Finance VII

Judge Richard Posner's book "A Failure of Capitalism" famously blames the financial crisis on deregulation. In the Fall 2009 Claremont Review of Books, James Keller demolishes the claim:

There is a widespread view that the derivatives market is the Wild West, and that it is nobody's job to know who owes what to whom. Many seem to believe there are vast exposures lurking undetected by regulators. This view is nonsense. The Office of the Comptroller of the Currency (OCC) publishes a Quarterly Report on Bank Trading and Derivatives Activities that lists this information for the nation's largest banks, the top five of which represent 96% of the total amount. Want to know the volume of credit derivative contracts entered into by the Regions bank of Alabama? It's in Table 12. . .

The anticipated chain of events was a large hedge fund failing and taking down its lenders in a chain reaction. Instead, the banks failed, threatening the hedge funds. The rush to re-regulate ignores the reality that the least-regulated entities in the system--hedge funds--fared far better than the highly regulated entities like banks and insurance companies.

One would have expected this negative correlation between regulation and success in weathering the storm would have leaped out at Posner. It is the type of interesting insight he normally pounces on. He does notice that hedge funds fared a good deal better than banks, but rather than explore this interesting point, he uses the Bernie Madoff affair as further proof of the need to regulate hedge funds.

The lessons from Madoff seem very different from the ones Posner wants to draw. First, in a nation with over 8,000 hedge funds managing more than $1.3 trillion, cases of undetected fraud like this one appear to be extremely rare. Second, it is now well known that the SEC had clear warnings of problems with Madoff's funds--whistles were blown--but failed to act on them. In fact, the relatively good performance of hedge funds in general could force the conclusion that the informal networks regulating hedge funds--the scrutiny of funds of funds, outside consultants employed by pension fund investors, credit departments of bank lenders, and rigorous internal risk management--did a far better job sniffing out risk than the regulators keeping watch over banks.

Posner is so sure that deregulation caused the crisis, he hardly bothers to offer any evidence that it did. It didn't. There are really no linkages between specific deregulatory actions and the current crisis. Unfortunately, his admonition to go slowly in crafting new regulations is likely to be ignored, and the failed regulators are busy drafting new rules to cover past incompetence. To the extent Posner provides ammunition for the re-regulators, he does us all a disservice.

Agreed. Keller's conclusion is worth highlighting:

The Obama Administration's latest proposals for financial reform seem to envision a superhuman regulator who will catch excesses before they occur. This is naïve. Regulators need not be heroes if creditors have an interest in being vigilant; and creditors will have such an interest if recklessness faces the penalty of real loss. Unfortunately, we have just assured all creditors that their interests will be protected, no matter how reckless they are.

(via Powerline)