Professional football has a lot to tell us about financial reform, and in particular what we should seek to achieve.   A comparison also suggests a way to think about restructuring the financial regulatory system.

In pro football, there are rules and regulations which govern three key aspects of the game.  One set lays out the basic parameters and nature of the game, such as the dimensions of the field (100 yards long with 10 yard end zones), the number of permissible downs to gain 10 yards or the ball turn overs to the other side, how points are scored, the number of men on a team, how many men must be on the line of scrimmage, how many men on offense can be in motion at one time before the ball is snapped, etc.  They play football in Canada too, but the initial rule parameters are so different that Canadian teams can’t play U. S teams.  The field is longer, the end zones are bigger, the scoring is different, there are 12 not 11 men on a team, more than one player can be in motion on offense, there are 3 not 4 downs to make a first down, etc. 

The second set of rules ensures safety and permissible and impermissible behaviors that define fair play.  This includes the definition of off sides, what constitutes a personal foul, when is a catch a catch, etc.

The third set of regulations are more global in nature and attempt to ensure that over time all teams have a reasonably equal chance to succeed.  The league imposes a salary cap which constrains total team budgets to ensure that big market, high revenue teams can’t fully exploit that advantage to buy the best talent.   But the league does not set or determine individual player salaries.  The draft is structured to give weaker teams priority access to talent, and yearly team schedules attempt to match up weaker teams with weaker teams and stronger teams with stronger teams as a form of handicapping.  Together, these regulations are designed to create a more level playing field and to prevent one team from long dominating others.

Over time, all these rules can change, for example, as offensive or defensive innovations evolve to give one a permanent advantage over the other, as certain blocking or tackling techniques threaten player safety, or as other innovations, such as the forward pass come into existence.  However, such changes occur gradually.

These three sets of rules are analogous to financial regulations.  One set of financial regulations sets up permissible powers for banking organizations, where they can operate, under what circumstances they can merge, coverage limits for deposit insurance, etc.  A second set of regulations – fair play regulations - govern primarily what must be disclosed to investors, what information must be given to depositors about the products they are contracting for and what the rights of debtors and creditors are in the case of default.  Financial institutions are also subject to anti trust and anti fraud regulations and standards which again define the rules of the game in terms of how they may compete with each other for business.  The third set of regulations govern institution safety and soundness to ensure that firms don’t exploit moral hazard incentive in government sponsored deposit insurance. 

Once the game begins, in the case of football, it is overseen by supervisors – referees – whose job is to enforce the rules of play and determine when violations of fair play occur.  There is not one referee, but four who are located on different parts of the field and specialize in watching the defense and offensive line play, the back field and defensive backfield.  In spite of this specialization, however, each can call violations and when two referees see the same play differently, they quickly resolve the issue and play goes on, perhaps with the benefit of instant replay.

In financial services, supervisors function as referees, and institutions’ actions may be scrutinized by more than one supervisor as well as by representatives from the Securities and Exchange Commission and Federal Trade Commission.  They can specify and enforce the applicable rules and also ensure that the participants are financially sound and can meet their obligations.

In football, the best referees are invisible in that they enforce the rules but don’t participate or interfere with the playing of the game.  Teams can succeed or fail, but they can do so on their own, within the rules.  It is critical that referees’ decisions not determine the outcome of the game, especially if an important play is either allowed or disallowed in error.  This too, should be the goal of financial regulation.  Financial institution supervisors should not be interfering with the playing of the game (such as allocating capital within healthy institutions) but instead should simply be determining whether institutions are competing fairly while being operated in a safe and sound manner and reporting their financial performance in a meaningful way.  Unfortunately, this is not the case.

In responding to the current financial crisis, the financial services game has now been altered in hurried and ad hoc ways that differ from the ideal just described.  Imagine a football game in which the referees can now specify not only who plays quarterback, but also how much he can be paid?   This is what the government is doing by dictating executive salaries and determining which CEOs must leave and who can stay in charge of their firms.   In some instances, the referees can even call the plays in that government representatives are “suggesting” that mortgage terms be renegotiated, certain business lines be terminated, etc.  The government is also now giving some institutions a financial advantage by liquefying illiquid assets, providing capital injections, granting special access to the Federal Reserve’s discount window, and making direct loans to troubled institutions. Over the longer term, should too-big-to-fail be maintained as a policy – explicit or implicit – this will be the equivalent to giving large market teams permission to exploit their financial advantage.   Should the present regulatory approach continue, it is also not hard to imagine the conflicts of interest that will confront the regulators.  As participants, rather than simply disinterested arbitrators of the financial game, they will inevitably have a stake in the outcome of the institutions that they have supported, be those institutions primary dealers or those in which the government has invested funds. 

Given the current regulatory approach, it is also easy to prioritize the areas that should first be the target of financial reform.  For example, re-establishing the regulatory agencies as unbiased supervisors and not participants in the game should be a top priority along with removing capital support, government ownership, and involvement in intuition management.  Similarly, ensuring that all institutions are adequately capitalized and eliminating the financial advantage that large institutions have over small ones due to implicit guarantees or too-big-to-fail polices are critical, as well.  Setting executive salaries may seem like an easy target, but will only get government more deeply involved in the micro management of institutions in an unproductive way.  Reforming regulatory structure should also be a lower priority activity compared with changing the underlying incentives to enforce the existing rules of the game, to ensure sharing of information and to resolve regulatory and jurisdictional conflicts promptly.  Football has multiple supervisors with over lapping responsibilities, but the referees’ incentives are better aligned.  Finally, as financial services have evolved into a global business, we now have firms competing with each other under unequal terms.  It is like having professional teams from Canada playing ones from the U.S. but with different rules, scoring and numbers of players. It just won’t work in the long run.   Hence, international cooperation and coordination are a must if the financial game is to be played fairly. 

This homely analogy suggests a litmus test question for assessing and prioritizing financial and regulatory reform proposals.  Would they make sense for football?