Arnold Kling  

Regulation that Encouraged Herding

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Avinash Persaud writes,


During booms, asset prices rise and measured risks fall. Acting prudently, financial firms will feel it is safe to expand lending. All financial firms expanding together will lead to a scramble for assets that will lead to unsustainable valuations and lending.

In this context, risk rules for individual firms tend to be procyclical. In good times, asset values are high and capital is adequate for expansion. When times turn bad, everyone has to sell the same assets in order to meet capital requirements.

Thanks to Mark Thoma for the pointer.

In 2000, Persaud wrote a paper that anticipated many of the problems that emerged in the recent crisis. He wrote,


markets find it hard to distinguish between the good and the unsustainable, market participants herd and contagion is common.

It is not just markets that find it had to distinguish between the good and the unsustainable. See a subsequent post on Gillian Tett's new book.


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COMMENTS (3 to date)
Jeremy, Alabama writes:

That's why there are contrarians.

El Presidente writes:

People have been known to purposefully engage in unsustainable behaviors with the hope that their personal benefit will exceed their personal cost or that the costs can be delayed. Which financial advisor wants to be first to say "This doesn't make sense, so I think you should play it safe and settle for a lower return" while everybody else is reaping large profits? Apparently it's one who doesn't mind losing his clients to competitors.

Herding is a defense mechanism that occurs when uncertainty prevails. People seek an equilibrium even if it is unstable. They try to get to the middle of the pack where they will be the last harmed. If we were more explicit about the good and bad of economic trends in real time, uncertainty would be reduced and individuals wouldn't be as inclined to inadvertently stoke market swings by herding. Instead we sound like cavemen grunting, "Bigger GDP good". My apologies to the GEICO cavemen.

Walt French writes:

...risk rules for individual firms tend to be procyclical.

Indeed, they are meant to be. When the Fed alters reserve requirements, opens the window, changes Fed Funds or any of its myriad of controls, it is with the express intention of changing our society's leverage.

Without standards enforcing minimum loan/equity ratios, etc., the Fed would only have sloppy controls over the banking system, if any.

The regulations are NOT the problem. The problems can come from the Fed allowing way too much or too little credit, with bad outcomes either way, as it, or the real economy, tries to cope. Especially with rapid changes. Or, they can come from the Fed accommodating lousy fiscal policy.

Many readers will have other candidates, but I don't think that many would want to disband all rule-based controls over the banking system. The alternative is either the pre-Fed chaos (probably, multiplied many times by our instant-transaction systems today) or a completely nationalized banking system.

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