Arnold Kling  

The Financial Regulation Problem

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The beloved Henry Paulson writes,


In March 2008, after conducting a year-long process of study, I put forward a series of comprehensive recommendations to modernise our regulatory architecture in the Treasury's Blueprint for a Modern Financial Regulatory Framework. The blueprint identified an optimal structure that was not designed to be accomplished overnight.

Note the word optimal. My theory is that we always have an optimal financial regulatory structure--for the previous cycle's financial system.

That is, think of financial markets as going through cycles of euphoria, crash, and recovery. Give each round of the cycle a number. For example, the 1930's might be cycle number n. Then the S&L crisis would be n+1. The current crisis would be n+2 (if you ignore other events, like the Penn Central commercial paper crisis of 1970 or the August 1987 stock market crash or Long Term Capital Management or the Dotcom bubble).

Note that after crisis n in the 1930's, we created an optimal mortgage finance system, in the sense that we no longer had short-term balloon mortgages. Instead, we created the S&L industry, with a mandate to issue thirty-year fixed rate mortgages. We created an optimal system to prevent bank runs, with deposit insurance, deposit interest rate ceilings, and other regulations.

Guess what crisis n+1 consisted of? S&L's going belly-up, because the fixed-rate loans were under water in a high-inflation environment. The deposit insurance system was exposed to be badly flawed, at great expense to taxpayers.

Crisis number n+1 was exacerbated because the mortgage loans were not marked to market and because capital requirements were not tied to risk. So we created an optimal regulatory system, consisting of risk-based capital regulations and market-value accounting.

Guess what crisis n+2 consisted of? "Toxic" assets created to satisfy risk-based capital regulations (the infamous AAA-rated securities were just what risk-based capital was supposed to encourage), and a vicious spiral caused by market-value accounting, which made everybody have to sell illiquid assets at once.

Suppose Henry Paulson and all of the other "experts" get their way, and we create another optimal regulatory structure that would have prevented crisis n+2. Can you guess what crisis n+3 will consist of?


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COMMENTS (19 to date)
spencer writes:

The S&Ls were deregulated, so it was a free market solution that they destroyed themselves.

Under regulation Q they were unable to do the stupid borrowing short and lending long that did them in.

Your fantasy of how the S&Ls destroyed themselves is completely wrong.

Floccina writes:

You should have started with the creation of the Federal Reserve which was to end bank runs and smooth the business cycles by being the lender of last resort.

It looks to me like all these regulations are put in place after people have wised up and fixed the problem, like now people have already stopped investing in the institutions that made the bad loans and so we do not need the regulation in the short term. In the very long term people will forget and the pressure to make money through to much risk and leverage will once again build and find a different crack to express through. This gets to my belief on risk and moral hazard and how it actually works. I do not think that people rational say look lets take a risk because we will be bailed out or we are too big to fail but after they see and hear a story about an a company that fell they act a little more cautiously. I think that people drive a little more carefully after an acquaintance dies in a car accident or after they see an accident on the road. I do not think that they say I have air bags so I will drive faster but air bags might lower the chances that they hear of a death.

So all of these complicated regulation cost something but seems to help little so I think we might as well go back to free banking then maybe people we can have smaller banking crises every 5 years or so and dead carcasses of banks will always be around to serving as a warning the new crop of bankers.

seff writes:

spencer, before you start chucking around terms like "fantasy", why don't you take a gander at the wikipedia?

Savings and loan crisis

Causes:

By enacting 26 U.S.C. ยง 469 (relating to limitations on deductions for passive activity losses and limitations on passive activity credits) to remove many tax shelters, especially for real estate investments, the Tax Reform Act of 1986 significantly decreased the value of many such investments which had been held more for their tax-advantaged status than for their inherent profitability. This contributed to the end of the real estate boom of the early to mid '80s and facilitated the Savings and Loan crisis. Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor's gross income. This, in turn, encouraged the holders of loss-generating properties to try and unload them, which contributed further to the problem of sinking real estate values. This turmoil and repositioning in real estate markets was caused not by changes in market conditions.
seff writes:

What I am saying is: deregulation does not necessarily equal free market. Deregulation in practice is a change in the governing rules.

david writes:

Regulation or intervention to address crisis N invariably introduces more moral hazard which, of course, sets the stage for crisis N+1.

Gavin Andresen writes:

It seems likely to me that crisis N+3 will be triggered by high inflation (I think double-digit inflation will be the least-politically-painful path out of this mess, so that's where I think we'll be in a couple/few years).

It's not clear to me which US financial institutions will get clobbered if inflation ramps up-- pension funds maybe?

spencer writes:

self -- please explain how what you are talking about has anything to do with the S&L's borrowing short and lending long.

Jim Ancona writes:

Spencer, what is the mechanism by which "deregulation" in the form of changes to Regulation Q caused the S&L crisis? I see them more as a too-little, too-late response to the the dislocations caused by the high inflation rates of the seventies (which were the result of government policy).

Jim

seff writes:

spencer, deregulation with the S&Ls was not free market, but a half-assed measure. They gave S&Ls more leeway to lend, but covered their losses with FSLIC insurance. This created a moral hazard.

Compounding this problem was the regulation I noted: Tax Reform Act of 1986. Which resulted in a dumping of real estate assets upon the open market. This act coupled with deregulation helped create the perfect storm which was the S&L crisis.


Nathan Smith writes:

It tempts one to ask: Why is financial regulation needed at all?

Protecting property rights is an extension of protecting people. Enforcing contracts is an extension of protecting property rights. Contracts often need to extend over time: you do x for me today, I do y for you tomorrow. Because the future is uncertain, my promise to do y tomorrow is inevitably conditional. This is not always important, but it often is. Enter risk.

Good-faith entrepreneurs raise money for projects they *believe* will pay off, at least in expectation. This belief will typically be based on some combination of reason and experience. Experience, however, can be a misleading guide.

Suppose I start a financial firm whose strategy consists of betting against something unlikely-- say, against a black man being elected president of the United States. For a couple of hundred years, this is a winning strategy, and I pay solid returns to my investors year after year. Then Barack wins, and-- boom!-- I'm bust. My counter-parties who bet the long odds against me are hoping for big payoffs now, but I can't pay. My investors' shares' values fall to zero, but they still did all right in the long run; in effect, they were accomplices in a con. I lose my job but keep my salaries and bonuses from past years and retire to Maui. If I'm very stupid, I might not even feel guilty about the affair. After all, the strategy had always worked before. How was I supposed to know the world was suddenly going to change?

The ultimate task of financial regulation should be to prevent this kind of con, which I think is what Tyler Cowen calls "writing naked puts," and which of course might be done in good faith by the people actually involved, the S&L's, banks, or whatever, or, more likely, done by people self-selected to be a bit stupider and greedier and more subject to self-serving bias than most, but not actually consciously dishonest. It's naive to decry financial regulation generally because financial regulation is an extension of the basic government function of property rights enforcement. But it's also naive to expect financial regulators to anticipate the ingenious new forms of writing the naked put that will evolve. This rhythm of market and regulatory co-evolution punctuated by crises may be the best we can hope for.

The only thing I'd add is that *morality* is important. Bankers should have a sense of honor, and should regard the prospect of being unable to fulfill their obligations with a sense of moral horror. This should be strong enough to cause them to forego some profit opportunities.

Michael Smith writes:

Spencer wrote:

The S&Ls were deregulated, so it was a free market solution that they destroyed themselves.

A free market does not feature a fiat money supply under the control of a central banker with the virtually unlimited, arbitrary power to expand or contract that fiat money at will and thus cause interest rates to be above or below their natural level. So whatever caused the S&Ls to go under, it did not occur in the context of a free market.

L. Burke Files writes:

The only regulation needed is "Full Disclosure", real and true full disclosure. That followed with the statute of frauds for punishing those who fail to fully disclose.

The rest of the regulations have been aimed at making the regulators Nanny's. The Nanny's are their to make sure their charges, investors, never get a booboo on Wall Street. Thus, Wall Street has been slowly regulated out of its function, as place to offer risk in exchange for possible rewards.

Is it any wonder, that Wall Street is in decline and the freer markets of Asia are on the rise?

The Sheep Nazi writes:

Forgive my ignorance, but I had though that all banking is borrowing short and lending long. (Maybe I've been reading too much Mencius Moldbug, but the basic notion that a demand deposit is a zero-term, continuously rolled-over loan from the depositor to the bank makes sense to me.) If that's true, then surely what happened to the S&L's was that the statutory mix of short and long was changed, and that the anticipated benefits ( S&L's staying competitive in an inflationary environment ) did not materialize, whereas some whacking great side effects did. Such are the perils of a mixed economy.

Greg Ransom writes:

This is sort of a "financial crisis cycle" version of Hayek's intervention ratchet in "The Road to Serdom".

The Snob writes:

@Floccina:

What we call recessions were in the 19th century often called "The Panic of 18--." It is not clear that is a lost golden age for which we should pine.

@L Burke:

Which Asian markets are we talking about? At least one of them is in a country where people are huge savers and forbidden by law from investing on foreign bourses. Many of the others have funky regulations on moving investments in or out of the country.

tom brakke writes:

First a disclosure: I have been personally involved in a major regulatory endeavor, the Global Research Analyst Settlement.

You are correct that most regulatory actions look backward instead of forward. That's not too surprising, since it is an apt description of most human endeavors.

The challenge for regulatory authorities is to get in the information flow and to seek out experts in all areas of importance in the markets on an ongoing basis, to get a view of how things are changing and where the evolving issues and risks are. Unfortunately, those giving advice are often "talking their own book" (perhaps even one B. Madoff when he was asked to give input on regulations); we need to find people who have the expertise to contribute and are willing to do so for the benefit of the system as a whole.

Nigel Kearney writes:

>Can you guess what crisis n+3 will consist of?

We don't know right now what crisis n+3 will consist of, but we'll be able to work it out as soon as we hear the 'solution' to crisis n+2.

Caliban Darklock writes:

I speculate that the earliest accurate predictors of crisis n+3 will make a boatload of cash by exploiting it.

Probably a good business to try and build on the side of whatever you're doing now. Sure, people will hate you; who cares? You'll be rich.

hacs writes:

That seems "we augmented the food production and now we have epidemic obesity", "we invented the penicillin and now we have super streptococci", "many countries are growing but that causes global warming", "we created competitive markets but when that mechanism is used to rent seeking, corruption, gangsterism, etc., its almost inherent efficiency causes enormous destruction", etc. So, what is the point?

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