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Bounds in Bank Regulation

In his recent essay, Bounded Institutions, Yair Listokin examines bounded and unbounded structures as two alternative designs for principals to delegate regulatory authority to their agents. Bounds refer to numerical or quantifiable limitations that are set by the principal on some dimension of the agent’s decision-making process, and include caps, quotas or grading curves. Listokin shows that bounds can be used to reach ideal regulatory outcomes even in cases where the principal is uninformed and the agent is biased. In this Response, I extend the logic and intuition of Listokin’s bounded institutions to banking, an area where information gaps and biases are pervasive yet bounded structures are not prevalent. For instance, in the debate about the right size of financial institutions, while there is consensus that a certain number of financial institutions have become too big, there is much that remains to be agreed regarding the right size of such institutions and how that ideal should be reached. Likewise, while there is broad recognition that there are accuracy and accountability issues in the ratings process of financial institutions, how this regulatory ratings process can be improved and how progress can be measured are open questions that are being debated. I suggest here that the numerical and quantifiable feature of bounds such as quotas and curves can offer a concrete solution to both of these and other regulatory puzzles in banking. I make the argument that more bounds can and should be used in bank regulation, first, by showing that the banking environment satisfies the theoretical conditions for bounded structures, and second, by examining the ways in which the special features of bounds can help solve the urgent challenges in the bank chartering and ratings processes.