Arnold Kling

The Chess Game of Financial Regulation

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I lay out the ideas here. Let me know what you think.


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COMMENTS (19 to date)
anon commenter writes:

Thanks for another excellent post. I find that your articles - especially your "fantasy testimony" post here - are very valuable for introducing inexperienced readers to the causes and nature of our banking crisis.

El Presidente writes:

Arnold,

Regulatory systems break down because the financial sector is dynamic.

I wonder if you could elaborate. I'm genuinely interested in your take on this and is wasn't addressed head-on by your remarks.

I guess it sorta sounds like you're saying laws are ineffective because people will break them, or that the current crisis cannot be attributed to people breaking laws. It reminds me of a saying: "Locks are to keep the honest people out." Laws do not prevent criminal acts and I don't know why we would expect them to. If the crisis can be attributed to criminal acts then we have a harder time blaming the form of regulations, don't we?

I don't know that the static nature of regulations versus dynamic nature of the industry is so much to blame in our present crisis as the behavior of those charged with enforcing existing regulations. I think a lot of people didn't see it coming because they didn't fully know about the abdication of responsibility by regulators (e.g. the SEC with respect to Madoff). They trusted the numbers even though they were too good to be true. The failure to aggressively enforce regulations allowed some to artificially raise profit expectations for all and thereby to induce market participants to incur greater risk in order to remain competitive. How can we insist the problem was with the regulations themselves if we have good reason to believe were not applied with due diligence by the regulators?

If laws were broken and it hurt the broader economy, and if regulators were not diligent in their roles, what regulation would work in similar circumstances to prevent the collapse?

kebko writes:

el presidente, I know your question is for Arnold, but I think you're making this too black & white.

It's not like these regulations are equivalent to laws about murder or stealing. We're talking about arbitrary rules on capital positions. Just because someone managed their capital to deal with regulations doesn't mean in the least that there was criminal activity.
I personally am hurting due to the economic downturn & one reason is that instead of managing our finances based on our actual needs, we have funds in tax deferred accounts so that our decisions were frequently influenced by the fact that there were penalties to use our savings in certain ways & benefits to using them in ways that increased our leverage before the downturn. So, the 2 tiered set of rules for regular taxpayers between taxable investments & tax deferred investments influenced us to be more leveraged than we would have liked before the downturn.
I can assure you I didn't do anything remotely criminal, and I certainly wasn't out to trick myself into losing money. But, laws which seem nice on their face, which allow us to save money with tax savings, actually had negative unintended consequences. Lord knows, I love having tax deferred options for saving, but if a simple regulation this seemingly nice can come back to bite us, imagine what a tangle of unintended consequences there are with Wall Street regulations, even if you allow yourself to assume that Wall Street isn't full of a bunch of muggers.

And, I think an analogy that would apply to what Arnold is saying would be if you had regulations on who could own TV broadcasting stations, and then the internet comes along & all sorts of people are suddenly broadcasting in ways you can't control. Just because somebody uses a new medium that isn't addressed by existing regulations doesn't mean they are being even remotely criminal.

Les writes:

I think your comments are excellent. But I would add a few points, as follows:

“A sobering fact is that the response to each of the first two crises helped to lay the groundwork for the next – and current -- crisis.” This is a useful truth. One might add that each response to a crisis was more government intervention, which gives the lie to the allegation that the crisis was due to “a lack of regulation.”

“Mortgage-backed securities fueled a housing bubble.” Not necessarily. If the packaged mortgages had required down payments of at least 20%, monthly installments that were affordable in relation to borrowers’ regular income, valid appraisals of home values, and monthly installments which included amortization of principal as well as interest, then mortgage-backed securities would have been safer investments and much less likely to fuel a housing bubble. In brief, it was relaxation of lending standards that triggered the crisis, rather than mortgage-backed securities.

“When the crisis hit, the problems were exacerbated by market value accounting.” The alternative to “mark-to-market” accounting is valuation at nominal par. As you correctly point out, “subprime mortgages could be transformed into AAA-rated securities.” Thus subprime mortgages were much below AAA quality, and had values much below nominal par. It follows that market value accounting is more factual than the fiction of nominal par. In other words use nominal par if you want to be precisely wrong, or use “mark-to-market” accounting if you’d rather be roughly right.

Carl The EconGuy writes:

What's the purpose -- ultimate, real Pareto sanctioned purpose -- of regulation? As Arnold points out, regulation is often polluted by special interest concerns. Can we trust the regulators even when they know what they are doing?

Jeremy Bentham said that the common law makes law the same way you train your dog -- you wait until he makes a mistake, and then you beat him. Why? Because you don't understand the real thinking and psychology of a dog. Same thing with regulators. They wait until something breaks, and then they try to fix it. Welcome to most policy making in democracies. Problem with a stubborn dog is that he finds new ways of making mistakes, and welcome to the market.

But markets, unlike policy makers and dogs, are often fast learners. In the current crisis, lenders have now figured out that consumers can be really risky borrowers; hence, watch consumer credit contract. They've learned that derivatives can't eliminate the risk from unqualified borrowers if there are more unqualified borrowers than anyone knew; hence, watch them pay more attention to the behavior of rating agencies.

Still, there are bad regulations in place, and they don't change quickly. Mark-to-market fed the upswing, and made the down-turn worse. I haven't seen any real evidence, except assertions, that too low capital requirements for derivatives and non-bank financial institutions were the *cause* of anything -- the problem was, rather, a serious underestimation of the risks inherent in consumer speculation in real estate, but that was fed by bad law and easy money, read bad policy. Do we even know which regulations were bad and which ones were good, i.e., the kind that the market would not figure out for itself? I doubt that very much.

Who's going to regulate the regulators? Especially when the regulators are insulated behind laws that prevent us from beating them when they err? I don't trust Congress and Geithner/Benanke to sort this out because I think they will have complex motivations beyond simple Pareto sanctioned regulatory schemes.

The markets are waiting for whatever these guys, fumbling around in the dark with no real clear aim, will throw at them. Indecision and lack of purpose in regulation is as bad as bad regulation itself. We're watching a Kabuki dance playing out in ultra slo-mo, and we have no idea if it's a comedy or a tragedy, because the authors are busy writing the script during the play. They're making up the rules in the middle of the game, and the players are waiting.

El Presidente writes:

kebko,

It's not like these regulations are equivalent to laws about murder or stealing. We're talking about arbitrary rules on capital positions. Just because someone managed their capital to deal with regulations doesn't mean in the least that there was criminal activity.

I appreciate your sentiment. I guess my concern is that there was extensive, persistent, and very visible accounting fraud (Enron, Worldcom, Tyco . . . Madoff). People were reporting numbers that were untrue and stoking unrealistic profit expectations. I tend to think that there was sufficient opportunity for the SEC to delve into this problem and keep people from tainting the market to the extent they did. I see Arnold's point, and I think it's a good point with a good analogy. For regulation to work, regulators have to match the moves of the market. Otherwise, regulations can become antiquated and ineffective. In that regard, it is not the form of the regulation so much as the diligence of the regulator that is to blame. I guess I would like to see good performance on the part of the regulators before we pass judgment on a particular regulatory scheme or regulation in general. I don't think we've had that good performance in recent memory and it seems that execution of the law is a necessary and insufficient condition for the law to produce the effect we intend.

I can assure you I didn't do anything remotely criminal, and I certainly wasn't out to trick myself into losing money. But, laws which seem nice on their face, which allow us to save money with tax savings, actually had negative unintended consequences.

And this is precisely my concern. You cannot avoid the penalties. They are automatic. There is no comparable automatic enforcement with respect to the people charged with managing your tax-deferred savings. They were not held to the legal standard in many cases, so the bargain you struck (save now, spend later) locked your money in their control and nobody seemed too eager to police them. If regulators had been consistent, tough, and fair, you might have had lower returns all along, but also less volatility and risk. When people are encouraged to lock away their assets so that there is ample capital in our financial system, it seems right and fair to ensure that they are not being cajoled into accepting unwanted risk. In hindsight, would you have exchanged some of your return for greater security via more active enforcement?

El Presidente writes:

Carl The EconGuy,

Jeremy Bentham said that the common law makes law the same way you train your dog . . .

It's a good analogy. Sometimes though, the dog wants things it cannot have. I wouldn't suggest beating it, but what is the remedy for unreasonable expectations?

I haven't seen any real evidence, except assertions, that too low capital requirements for derivatives and non-bank financial institutions were the *cause* of anything . . .

This was the fuel, not the match.

. . . [T]he problem was, rather, a serious underestimation of the risks inherent in consumer speculation in real estate, but that was fed by bad law and easy money, read bad policy.

This was the match, not the fuel.

It takes both to make the fire.

Who's going to regulate the regulators?

We have to. That's our job. That's why I think we need to require regulation that is clearer, enforcement that is more agressive and consistent, and disclosure that minimizes the ability of individual actors and whole industries to transfer risk in exchange for short term rewards.

kebko writes:

el presidente,

I think I didn't explain myself clearly enough. My point was that there are rules that say I'll pay less tax if I put my money in "X", then there are rules that say, once in "X", there are penalties for taking it out of "X", so I have a jumble of IRA type accounts and I carry mortgage debt, because the government has made both of these positions so lucrative compared to the alternatives that my investment decisions end up being the product of these regulatory incentives instead of simply being a product of what my family needs for the long run. I'm not blaming anyone for my decisions, but I'm saying that the result of regulatory incentives for me to save (which sounds like a great idea) is that I am more induced to be leveraged. Incentives matter, and if all these tax breaks didn't exist, we probably wouldn't save as much, but we also would be less leveraged. This is analogous to what happened on Wall Street, and my point is that, as with my situation, Wall Street managers who were simply trying to maximize returns within the limits of the regulatory regime & its unintended consequences could certainly find themselves in a position which they never would have arrived at in an unregulated world, and without having any intent to defraud.

Methinks writes:

El Presidente

I guess my concern is that there was extensive, persistent, and very visible accounting fraud (Enron, Worldcom, Tyco . . . Madoff). People were reporting numbers that were untrue and stoking unrealistic profit expectations.

These are just cases of Fraud. You tend to think that the SEC had enough information to catch these things, but you'd be wrong. Unless the SEC itself audited every single statement these companies produced, they really weren't able to catch these frauds ("reporting numbers that were untrue" is too generous a description). Moreover, the regulator is so politically driven that politically connected individuals (Madoff) and companies are routinely left untouched even if there is suspicion.

Regulators act as industry policemen. Even if we remove politics (which we can't), the only way to catch fraudsters is to audit each statement itself and hope that there is no internal fraud. That's unrealistic and the expense of doing so is greater than the benefit such a program would provide because fraud is actually very rare (despite the media laser focus).

For regulation to work, regulators have to match the moves of the market. Otherwise, regulations can become antiquated and ineffective.

Two things: By "work" I'm assuming you mean "achieve their intended outcome". That's a fantasy if for no other reason (and there are plenty of other reasons) than the SEC is captured by the companies it regulates. It's a very co-dependent relationship. You're right about regulations becoming antiquated. However, regulations will always be out of date because the industry must dream it up before the regulator can regulate it. None of the things the regulator regulates are actually invented by the regulator. It's like computer security - security experts can only respond to new threats when they arrive on the scene after they've infected some computers. They can't defend against viruses that don't yet exist.

I guess I would like to see good performance on the part of the regulators before we pass judgment on a particular regulatory scheme or regulation in general.

You'll be waiting until the end of time. First of all, most of what you attribute to the failure of regulators isn't. Second, the regulator is incentivized to protect the industry rather than the consumer. Third, the regulator is under political pressure. Fourth, the regulating bodies are brimming with individuals who are less bright than the people they are regulating because the bright people are immediately lured away by private industry. The turnover alone is very disruptive. And finally, most of the requests and demands I get from my regulator are to show that whoever is sending the requests and demands is busy. They don't care much about the answer and they definitely don't want to be there past 5:00 pm. Plus, they almost never understand what they're looking at when I send it to them. No bright thing would prefer to work for a bureaucratic government nightmare when they can work for a dynamic and energetic firm, so the SEC gets only the people who couldn't find better opportunities.

Methinks writes:

We have to.

Who is "we"? This is a key point.

That's why I think we need to require regulation that is clearer, enforcement that is more agressive and consistent, and disclosure that minimizes the ability of individual actors and whole industries to transfer risk in exchange for short term rewards.

Do you know how often I violate some minor rule? All the time. That's how many regulations are on the books. The enforcement is aggressive. If it were any more aggressive, it wouldn't be worth staying in business because the cost of regulation would be too high - even with all the rents they wrote in for us. There's plenty of disclosure. Unfortunately, most people don't understand what is being disclosed. Disclosure is pretty worthless if you don't understand it. Transferring risk will always happen. But, I suspect that you're not really talking about transferring risk.

Although, with your fuel and match response, you seem to at least understand that regulation was not the issue. All banks were in compliance with regulation when they all went bankrupt (most, anyway). The regulator will never ever be able to prevent the next disaster and there will always be one. They can cause a disaster, but they can't prevent it.

El Presidente writes:

kebko,

I get it. So, I guess my question to you is, do you think that the impact of corporate financial misstatements and outright fraud was negligible, or do you think it had a significant role in the bubble and collapse?

Methinks,

You tend to think that the SEC had enough information to catch these things, but you'd be wrong. Unless the SEC itself audited every single statement these companies produced, they really weren't able to catch these frauds.

So, they had the statements but they didn't audit them. Thus they had the information and they didn't analyze it. That sounds like failure on the part of the regulator to me. It might be because they're dullards (I think they'd disagree). It might be because they are not given sufficient resources to enforce the laws that exist (they wouldn't say so in polite company). It might be because they have an interest in looking the other way (they might never admit to this). It's probably generous portions of each. However, none of these things means the rules were wrong. If we are concerned about getting rules that work, then we need to examine each of these causes of failure but not confuse them with the quality of the rules.

If reporting was standardized and automated, they could devise ways to track the information better. It can be done if we are at all inclined to make it happen. It would rub a lot of people the wrong way though, not the least of whom are firms that want to protect their 'privacy' by shrouding their financial statements in mystery. Many government workers will likewise be unenthused about having to be more thorough. It can be done, but it won't be pretty. We might even need to pay government workers more (gasp) so that we get the talent you say we don't already have. I see plenty of good explanations in your remarks for what failed, and I agree with 90% of your explanation. I see no reason to believe it was inevitable or that it must be in the future.

"We" is the electorate.

kebko writes:

I don't think fraud was systemic, but I only invest in companies with simple balance sheets, so I don't have any personal experience in checking the accounting on the companies at the heart of the bubble. And, I think it's rare in public discussions to see people make the proper distinction between employees & owners. CEO's have too much power, and there may be a decent group of employees that made off like bandits at the expense of shareholders, but generally shareholders have paid a high cost for this market. The shareholders who may be getting away with something are the ones who are at the Paulson trough, but government's active involvement in the industry is the problem there, not the solution, so I don't see how regulation has much to do with that.
I identify as a shareholder, and to the extent that the SEC is protecting me from CEO's, I would ask that they deregulate about 90% of what they do, because beyond some very basic rules of play & prosecution when frauds do happen, they don't do much of value for me.
As I said, I invest where I understand the numbers. There are companies I don't touch, regardless of the regulatory environment. I am an active personification of the way markets self-regulate. Maybe if we didn't pretend that the SEC could make those distinctions for us, more investors would act like me & companies with peculiar balance sheets would find it hard to raise capital.

That's probably not a satisfactory answer for you. I'd like to give you a satisfactory answer, but I think we're just operating with mismatched priors.

El Presidente writes:

Kebko,

I don't think fraud was systemic . . .

That may be, but profit expectations are systemic as capital seeks its highest return, wherever that may be. You are careful, but others may not be so careful or may be investing for a shorter period. So, the high mark sets the bar for others to match.

I'd like to give you a satisfactory answer, but I think we're just operating with mismatched priors.

Maybe, but I do appreciate the dialogue. Thank you.

kebko writes:

"others may not be so careful"

Then those others should lose their money. I frequently lose mine for any number of reasons, and would expect no less of everyone else. There are countless ways to lose money in the market. I don't see how it makes much difference for an investor if there are regulations purporting to protect against one kind of risk.
In fact, if all the regulations curbing corporate behavior, like many of these banking regulations do, were just eliminated, the end result would certainly be that companies would simplify in order to attract investment, because complications and overleverage would tend to drive away investors. That would be a good thing.

Methinks writes:

So, they had the statements but they didn't audit them. Thus they had the information and they didn't analyze it. That sounds like failure on the part of the regulator to me.

That's because you don't understand the role of the regulator. The regulator isn't equipped to audit every statement filed. They do random audits and audits if there's reason to believe something is amiss. The cost of auditing every statement would a.) outweigh the benefit and b.)not catch every fraud.

It might be because they're dullards (I think they'd disagree).

I'm sure they think they're plenty smart. Actually, I don't think they think about it at all. But, if you had to work with them, you'd think they were...um...not that bright. If I find a bright one, I'd offer him/her a job right away. So, the bright lights get picked off pretty quickly. One of my undergraduate classmates became an SEC lawyer and had to quit because it was no fun being so outmatched by industry (she was bright and got picked off).

Once again, the regulators don't enforce laws. Regulations are NOT laws.

It would rub a lot of people the wrong way though, not the least of whom are firms that want to protect their 'privacy' by shrouding their financial statements in mystery.

"Shrouded in mystery"? You really have no idea what you're talking about. Reporting IS standardized and automated. There is no "privacy" for public firms. Everything one needed to figure out Enron was disclosed in publicly available statements. In fact, the "cover" was blown by a fixed income analyst who only had access to publicly available information. To blow the cover on WorldCom, you would have needed access to NONPUBLIC information. The fraud of sticking expenses in CAPEX is not something the regulator would catch. EVER. It's the job of auditors.

"We" is the electorate.

First of all, the electorate doesn't own and didn't own Enron and WorldCom. The electorate was not invested in Madoff. Second, when have you gotten 10 people to agree on anything, much less 300 million? The "electorate" cannot effect anything.

You're living in a fantasy. Sure, we could pay regulators more and spend trillions of dollars auditing every statement. We still won't catch every fraud, but our costs will be so high that our standard of living will drop like a rock. Would the cost be worth catching the very tiny number of frauds out there? No. Not by a long shot. Just in case you think the regulators are just sitting around doing nothing, they are very busy harassing everyone in the industry. Everyone I know gets at least two requests per day about utter minutia which requires an answer and a copy of the company's procedures for dealing with said minutia. Then, they slap a fee on the company for some meaningless technical violation and justify their job to their boss. We pass that cost along to the customer in various ways but it's such a pain that many companies are just shutting down or moving out of U.S. markets. The United States is not the only place to do business, you know. The regulator may end up with no industry to regulate and we may end up with a stagnated economy.

As I said before, even if regulators audited everything all the time, they don't understand what they're looking at when I give them my company's data. If they show a glimmer of understanding, I'll probably hire them away. And even if they did all that, the industry would still stay one step ahead of the regulators by inventing something the regulator has no written regulation for. They will always be one step behind.

I mean no offense by this, but you are very ignorant of what actually happens in highly regulated industries. It's generally a very bad idea to demand change based entirely on one's ignorance.

El Presidente writes:

Methinks,

The regulator isn't equipped to audit every statement filed.

Then we should work on that.

If I find a bright one, I'd offer him/her a job right away.

Let's do something to make it worth their while to decline your offer.

Regulations are NOT laws.

Actually, you are incorrect. Regulations are not statutes, but they are law. It's a fine distinction. Don't feel bad; most people don't know that.

To blow the cover on WorldCom, you would have needed access to NONPUBLIC information.

Precisely.

First of all, the electorate doesn't own and didn't own Enron and WorldCom. The electorate was not invested in Madoff. Second, when have you gotten 10 people to agree on anything, much less 300 million? The "electorate" cannot effect anything.

The electorate is invested in the wellbeing of financial markets and the economy as a whole(AKA the general welfare). The electorate has made some very bad policy decisions in California (ballot initiative process). If they can make bad ones, they can affect something. I would like to help them make better ones. Fantasy? Perhaps. But the other options bore me, so I will indulge.

They will always be one step behind.

If it's only one step, that's close enough for me. However, I think initiative can keep policy makers one step ahead. "What is the price of gold today, Mr. President?" Let's hope that won't be necessary.

The Sheep Nazi writes:

"What is the price of gold today, Mr. President?" Let's hope that won't be necessary.

Let's work on making it impossible once again.

Methinks writes:

Then we should work on that.

One more time: too expensive.

Let's do something to make it worth their while to decline your offer.

I stick the auditors into an overheated, small, windowless room and don't feed them. They spend their time mired in boring minutia. A lot of them will take a pay cut to get away from that. Unless the SEC becomes the center of exciting financial innovation, nobody with a brain will stay long. Unless you're willing to pay more than industry, they won't stay. But if you're going to pay more than industry, where are you going to get the money?

The electorate is invested in the wellbeing of financial markets and the economy as a whole(AKA the general welfare).

So, your property is my property, right? In that case, I will use political connections to steal as much as I can.

If it's only one step, that's close enough for me. However, I think initiative can keep policy makers one step ahead.

One step behind is all it takes. How do you propose they stay one step ahead? Talk is cheap. Let's see your plan. Don't forget to weight the cost of your grand control plan with the costs. What you're sort of proposing is already basically government control of industry. We have plenty of experience with how well that works. Since you're such an expert on this subject, let's see your proposal.

El Presidente writes:

Methinks,

One more time: too expensive.

Let me get this straight. Entrepreneurship and innovation drive the private sector and yet are incapable of aiding the public sector? That seems more than a little inconsistent.

I stick the auditors into an overheated, small, windowless room and don't feed them. They spend their time mired in boring minutia. A lot of them will take a pay cut to get away from that.

I am told that in Italy the reverse is true. When the government requires an audit, the employees, managers and owners are detained within the business, the ledgers must be produced, and nobody gets to leave until the information can be validated. If your attitude toward auditors is that they exist to be screwed with, there are other enforcement models we can use.

But if you're going to pay more than industry, where are you going to get the money?

The power of taxation sounds like a good means to me. If compliance becomes expensive it creates a market for innovation. People will find ways to adapt and bring the costs of compliance down. When they do, we can reduce their taxes as costs decline. We only need to make sure that they are actually complying. Isn't that the beauty of the marketplace? Alternatively, we could revoke incorporation. Corporate charters are issued as a public trust and are never presumed by law to be permanent. The corporation has no property right to its business form.

So, your property is my property, right? In that case, I will use political connections to steal as much as I can.

What part of capitalization of value doesn't make sense? The reverse is equally real. If your house burns down next door, mine becomes less attractive. If you behave like a firebug and the house is your only property, will it suffice to wait until after your house burns down to do something to protect my equity and property? Property is not nearly as neat a concept as libertarians and likeminded individuals consider it to be. If markets exists at all, then value is always in some measure socially determined as consumers and producers compete amongst each other.

Since you're such an expert on this subject, let's see your proposal.

Thank you for the compliment. The basic thrust of it is this: when we have evidence that verifies the malevolence of owners and managers (like your comments above), government should have no qualms about meeting them with force. A person who's chief love is property is a sick individual. The personification of property is frequently accompanied by the objectification of people. We ought to be neither empathic nor abashed when it comes to breaking them at the root and laying them in the sunlight to whither. The funny thing is that people with something to lose usually find a way to lose as little as possible. They are, in a word, responsive. These are the people with whom regulation and oversight have the most consequence if they are applied diligently by people of integrity. Assuring regulators they will be cared for and will be caught and punished if they dishonor the public trust helps to minimize their incentive to be manipulated by private parties.

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