Error and Regulatory Risk in Financial Institution Regulation

This article provides a rationale for why past and present efforts to regulate systemic risk have failed to create incentives for bankers to limit their own excessive risk taking. Specifically, the bureaucratic proclivity to systemize and generalize regulation leads large, systemically important financial institutions to conduct business and to analyze risk in a single, uniform way. This proclivity generates error and has the unintended consequence of increasing systemic risk in the economy by causing a herding effect. In other words, by reducing the heterogeneity of firm behavior in an economy, regulation—even regulation aimed at reducing systemic risk—often increases such risk. The second insight is that rational regulators will be averse to type I risk, which is defined as the perceived risk that a systemically important financial institution will be mischaracterized as nonsystemically important and left underregulated. The professional consequences of such an error in categorization would be significant for the regulator or bureaucracy making such an error, and therefore regulators will attempt to avoid this type of error at all costs. Type II error occurs when regulators characterize institutions that are not systemically important as being systemically important. There are few bureaucratic consequences for regulators who commit this type of error. As such, type I risk leads to the overcategorization of financial firms as systemically risky, which leads to homogeneous regulation and herding. These problems exacerbate the ongoing dialectic between government, which seeks to control excessive risk taking, and the banking sector, which seeks to engage in such risk taking because the owners of the firms in this sector can diversify their holdings and thereby obtain the rewards of such risk taking without experiencing the consequences.