than to actually actively deregulate.

I think that the total amount of regulation of financial markets today compared to when the SEC started is incomparable. Correct. And some of it is very good. Most of it is fairly inconsequential, and there's some that's very bad.

Well, on that note, thank you very much, Jay, for joining us. Thank you so much. It was great. Thank you. Okay, take care, guys.

Thanks for listening to the All Else Equal podcast. Please leave us a review at Apple Podcasts. We love to hear from our listeners. Also, be sure to catch our next episode by subscribing or following our show wherever you listen to your podcasts. For more information and episodes, visit all else equal podcast dot com or follow us on LinkedIn. The All Else Equal podcast is a joint production of Stanford University's Graduate School of Business and the Lauder Institute at the University of Pennsylvania. It is produced by University FM.

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