Arnold Kling  

Financial Regulation Questions

Bank Regulation Boosts Payday ... Jacob Hacker Admits that Gover...

Both from readers.

1. Is it more dangerous for TARP to succeed or to fail?

Interesting question. Think of four possibilities, based on perceptions and reality

1. TARP is perceived as a success, and it really was a success.
2. TARP is perceived as a success, and it really was a failure.
3. TARP is perceived as a failure, and it really was a success.
4. TARP is perceived as a failure, and it really was a failure.

For me, the worst case scenario is (2). I also think that (3) would be bad, on principle, because I don't like living a lie. I could go back and forth on the others. The problem with (1) is that there would be an inclination to do it again, which in turn would mean that there would be an inclination to let too-big-to-fail banks grow out of control again. The problem with (4) is that failure is not good.

For what it's worth, I believe that the success or failure of TARP will be difficult to determine. Is the economy doing better than it would be otherwise? Who knows? How can one tell?

If I were pressed, I would be inclined to judge TARP as a failure. The original proposal was to fix a temporary liquidity crisis, by buying toxic assets. The fact that this was not even tried raises doubts about the soundness of the original concept. And the fact that TARP money was used to bail out GM reinforces those doubts. The notion that the economy as a whole needs certain institutions to be maintained is really ripe for a failure to discern the seen and the unseen.

2. On my idea of passing a law that would send financial executives to prison if they fail to preserve the soundness of their institutions, a readers writes, "The symbiosis between regulators and executives is so complete that you'd never be able to punish one and not the other."

I don't agree with this. Once a bank fails, it would be up to prosecutors to determine if the law should be applied. They are not the same as regulators. Only if the regulators were willing--and able--to rise to the defense of mismanaged banks would the symbiosis be an issue.

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COMMENTS (7 to date)

Why would we think the "toxic asset" problem was a liquidity problem? The toxic assets in question were always able to be bought and sold at some price. The real issue was who was going to take it in the neck. That question was answered by TARP.

I didn't catch your piece that recommended sending financial executives to jail for failing to preserve the soundness of their institutions. But even without reading the full piece, the very idea strikes me as rife with ambiguity.

Wouldn't the much simpler prescription of non-compulsion suffice? In other words, the only law we need is law that says one person may not compel another person, either by force or deceit. Can you think of a case where that simple prescription fails to do what need to be done?

joe cushing writes:

We don't need the threat of jail time to solve the problem. It wouldn't work anyway; the definition of the crime would be too vague and open to arbitrary interpretation. All we need is for rich private individuals to be major shareholders in banks. They will make sure the banks are run well. Right now, nobody is in chaerge of the CEOs, so they run wild. I believe the reason we don't have this type of ownership now is because it is not legal.

Prosecutor: "You knowingly bought triple-A mortgage securities that you knew full-well were worthless, just to satisfy capital requirements!"

Defendant: "Your honor. We checked with the SEC before doing it, and in fact so-and-so suggested the exact amount we would need to buy".

I'm not saying that it couldn't be done (to only punish the executive), but it would be quite unfair. It's a bit like the problem with corruption: do you only punish the briber and let the bribed politician go free?

michael writes:

I've seen you advocate jail time for execs a few times now. It strikes me as particularly illiberal.

Why not just give execs personal fiscal liability for the actions of their banks? I.e remove the legal protections given under US law to people who run corporations. Losing all your money and your home is still pretty bad. It also seems better matched with the crime.

Thomas Sewell writes:

If you are trying align incentives between executives, regulators and stock holders, perhaps require executives and regulators of large financial institutions to regularly purchase (or sell, depending on the agreement) long-term options on the stock of the regulated entity.

If the company continues just fine, then they can make a little profit. If the company goes bankrupt, they lose a bunch of money, along with the equity owners.

The keys here being that the options are long term and kept to term, so they always have a long time horizon, and they increase in value as the stock does, but they become worthless (or cost a lot of money) if something catastrophic happens.

Just don't ever give those same regulators the power to bail the company out in order to save their options.

Political Observer writes:


Of the scenarios that you list I would vote for nuber 4. I do not think the government should be in the business of using my hard earned money to relieve someone else of their bad decisions. Whenever government distorts the markets by this kind of intervention the more likely you will continue to have this kind of reckless behavior.

With regard to sending executives to prison for demonstrating bad judgement I would only support such actions if it feel equally upon government bureaucrats who are guilty of misapplying the laws or in any other way make bad decisions with my money.

Realistically however I don't think this is the way to instill prudent behavior. Instead I would take a more systems view of why this behavior exist and what should be done to provide the right incentives to get the behaviors you desire.

First off I think that how corporations are governed is a serious problem. Instead of looking for "marquee" names to signify some sort of legitimacy, a corporation should determine the number of board members it wishes to have and then go down the list of stockholders and fill the list starting with the largest owner. At least then you would have people on the board who really have something at stake - and a reason to protect that interst.

A second change would be to lift the limited liability that protects managers and directors from the results of their bad decisions. In cases where neglect or carelessness is proven, all of their assets can be attached to settle what ever damages were incured by the plantiffs. However I would be careful in expecting that whatever standards are used they are clear and articulated before the acts are litigated. (I have a serious problem with ambiguous legislation where one cannot determine a tort until after a jury has ruled.) I would also state that this needs to be a civil action. There is no value in the government being involved in these property disputes.

Daublin writes:

Jail is physical confinement. I think of it as mainly applicable to people who, if free, would be *physically* dangerous to others. I don't see why it would be a good idea to apply jail time to business crimes. At the very least it would be a strong disincentive for anyone to go into business, and that at a time in history where entrepreneurship is more important than ever.

For that matter, what kind of behavior by a banker would rise to the bar of criminally bad? The problems you've been writing about sound to me like errors of judgment, sure, but sabotage? How often has a bank exec actually watched their bank go down and been fine with it?

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