Arnold Kling  

Time Consistency in Bank Regulation

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David Leonhardt writes

By definition, the next period of financial excess will appear to have recent history on its side. Asset prices will have been rising, and whatever new financial instrument that comes along will look as if it is safe. "When things are going well," Paul A. Volcker, the former Fed chairman, says, "it's very hard to conduct a disciplined regulation, because everyone's against you." Sure enough, both Bernanke and Geithner, along with dozens of other regulators, overlooked many signs of excess over the past decade.

The essence of Leonhardt's article is a sympathetic portrayal of Treasury Secretary Geithner.

He warned that periods of calm often led to unanticipated crises and that once confidence started to slip, it could quickly vanish. Intellectually, he understood how things could go wrong.

What he missed, however, was the fact that things were going wrong in some of the very institutions he was overseeing. "Financial innovation has improved the capacity to measure and manage risk," Geithner said in a speech at a Fed conference in Georgia in May 2007. Large firms, he added, "are generally stronger in terms of capital relative to risk." Bernanke, who may have years as Fed chairman ahead of him, made statements that look even worse in retrospect.

The basic message of the article is that human nature makes regulation procyclical, meaning that regulators naturally loosen up in good times and tighten up after a crash. The challenge is to come up with a time-consistent regulatory regime.

One time-consistency problem is making credible commitments not to bail out failed banks. You promise not to bail them out, but when the crunch comes the incentive of policy makers is to bail them out. It is exactly like paying ransom to a kidnapper. To discourage kidnapping, you want to have a policy of never paying ransom. But when the kidnapping occurs, your incentive is to pay the ransom "this time," because you cannot tolerate the consequences if you do not.

The other time-consistency problem, which Leonhardt's article brings into focus, is that you need to make credible commitments to keep rules in place when times are good. So now, when we've just had a crash and nobody is in a mood to take risks, it may be relatively easy to enact regulations that limit risk-taking. But as time moves forward and banks become willing to extend credit more readily and undertake innovative financing methods, the commitment to today's regulatory regime is going to break down.

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COMMENTS (7 to date)
Floccina writes:

He warned that periods of calm often led to unanticipated crises and that once confidence started to slip, it could quickly vanish. Intellectually, he understood how things could go wrong.

After your Passover sermon I was just thinking about the year of Jubilee in the bible. If every so often the financial system blows up, a year of Jubilee might be an interesting attempt at a solution. In the year of Jubilee, every 50th year, all debts are wiped out. So the terms of loans would get shorter as the year approaches. The change might be enough to keep everyone paying attention. Just an interesting thought. One should wonder why such seemingly strange laws existed.

Ted writes:

I don't think it's possible to make a credible commitment to not bail out firms. When push comes to shove, governments always bail out the financial institutions.

But even if the commitment were "real," in that we would let the institutions fail - we would have a disaster on our hands. All the financial community has to believe is that the government will break it's promise - it doesn't even matter if their expectation is correct. I think that no matter what commitment is made they are going to believe the promise will be broken. Once they believe it they will act just as recklessly and when the crash comes we have two choices. Either we bail them out. Or we let them fail and in my view Friedman-Schwartz make a persuasive case this was not too smart in the Great Depression. I also subscribe to Bernanke's research that the credit allocation process was grossly disrupted in the Great Depression due to bank failures, which led to prolonged damage. Bankers also know these theories and so would even be more inclined to believe that the bail out would be coming.

In an ideal world we could make that commitment so massive failure of the financial system wouldn't happen - but history is now set. History has placed us in a trap where the commitment is nearly impossible to make credible and when the crisis comes based on the lack of believe in that commitment we can either prove them correct and bail them out, or watch disaster unfold.

The only way of making the commitment truly credible, in my view, would be a constitutional amendment. Which would be impossible to get and I don't think we should lock ourselves into a particular type of economic policy anyway, sometimes flexibility is needed.

dWj writes:

Regulation is pro-cyclical because the electorate demands it. As recently as 3 years ago, deliberate tightening of mortgage leverage (whether by Fed regulation or by less avid promotion of Frannie and securitization) would have been decried as robbing the lower middle class of its opportunity to invest in real estate, which, of course, never goes down in value, and is therefore a clear path to wealth. I'd be willing to bet that, within a decade, it will again be racist not to require lax underwriting.

mark writes:

Given the political process, I think that a credible bar on bailouts would exist if Congress simply passed a bill saying that the Fed and the Treasury could not lend or otherwise inject funds into any private firm or purchase assets to provide liquidity without an independent appraisal and a 30 day period for notice and comment thereon. I am perplexed why no one has sponsored such a bill in lieu of the 1000+ page aircraft carriers that they have wonked up.

bjk writes:

The moral hazard argument doesn't make sense. None of these firms thought they would get bailed out, nor did they act as if they would ever need to be bailed out, nor did Bear Stearns or Lehman get bailed out. Morgan Stanley lost $9 billion, according to Michael Lewis, while making what they thought was a perfectly riskless trade. It's true that the money market funds got bailed out, but that's a different story. The investment banks weren't reckless, they were stupid. And you can't fix stupid.

floccina writes:

@bjk I think that the argument is that had likes of LTCM been allowed to fail, their stinking carcasses would have influenced bankers to be more cautious. Not sure that I buy it but it may be true.

DB writes:

The only way to have a truly time consistent system for banking regulation is to have a set of rules, procedures, and policies that you adhere to regardless of the state of the market. Regulations should not become lax simply because things are going well, because we have learned from past experience that when regulations get lax then things go wrong. We have to remember that the regulations were put in place for good reasons.

Another function of these regulations is to ensure that the market cycle can follow its normal course. If a firm cannot support itself due to poor business choices then it should not be kept in the market, supported by government money, in order to keep making bad choices, especially if such firms have a history of doing this. By allowing such firms to fail, it makes room for firms better suited to survive to come into the market.

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