Thursday, April 22, 2010

The Myth of Super-Regulator

UPDATE: I'm speechless.

Re-regulation is all the rage. The underlying assumption is that regulators could prevent mishaps, like the credit crisis, better than the free market.

I'm skeptical--ill-designed regulation and political influence, such as with Fannie/Freddie, were partially responsible for the financial melt-down. That's not necessarily the fault of regulators, but it is systemic, according to Ilya Somin's essay on Volokh Conspiracy on why regulation by well-meaning paternalistic bureaucrats often fails:
Regulators Lack Expertise on the Subjective Benefits of Risky Activities.

Regulators may have greater knowledge than consumers about the health or safety dangers of risky activities. But they lack comparable knowledge of the benefits that consumers derive from those activities. A public health expert probably knows more than I do about the risks of drinking or smoking. But only I know how much enjoyment I derive from having a beer or puffing on a cigarette. This is especially true when we remember that preferences about such things vary widely. . .

Limitations of Regulators’ Analysis of Risk.

Expert regulators are also vulnerable to interest group pressure. The more complex and technical the regulations they administer, the greater will be the opportunities for interest group lobbying and "capture" of the regulatory process, since rationally ignorant voters will have great difficulty in monitoring the experts performance. Ironically, expert regulators will be least likely to function as truly disinterested experts on precisely those issues where expertise is most needed. . .

The Advantages of Relying on Private Sector Experts.

None of this proves that we don’t need experts. To the contrary, there are many decisions where we can benefit from expert advice. However, the private sector offers a wide range of opportunities to avail ourselves of such advice without incurring the risks posed by government coercion.
And nothing's different in the Obama Administration (especially the SEC).

Read the whole thing.

(via Instapundit)


computer gadget said...

Hem......interesting post

A_Nonny_Mouse said...

NEW regulations aren't necessarily the answer; enforcing EXISTING regulations would go a long way toward restraining those who try to gin the markets.

It's the "broken windows theory" applied to finance: when banks see there's BIG money to be made, and nobody is calling out anybody else on questionable activities (like bundling BBB investments and rating some tranches of the bundle as AAA), they may be unable to resist the temptation to join the party. After all, their job is to make money, and "everyone else is doing it".

Carl said...

A_N_M: The rating agencies clearly were mistaken in giving AAA ratings to bundled BBB mortgages (as Michael Lewis's latest book details). But this was neither fraud nor a violation of any existing regulation. Moreover, I'm not sure (nor is Lewis) how to fix it. Thus, I'm not sure your example supports your conclusion.

Geoffrey Britain said...

The answer is simple, look to Europe. Europe's love affair with regulation hasn't helped with Greece, Portugal, Spain, Ireland and Iceland, In fact, every Western democracy is now insolvent.

Regulation in favor of a fair economic playing field, something we once had is in everyone's interest. Regulation supporting an entitlement state is a formula for economic collapse.

Bob in Los Angeles said...

The best way to regulate the industry is to keep their hands out of the U.S. Treasury. Everything else is secondary.

Carl said...

GB: Agreed.

B_I_LA: It's not that simple, at least in finance. We need deposit insurance for commercial banks. Therefore, for those institutions, there's always a link to the Treasury (and always a need for some regulation). What I oppose is the extention of that concept to investment banks, Fannie/Freddie, and automakers. AIG is a closer call, but the justification for that bailout remains the risk to counterparties who may have crashed if AIG went under.

Outside of the financial sector, I agree completely--hands off the Treasury.

Bob in Los Angeles said...

Carl -- Part of our disagreement may be in perception, part may be in policy.

There were several other alternatives to paying off AIG 100 cents on the dollar -- including (1) paying off a fraction of the dollar (2) canceling AIG's contracts with the banks and returning their initial investment and (3) letting AIG dig their own hole. None of those alternatives was debated seriously as Goldman Sachs et. al. created such a crisis that the government 'had to step in'. The decision to pay off AIG for 100 cents on the dollar was not a 'close call' from my perspective as you put it. It was simply the investment banks opening up the treasury to fill AIG's coffers so they could be paid off in full. A horrible policy decision that allowed all the politicians to brag they 'averted disaster'. Hogwash.

As for deposit insurance -- that can be privatized it does not need to be backed by the treasury.

Another lesson in 'less government is better' and that our politicians have only their interests in mind.

OBloodyHell said...

> As for deposit insurance -- that can be privatized it does not need to be backed by the treasury.

I wasn't going to state that as a given, but that was my initial response, too.

I think we allow fractional reserve banking to cut a rather too fine line on the amount in reserve, but I don't see how a fully privatized FDIC would be a bad thing.

Carl said...

B_i_LA & OBH: I yield to none in my preference for reliance on the private sector. Yet I wouldn't apply it to commercial bank deposit insurance for five reasons.

First, a bank per force seeks to guarantee soundness; deposit insurance steps in when there's a failure. Second, privatizing deposit insurance merely would force regulators to scrutinize the terms and conditions of the private guarantee contracts, and the soundness of that entity, in a fashion that wouldn't in practice result in reduced regulatory oversight. Third, the risk of failure of the private entity would drive up the cost of capital and reduce liquidity--the last thing we need now. Fourth, and alternatively, as practical matter, in order to prevent systemic financial meltdown, the Federal government would continue to be perceived as the guarantor of last result--so we might as well be explicit. Finally, private guarantees didn't work for private pensions; hence the PBGC.

In sum, deposit insurance is one Roosevelt-era invention I think better than the alternative.

MaxedOutMama said...

For seventy years we had a separation between investment banks and commercial banks, and we had a stunningly stable but very dynamic banking system.

There is no way a regulatory body can successfully deal with the risks involved in investment banking. You have to let them fail if they do fail - that is the only real corrective.

But if you separate the commercial banks and insurance, your entire financial system does not go down, and you can deal with any shocks.

The real solution is to separate their activities again.

Second, we have allowed two commercial banks to get "too big to fail". They are Citi and BofA. Citi is going to have to sell off some, but BofA was allowed (and encouraged) to aggregate to much with the ML and CW purchases. We should move toward a statutory separation of risks and these two organizations should be forced to separate their activities.

Finally, we simply must institute a swaps exchange and regulate that similar to commodities.

The problem with thinking regulatory bodies can control these risks is that they can't. The risks exist; regulatory bodies have tended to make them worse of recent years.

Carl said...

I agree with some, but not all, of M_O_M's points, especially the limits to regulation and the inadvisability of bailing out investment banks. But, I remain unpersuaded about re-imposing a separation between commercial and investment banks: combined banks were not more likely to fail, bank mergers aided recovery and Europe never separated banks, yet had similar failures. I agree with M_O_M that commercial banks' investment in less-regulated non-bank activities (e.g., Wachovia/Golden West) is a problem, and perhaps should be constrained. But I don't know whether, or how, to re-regulate such currently less-regulated industries (like non-bank mortgage companies). Further, while there's scope for increased transparency in derivatives, I'm not sure that commodities-type regulation is warranted: derivative and CDO buyers know that their counterparty is placing the contrary bet and, if fraud occurred, it already is unlawful.

I'd support separating investment and commercial banks if I thought it would have moderated the current crunch or help prevent the next. But, so far, that case hasn't been established.

Carl said...

Via A_N_M, from biz prof Peter Morici in the NY Post:

"Banning banks from derivatives makes little sense, unless we bring back the Glass Steagall Act and restrict banks to taking deposits, making loans and holding government debt -- and Congress has no stomach for that.

Banks provide trust services and make markets in municipal and state bonds -- both vital services. Banks need to hedge positions, and the recent financial crisis would not have been averted had JP Morgan, Citigroup and other big banks been banned from derivatives trading.

Virtually all of the 200 banks that failed over the last two years had no trading desk. Most failed making lousy loans and investing in poor commercial mortgage-backed securities. Now, investment banking activities -- yes, trading -- is helping to redeem Citigroup. . .

On synthetics, arbitrary limits just won't work. Derivatives are simple contracts among consenting adults, and we know how laws to enforce private morality work -- they don't."