Friday, September 18, 2009

Financial regulation

A few good columns on the subject of financial regulation found on realclearmarkets this morning. First up is Veronique de Rugy, who asks if this is what the alleged deregulation over the last two decades looks like:

Next up is Johan Norberg, discussing regulation and its unintended consequences:
In the 1970s, the SEC gave the big rating agencies a regulatory role. They got the right to officially define risk, and other investors were forced to abide by them; many funds were not allowed to invest in anything that was not considered investment grade, and other institutions were forced to hold more capital if they did.

This oligopoly was granted in order to control risk. But the institutions used their new role to inflate the ratings, and dangerous mortgage-backed securities were suddenly considered risk-free. The deal would get the same generous treatment even if it was structured by cows, as an analyst at a big rating firm said in an internal discussion. Since the cows paid well, and the market was forced to follow the ratings anyway, why not?

The banks did not hold these securities in a transparent way, but in the opaque "shadow banking sector, " in an attempt to reduce risk. The smartest bank regulators in the industrialized world met for six years to produce the Basel agreements on capital requirements for banks. Their requirements made it expensive for banks to hold assets - like mortgage-backed securities - on their balance sheets, but very profitable to put them in non-transparent conduits or vehicles financed by short-term loans on the market.

So even if the best and the brightest introduce regulation because they think it is in mankind's best interest, there are unintended consequences. Indeed, bureaucracies and governmental authorities also have their own agendas and their own interests, and sometimes that trumps social welfare. One reason why financial regulators did not notice what was going on was that they were engaged in turf war. One former SEC commissioner admitted that his agency failed to develop open marketplaces for mortgage-backed securities because it was "distracted." The object of its time and resources: grabbing power from other government agencies by starting to regulate hedge funds and introduce new types of supervision of mutual funds.
Lastly, Robert Pozen argues that some of the actual deregulation which occurred during the Clinton Administration -- the repeal of the Glass-Steagall Act -- actually helped to ease the financial crisis:
At the same time, the repeal of Glass-Steagall facilitated the rescue of four large investment banks and thereby helped reduce the severity of the financial crisis. When Bear Stearns and Merrill Lynch got into serious trouble, they were promptly acquired with federal assistance by JPMorgan Chase and Bank of America, respectively. These rescues happened only because banks could own full-service broker-dealers. When Goldman Sachs and Morgan Stanley were challenged to find adequate short-term funding, they were allowed to quickly convert from broker-dealers into bank holding companies.

Banks have a significant advantage over broker-dealers in obtaining short-term financing in illiquid markets. A bank can rely on insured deposits and Fed loans as well as short-term financing in the form of commercial paper. Commercial paper buyers are a fickle bunch. Bank depositors are more stable retail customers.
As I have said before, at its core much of our regulation is based on the idea that government officials know better how to run a business and the inherent risks involved than those who actually work in the industry. It's an absurd proposition that appeals more to people's fears -- more rules can avert the next crisis and protect you -- than their intellects.

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