Arnold Kling  

Financial Reform, 2

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This is the promised follow-up to Friday's post. These are further notes from the conference on financial regulatory reform.

The last speaker (the best, in my view) had a number of good points. What follows are my notes on what he said.

First, we are bound to get some legislative change. We have not had a major financial crisis in this country without political repercussions. (Me: I hope that what they do is mostly symbolic and has little substance. The more substantive the reform, the more likely it is to do harm.)

He compared securitization with asbestos in buildings. It seemed like a great idea at the time, but in the end it caused huge problems. In particular, mortgage securities fell apart in an environment where house prices declined. Securities need to be redesigned to be able to handle that event.

There seem to be multiple equilibria. How do we prevent bad equilibria?

Another point was that bank regulation and the resolution of failed institutions worked reasonably well at small banks. The problem was that with large banks regulation failed and failures were impossible to resolve quickly enough. (Me: Simon Johnson would argue that the problem with regulation was regulatory capture by the large financial institutions, and what we need are smaller banks. Johnson was not at the conference.)

The Fed is the de facto systemic risk regulator, and Fed already "takes everything into account." The issues that people think of as systemic risks, such as the housing bubble and shadow banking, were under discussion at the Fed. For example, Ned Gramlich, the late Fed governor, wrote a book on the problems of sub-prime lending. William Poole, a former Fed President, was one of the most outspoken critics of Freddie and Fannie. Gary Stern, another Fed President, was outspoken on the issue of "too big to fail."

During the general discussion, one participant pointed out that systemic risk regulation might lead to unintended consequences. Suppose that a systemic risk regulator in 1995 had looked at Netscape's initial public offering and seen irrationality and a potential bubble. Would the regulator have clamped down on IPO's by internet firms? Would we be better off if a clamp down had taken place?

Also, how is any one firm supposed to be able to predict the behavior of a systemic regulator? A firm could put a lot of effort into creating an innovative product or process. After it gets going and start to earn a return on investment, it could be whacked by the systemic risk regulator. What happens to the effectiveness of financial markets in that environment?

Overall, what was least satisfying about the conference was that we did not have a working definition of "systemic risk." I think that is a big issue, and I will try to write more about it. As readers of this blog know, I think it is important to separate out three issues:

1. Financial institutions making bad bets.
2. Financial institutions making bad bets with lots of leverage, often spurred by government policy.
3. Bank runs and their equivalent.

I want to limit the notion of systemic risk to (3), rather than include (1) and (2). But I think that the financial crisis of 2008 was mostly (2), and too often in discussing financial reform people fail to distinguish (2) from (3).

Another issue to think about is that of risk-taking and incentives. In my view, the process of selecting financial CEO's selects over-confident, aggressive men. (At the conference, I repeated my line that if I were a regulatory czar charged with getting the risk-taking out of banks, then I would change the gender of the CEO's at those companies.) Maybe changing the compensation structure would change that selection process. But I would like to see a system in which government-backstopped institutions are run by boring bureaucrats, and the gunslingers are drawn to institutions that can fail without attracting public bailouts.


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COMMENTS (2 to date)
Matt C writes:

In my view, the process ... selects over-confident, aggressive men ... I would change the gender of the CEO's at those companies.

Heh. I hope this is the policy suggestion that you wanted to be remembered for, because it is more likely to find its way into the mainstream than anything else you've said.

But I would like to see a system in which government-backstopped institutions are run by boring bureaucrats, and the gunslingers are drawn to institutions that can fail without attracting public bailouts.

I'd like to see a system where there are no government backstopped institutions at all. I do not think my daydream is particularly more unrealistic than yours.

Arun Eamani writes:

Under CAPM, Portfolio risk is less than sum of individual instruments idiosyncratic risk.

Systematic Risk could be defined as risk when the sum of portfolio's risk is greater than the idiosyncratic risk of the participants portfolio's

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